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 
Frances,
Obviously a “Nick Rowe No.2” / Kotlikoff / Positive Money system would cause a substantial proportion of existing depositors to flee to the safety of “full reserve” accounts as Nick calls them (or “safe accounts” as I think Positive Money calls them). But I don’t agree that therefore there’d be a drastic shortage of funds for those wanting to borrow: reason is that ordinary people are quite happy to lend out or invest trillions in a way that quite clearly carries an element of risk: they invest trillions on the stock exchange, mutual funds, etc.
One consequence of the change would undoubtedly be that borrowers would pay more, but I’m not bothered because the change gets rid of a subsidy: the subsidy that banks enjoy. That is at the moment a bank can, 1, borrow $X from a depositor, 2, promise to return exactly $X, while 3, investing or lending on the money in a less than 100% safe way. That just doesn’t add up. Someone is carrying the ultimate risk there, and it’s the taxpayer!
I.e. the change would give us something nearer a genuine “subsidy free” free market.
Also, if you think giving banks the ability to create what is accepted as medium of exchange (deposits) is valuable, then you might justify the taxpayer backstopping it so that it actually works.
Nick,
Providing people of limited means with a safe place to put money and a secure payments transmission mechanism is perceived as a social good. It’s an economic good too, in my view. You really think going back to an economy that runs mostly on physical cash is an improvement?
You speak as if risk-aversion is unusual. I’ve had enough discussions with savers to know that it is not unusual – it is normal. So where are these 100% reserve banks that “always exist”? They don’t at the moment. We would have to create them. And then who would put money in your banks? Only people who were prepared to accept losses. High net worth individuals, in short.
Ralph,
“…they invest trillions on the stock exchange, mutual funds, etc.”
And so why would the average Joe on the street ever want to buy into the shares of an individual bank when there are more diversified means of investing available to him?
Ralph,
What Frank said. If investors are happy managing their own portfolios or paying professional managers to do it for them, why would they stop doing that and put their money in a bank?
Frances: we won’t get 100% reserve banks if the government will bail them out anyway.
With a 100% reserve bank, you can use cheques if you don’t like cash.
Whenever I hear the words “social good”, I reach for my Browning!
Look at Ireland, for one example. The taxpayers on the hook for God knows what % of GDP, to bail out the bank depositors. Not to mention the government spending cuts. Was that a “social good”? Did that make the average person’s well-being safer?
Nick,
100% reserve banks are by definition entirely guaranteed by government, because reserves are government-guaranteed safe assets. Whether you guarantee deposits in a lending bank, or provide 100% reserves for a savings bank, you accept the demand of the risk-averse that government should guarantee the safety of their money. You could equally provide sufficient reserves to a lending bank to back all deposits (ring-fenced, of course). There is no difference. What you are not doing is forcing people to take risk – which is what your original proposal involved.
Suppose that all risk-averse depositors moved their funds to 100% reserve banks. As that is most depositors, that would create a sizeable funding gap. If you want to move to an equity-funded model, you would issue lots of shares to close it. If risk-tolerant depositors bought those shares, risk lending to the wider economy could continue as before. But why would they do that? As Frank said, their money is already tied up in other investments. Of course, you might find that speculative investors buy in. But hedge funds and the like don’t make deposits. They buy shares. What you would end up with would not be a bank in any normal sense – it would be a pure own-equity lender.
But if the risk-tolerant and/or speculative investors did not provide sufficient share capital to compensate for the loss of the deposits of the risk-averse, then either there would be a fall in bank lending, or government would have to underwrite the capital shortage – which would mean part-nationalization. If the government did not wish to contribute an equity stake, then it could find some way of replacing the lost lending, perhaps by recycling the lost deposits back into the economy via something like a state investment bank. If it contributed neither an equity stake in lending banks nor a state lending scheme, then there would be a credit crunch and a fall in broad money. Positive Money suggest that this could be offset by increased monetary base spent directly into the economy. I have a bit of a problem with this because I think central banks’ forecasting skills are so awful that they would be almost certain to misjudge the quantity of money required and therefore lose control of inflation. But at least Positