Why can't all banks be as safe from insolvency as the Bank of Canada?
I put a question on my final exam:
"What is a bank? Should banks have legally required minimum reserve ratios? What about 100% reserve ratios? Should banks have legally required minimum capital ratios? What about 100% capital ratios?"
I wanted the students to talk about illiquidity and insolvency. I only threw in the bits about 100% ratios to get them to think about trade-offs, by thinking about the two opposite extremes.
There is a long literature on banks with 100% reserve ratios. Forget that.
There is a literature on capital ratios. But sometimes it helps us get our thoughts clear by imagining an extreme case. What about banks with 100% capital ratios?
What would a bank with a 100% capital ratio look like?
I can think of two very different answers:
1. The bank has (say) $100 in chequable demand deposits on the liability side. And $200 in (say) loans on the asset side. So its net worth (shareholders' equity) is $100, and equal to 100% of its demand deposits. Basically, the shareholders give $100 to the bank in return for shares, and the bank lends out that $100, plus another $100, and creates $100 in demand deposits. But that bank (unlike the 100% reserve bank I told you to forget about) can still become insolvent. If its loan portfolio loses more than 50% of its value, that bank would become insolvent. It would need an infinite capital ratio to completely eliminate the risk of insolvency. (Or capital equal to 100% of its assets, which means it has no deposits at all, and isn't really a bank.)
2. The bank has $100 in loans, and $100 in chequable demand deposits, but those demand deposits are themselves shares in the bank. They do not have a fixed dollar redemption value. So if you want to say they are not really deposits, OK. But they are chequable. If you write a cheque for $20, the bank debits your chequing account by S shares, where S = $20 divided by the current price of shares. So the shares are not the medium of account (Bank of Canada currency remains the medium of account), but the shares can be used as a medium of exchange, provided those shares are "deposited" in the same bank whose shares they are.
That second 100% capital ratio bank cannot become insolvent, unless its loans lose 100% of their value. Because its own shares are its only liability.
There is a risk that cheques might bounce if the share price dropped too much in the short delay between looking up the share price to see what's in your account, writing the cheque, and the cheque clearing. But electronic debit cards could help resolve this problem, by shortening that delay.
(It's a bit like writing cheques on a closed-end mutual fund, where the mutual fund owns shares that are not themselves traded. I vaguely remember reading some monetary or finance economist writing about something like this. Was it Fischer Black? Or Fama? Both my memory and Googling skills have failed me. [Update: Bill Woolsey says "It's Fama. But Greenfield and Yeager's first pass at the BFH (for Black-Fama-Hall) emphasized purely mutual fund banking."])
[Just as an aside: what would happen if those banks bought put options on their own shares, to make their shares safer?? Do companies ever do that? It's too weird to think about.]
You can think of the Bank of Canada as a bank like that second case. Owning a $20 note is like owning 20 shares in the Bank of Canada. They are worth whatever the market thinks they are worth. Except they are non-voting shares. And they don't pay dividends. (They do pay dividends if you deposit them in your chequing account at the Bank of Canada, but only commercial banks and the government are allowed to do that). And the management turns over most of its profits from its loan portfolio to the government, the voting shareholder. The management issues new shares, and buys back old shares, to try to make capital gains on the shares stay at roughly minus 2% per year. In a worst case scenario, the Bank of Canada might fail to prevent the shares depreciating at only 2% per year. But the Bank of Canada can never go insolvent. Because it has a 100% capital ratio. Because its own shares are its only liability. It's a bank whose own shares are used as money.
Why can't all banks be as perfectly safe from insolvency as the Bank of Canada? They could be, if we imposed 100% required capital ratios on all banks, interpreted in that second sense.
(BTW, I didn't expect my students to give that answer.)
[Update: I now realise this post wasn't clear enough, so I am going to add this, from one of my comments below, to make it clearer how my 100% capital version 2 works:
Suppose I bank at BMO, and I have 100 BMO shares in my chequing account at BMO. The bank is like my stockbroker.
Suppose I write a cheque for $20 to buy a bike from someone who banks at TD. That cheque is an instruction to my bank to sell $20 worth of my BMO shares and transfer the cash proceeds to TD bank, which buys $20 worth of TD shares and deposits those shares in the bike seller's account.
Presumably other people who bank at TD are writing cheques to buy things from people who bank at BMO. So there is a central clearing house which is transferring reserves between banks (just like today), but is also buying and selling bank shares, just like the stock market does today.
If I want to withdraw $20 in currency from my account at BMO, the teller would give me $20, send an instruction to their broker to sell $20 worth of BMO shares on the stock market on my behalf, and debit my account the appropriate number of shares, depending on the current market price.
If the stock market were closed, because it's a weekend, so that the current price of BMO shares was not observable, BMO might need to impose a haircut on immediate withdrawals. You can only withdraw 80% of what is in your account based on Friday's share price, just in case BMO shares drop by 20% when the market reopens Monday morning. I think that is the only case where a delay comes in, and it's only a delay in withdrawing the full 100% of what is in your account.]
Worthwhile Canadian Initiative 
This doesn’t sound right, the monetary base is mostly backed by assets on the CB balance sheet. That’s not 100% capital.
I think you’re looking for the fiscal theory of the price level here, like Cochrane’s “Money as Stock” paper.
Adam P: suppose a company issued two sort of shares: voting and non-voting. And invested in government bonds. And suppose the management could discriminate between the dividends it pays to voting and non-voting shares. The management decides to pay no dividends to non-voting shares, and issues new non-voting shares, or buys back non-voting shares, whenever it feels like it. At the moment, the management says it will issue new non-voting shares, or buy back old non-voting shares, to ensure they depreciate at 2% per year. And it uses its assets (those government bonds) to finance share buybacks.
Are those government bonds capital that backs the non-voting shares? Yes and no. Because non-voting shareholders have very few rights (none at all, except what management chooses to give them).
This is like Cochrane’s Money as Stock, but it isn’t Fiscal Theory of the Price Level. (The book I’m vaguely remembering was older.)
Bank #2 is a CDO. No? Or more specifically, some kind of credit-fund, whose shares are linked to a CDO, and that is willing to redeem at any time rather than only in specific periods.
This is not what most people think of as ‘bank’. 🙂
I think the fundamental question you’re getting at is, what’s the best way to turn an illiquid asset into a liquid one? Banks are one answer, stock markets are another.
The problem with an open ended (you said closed end, but I think you meant open end) mutual fund that holds illiquid assets is, how do you price the shares? If the shares are mispriced, then you can have wealth transfers between shareholders. People who don’t want to be exploited will avoid such funds.
Rwcg: I don’t think its a Collateralised debt obligation. More like a mutual fund.
Max: I did mean “closed end” when I wrote that. Because shares in closed end mutual funds are themselves traded. But the bank would be free to increase or decrease the number of shares, to maximise profits, so it’s more like an open ended mutual fund in that sense. And it is unlike both an open-end fund and a closed end fund in that its assets will be very illiquid, so do not have an observable market price. Nobody knows for sure what a bank’s loan portfolio is worth, just like with the assets of any regular business corporation. Their shares are worth whatever the market thinks they are worth.
Yep, banks and stock markets are two ways to convert illiquid assets into liquid assets. This is like putting the two together.
Nick:
“what would happen if those banks bought put options on their own shares, to make their shares safer??”
It would be the opposite of the case where a bank holds calls on its own shares, and it would act to stabilize share values. Unfortunately, central banks hold bonds denominated in their own shares (i.e., their own money), which is like holding calls on your own shares, and acts to destabilize their money through an inflationary feedback effect.
But as you observed, a bank that has issued inconvertible money is immune to insolvency (and bank runs).
It’s a mutual fund whose assets amount to (explicitly or implicitly) exposing its shareholders to a CDO. Such things exist currently, as ‘total return credit funds’ and the like.
Mike: thanks for confirming what i suspected.
“Unfortunately, central banks hold bonds denominated in their own shares (i.e., their own money), which is like holding calls on your own shares, and acts to destabilize their money through an inflationary feedback effect.”
Hmm. I never thought of it that way. Plus deflationary positive feedback effect, in reverse.
It’s Fama.
But Greenfield and Yeager’s first pass at the BFH (for Black-Fama-Hall) emphasized purely mutual fund banking.
The first bank has a 50% capital ratio.
The second bank has a 100% capital ratio.
The ratio is capital to assets, right?
By the way, if the monetary instruments were like preferred stock, it could work more or less like a conventional bank except when earnings are negative.
Thanks Bill. I guessed you would know the answer. I have updated the post to add your comment.
Bill: “The ratio is capital to assets, right?”
I was wondering about that. I always assumed it was the ratio of capital to deposits, like the reserve ratio. But I wasn’t sure, which is why I hedged a bit at the end of my first example. If the capital ratio is small, it doesn’t matter much which way we define it. But it does matter at 100%.
I don’t see ad the end in the second case if it is a bank. Can it have a transformation function? – deposit into credit?
Miguel: sure. You take a $20 note to the bank, it credits your account with an equivalent number of shares, and makes a $20 loan. Just like a regular bank, except what you have in your account represents a certain number of shares rather than a certain number of dollars.
I’m now waiting for someone to jump in and say: “BUT LOANS CREATE DEPOSITS!!!!”
So let me forestall them. The bank makes a loan of $20 by crediting the borrower’s chequeing account with S shares in the bank, where S = $20/(share price), in return for the borrower’s IOU for $20.
Yep, that is possible too!
“Hmm. I never thought of it that way. Plus deflationary positive feedback effect, in reverse.”
I believe we talked about some of this stuff back in 2009:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/10/why-do-central-banks-have-assets.html
JP: I just re-read that old post, and all our discussions in comments. Yep. Your memory is good. Mine is failing.
“But those demand deposits are themselves shares in the bank” – you have described bitcoin here!
“Why can’t all banks be as perfectly safe from insolvency as the Bank of Canada” – here it is useful to distinguish between accounting insolvency and policy insolvency. BoC is safe from accounting insolvency, but is vulnerable to policy insolvency, and policy insolvency is what interests us.
Vaidas Urba: “policy insolvency is what interests us.”
What do you mean by policy insolvency? The Bank acts as though it were insolvent?
Min – policy insolvency means that the central bank is unable to achieve its policy objective unless it receives transfers from the government. Think Iceland (2008) or Zimbabwe.
Vaidas: If you destroyed the Bank of Canada, and all its assets, but left the fixed stock of currency in circulation, you would get Bitcoin.
The problem in Iceland was that the commercial banks went bust, and the central bank couldn’t bail them out.
The problem in Zimbabwe is that the government required the central bank to make transfers to the government that were bigger than the maximised present value of the central bank’s seigniorage profits.
Nick:
” If you destroyed the Bank of Canada, and all its assets, but left the fixed stock of currency in circulation, you would get Bitcoin.”
Like other dotcom companies, bitcoin has got plenty of assets – intellectual property, brand value, etc. And indeed markets value bitcoins similarly to dotcom shares. Fortunately, Bank of Canada has got plenty of intangibles too, as we should definitely include the present value of future seigniorage on the balance sheet. One year ago there was a serious debate in the UK about cancelling the QE debt – imagine the inflation UK would get in the absence of intangibles on the balance sheet.
Regarding Iceland, my guess that the policy insolvency has happened before the commercial banks went bust. The central bank was already policy insolvent in the summer of 2008 when the Krona crashed in the foreign exchange markets to a level incompatible with policy targets.
I agree that the fiscal policy is the reason why Reserve Bank of Zimbabwe became policy insolvent. It remains unclear if Reserve Bank of Zimbabwe is insolvent in the accounting sense – the latest balance sheet is dated 23 September 2005, with tiny but positive capital.
Policy insolvency is an extreme scenario, but fear of policy insolvency is an important factor that constrains central banks. Good examples are the Fed in 2008 and the ECB right now. Central banks do think that money is their liability. That’s why Bernanke has started tapering.
Nick,
“Basically, the shareholders give $100 to the bank in return for shares, and the bank lends out that $100, plus another $100, and creates $100 in demand deposits. But that bank (unlike the 100% reserve bank I told you to forget about) can still become insolvent. If its loan portfolio loses more than 50% of its value, that bank would become insolvent. It would need an infinite capital ratio to completely eliminate the risk of insolvency.”
A capital ratio does not diminish or eliminate the risk of insolvency. All that a capital ratio does is determine who partakes in that risk. Even if a bank was able to sell an infinite number of shares for a $1.00 each, there is still the possibility that those shares could become worthless.
The only way a bank (or any enterprise) avoids insolvency is to have assets that always have a higher future value than liabilities. The value of assets / liabilities can be market determined or can be legally determined.
Frank: “A capital ratio does not diminish or eliminate the risk of insolvency.”
That makes no sense at all. Insolvency means your assets aren’t worth enough for you to pay what you promised to pay. If your only promise is to pay a share of whatever your assets are worth, you cannot be insolvent.
Unless your reply has a very high quality/length ratio, let’s just leave it there.
Nick,
http://en.wikipedia.org/wiki/Insolvency
“Insolvency is the inability of a debtor to pay their debt. In many sources, the definition also includes the phrase or the state of having liabilities that exceed assets or some similar phrase.”
I have an asset – a house for example. I have a liability – a mortgage. I can be insolvent (house worth less than mortgage) even while I am current in my payments on my mortgage (making my promises to pay).
Likewise, the market value of a banks assets may be worth less than the market value of a banks liabilities EVEN IF the bank is current on all payments.
Because we are talking about a bank that has no debt (only shares), the first definition of insolvency does not apply (inability to pay debts) but the second definition still does.
“If your only promise is to pay a share of whatever your assets are worth, you cannot be insolvent.”
The value that the market is willing to pay for a bank’s assets may be less than the value that holders of that bank’s shareholders put on them.
Frank: that comment failed the ratio test badly. Stop now.
Frank’s point is better made by noting that it’s unrealistic for all liabilities to be in shares:
Assets = $100 loans
Liabilities = $150 regulatory fees; 100 shares
Share Value = $-0.5
Only BOC can insure that all its liabilities are in its own shares. (And for developing nations that might not even be true – given non-domestic payments/trade/etc).
How’s the ratio?
Squeeky: That might be a point worth making. But it’s not Frank’s point.
test
“1. The bank has (say) $100 in chequable demand deposits on the liability side. And $200 in (say) loans on the asset side. So its net worth (shareholders’ equity) is $100, and equal to 100% of its demand deposits. Basically, the shareholders give $100 to the bank in return for shares, and the bank lends out that $100, plus another $100, and creates $100 in demand deposits. But that bank (unlike the 100% reserve bank I told you to forget about) can still become insolvent. If its loan portfolio loses more than 50% of its value, that bank would become insolvent. It would need an infinite capital ratio to completely eliminate the risk of insolvency. (Or capital equal to 100% of its assets, which means it has no deposits at all, and isn’t really a bank.)”
I’m pretty sure the accounting people would say Bill Woolsey is correct. The capital ratio is capital to assets. Bank 1) has a capital ratio of 50%, not 100%. Bank 1) is not a 100% capital ratio example.
Let’s take that a step further.
There is 50% capital ratio/requirement for loans. All other assets have a 100% capital ratio/requirement. Start here.
A: $100 in reserves plus $200 computer loans
L: $200 in DD’s (fixed 1 to 1 convertible to currency)
E: $100
Pay back all the loans with no interest.
A: $100 in reserves plus $0 computer loans
L: $0 in DD’s
E: $100
Now the bank itself can only spend $100 for computers (not $200 that the loans allowed). Notice the $100 difference.
“2. The bank has $100 in loans, and $100 in chequable demand deposits, but those demand deposits are themselves shares in the bank.”
#1 For the bank 2) scenario, I don’t think the accounting can work that way.
A: $100 computer loans
L: $100 in DD’s
E: $0 in shares
Or
A: $100 computer loans
L: $0 in DD’s
E: $100 in shares
I think you are double counting. I am not guaranteeing that.
And, “They do not have a fixed dollar redemption value”.
#2 I assume that you mean DD’s/shares are not 1 to 1 convertible to currency. If so, I’m not accepting that as MOE. Sell whatever and bring me currency.
Comment in spam?
Nick,
Making banks insolvency-proof in your second sense is pretty much what’s advocated by Lawrence Kotlikoff, Positive Money and others. See respectively:
http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html
Click to access NEF-Southampton-Positive-Money-ICB-Submission.pdf
However, their system is better than yours for the following reason. Many people want to deposit $X somewhere and be 100% sure of getting $X back. Indeed, I think that’s a basic human right. Your system does not offer that, whereas a Kotlikoff / Positive Money system does. They do it by offering depositors a choice between two basic types of account. 1. 100% safe accounts where nothing is done with the relevant money (e.g. it could be deposited at the central bank), with depositors having instant access to their money (e.g. via checks). 2. Mutual funds, as per your suggestion. Access to money from mutual fund accounts is not instant, but like existing mutual funds, fund units can be sold, and cash obtained within a week or so. Banks would offer a range of funds for depositors to choose from: e.g. depositors could choose to put their money into safe mortgages, NINJA mortgages…etc etc.
Adam P,
You didn’t provide a link to Cochrane’s ideas on this subject (which are similar to Kotlikoff’s). There’s an article by Cochrane here:
http://www.hoover.org/news/daily-report/150171
Rwcg,
Re your point that a bank-like institution suggested in Nick’s second option is not what most people think of as a bank, you’re quite right: Lawrence Kotlikoff is quite open about the fact that he wants to destroy banks as we currently understand the word and set up entirely new institutions which perform some of the functions of banks and not others.
Capital adequacy ratios use risk weighted assets.
Credit Exposure Type Percentage Risk Weighting
Cash 0
Short term claims on governments 0
Long term claims on governments (> 1 year) 10
Claims on banks 20
Claims on public sector entities 20
Residential mortgages 50
All other credit exposures 100
This makes government bonds very attractive, and in the Euro zone, bonds of all Euro members are treated the same. You can see where this might create a problem.
Spanish banks, for instance held EUR235bn Spanish government bonds in August, equivalent to around 40% of the total stock.
http://www.spiegel.de/international/business/ecb-holds-back-controversal-bond-recommendations-a-935540.html
Nick, three somewhat related comments:
1. This post is not a post about monetary policy. Let’s examine the logical structure of the post. The key assumption is that central banks do not promise anything, i.e. central banks do not promise to achieve their policy goals. While the post is fine as it is, it would be a fallacy to argue that it has any consequences for monetary policy. Gustavo Adler, Pedro Castro, and Camilo E. Tovar have an IMF working paper “Does Central Bank Capital Matter for Monetary Policy?” that empirically examines central bank capital in a way that is relevant for monetary policy. Ulrich Bindseil, Andres Manzanares, Benedict Weller have a paper “The role of central bank capital revisited” that is more theoretical.
2. This post is about nominal solvency, but we should also care about the real solvency. 100% capital requirements protect against nominal solvency, but they do not protect us against adverse scenarios where the real capital of the financial system evaporates. It not obvious if a move to 100% capital requirements will reduce or increase the real risks.
3. While the real central banks have a capital buffer that protects their policy solvency and protects the real value of their monetary liabilities, bitcoin does not have such a buffer. And guess what – bitcoin is not used as a medium of account. Maybe the capital is what enables monetary liabilities to be used as a medium of account.
Nick: actually I think that banks already have something akin to #3 – that deposits are something akin to shares, or to be more precise that deposits are like bonds sold purchased from a bank. This is what basically happpened in Cyprus: it was not only shareholders but also people owning demand deposits that had to accept the “haircut”. Similar thing happened in Iceland where it was decided that deposit insurance does not apply to foreigners who lost a lot of money.
Ralph: Kotlikoff’s 1 sounds like 100% reserve banking.
I’m saying Kotilkoff’s 2 could be implemented without the one week (or whatever) delay. You don’t need to convert it into cash before writing a cheque.
Vaidas:
1. The regulation of financial institutions that produce money can be thought of as monetary policy, in a broader sense.
2. I think that is a key problem with my proposal. Banks wouldn’t go bust in a financial crisis, but the money supply would fall if the value of banks’ assets fell. Bank shares would be less risky than they are now, since banks would have zero debt, but they would still fluctuate in value.
JV: Yep. When a bank goes bust, with no deposit insurance, bank deposits end up being like bank shares. But those deposits get frozen while everything gets worked out. Plus depositors weren’t informed about the downside risk.
Nick, re (1) – the part of the post where central banks are discussed is not about monetary policy, but the part about commercial banks is.
Peter N: Yep. Looking down that list you posted reminds us how much of a joke those capital ratio regulations are. Plus, there’s the whole mark-to-market vs book value question.
Vaidas,
Re your second point (about risks run by banks), turning all bank creditors into loss absorbers ought to reduce risks run by banks. Reason is that if depositors stand to lose everything when a bank fails rather than depositors being bailed out by taxpayers, then depositor / loss absorbers will keep a keen eye on what banks do, and depositors will allocate their money to activities which suit the level of risk they want to run.
In contrast, where depositors want to run no risk at all, that option is available to them under the system advocated by Kotlikoff, Positive Money, etc (see by above comment).
But even if making all bank creditors loss absorbers DOESN’T reduce risks run by banks, the system still has advantages, as follows.
First taxpayers are absolved from any exposure, which in turn disposes of the TBTF subsidy (something that Dodd Frank and other regulators round the world have spectacularly failed to do).
Second, as Nick suggests, insolvency is impossible. And insolvency is a scenario where some entity owes $X to another entity which it cannot pay. And disposing of that possibility is an obvious plus.
Nick: yes, deposit protection is complicated but so is bankruptcy laws. In case of insolvency some creditors can have preferential claim on the remaining equity of a company, for instance in some countries it is social security debt, wages and some other classes of debt that are prioritized over regular loans/bonds or unpaid invoices for goods/services provided to insolvent company. So it is with a bank bankruptcy – especially too big to fail ones. Everybody can try to make claim on what is owed by the bank: from bank shareholders to bank employees or even owners who have their money deposited in bank on various types of accounts with various sums.
But all in all I think it is always good to think of a bank deposit as if it is a safe “colaterized debt obligation” where government shoulders some of the risk by absorbing the most risky “tranges” through deposit insurance. But there is no guarantee that this AAA type of security will not turn sour in a blink of an eye as people with their money in Cypriotic or Icelandic bank can attest.
Ralph: I think we are sort of on the same page here (for once!).
Getting rid of the risk of insolvent banks, and getting rid of TBTF, and bailouts, would be a big advantage.
I think we would see a spectrum of banks. At one extreme some people would want 100% reserve banks, and would get it. At the other extreme would be banks making lots of risky illiquid loans. And most would have a mix of assets, and be somewhere in between.
Take, for example, a Canadian bank, as it exists now, with its current assets.
Suppose we add together: the total market value of its shares, its bonds, and it’s deposits. Call it V, for the total value of the bank. How volatile would V be? Not very. The shares are the most volatile component of that list, and those shares are a small proportion of the total.
Under my proposal, even if banks had exactly the same assets as Canadian banks have right now, the volatility of the price of bank deposits would be the same as the volatility of V.
Ralph,
Look at bitcoin. No runs, no TBTF, insolvency is impossible. But the fluctuations of real value are enormous.
Vaidas: But Bitcoin doesn’t own any assets. Bitcoin is like Bank of Canada notes, if you froze the total quantity (roughly), and you didn’t have any idea how big Canada was going to be, if everybody in the whole world would become Canadian, or if Canada would disappear next week.
The overnight loan market between banks would be replaced by a market in which banks trade each other’s shares, rather like a forex market.
Nick: “I think we would see a spectrum of banks.”
There are ETFs listed on Toronto stock exchange for that. ZFS is virtually a 100% reserve bank, riskier alternatives are lisited too.
“Under my proposal, even if banks had exactly the same assets as Canadian banks have right now, the volatility of the price of bank deposits would be the same as the volatility of V.”
First we have to consider the liquidity of total V, which is much lower than liquidity of its deposits. We should substract a time-varying liquidity discount to get the value of V under your proposal.
George Selgin was thinking along similar lines to Nick’s “No.2” idea many years ago. In Selgin’s book “The Theory of Free Banking” (p.37) he says, “One way . . banks can prevent runs is . . . to link checkability to equity or mutual-fund type accounts . . . For a balance sheet without debt liabilities, insolvency is ruled out…” Selgin’s book is free online here:
http://cafehayek.com/2013/06/free-online-edition-of-george-selgins-theory-of-free-banking.html
Nick, bitcoin holds dotcom intangible assets, like Twitter or Facebook. To get a sense of volatility of V under your proposal, it makes sense to look at old economy, good example here:
finance.yahoo.com/q/bc?s=LQD&t=my&l=on&z=l&q=l&c=
But I’m afraid we will get the volatility of JNK instead of LQD.
The key issue – having different classes of liabilities increases the total liquidity of V. This effect is very strong.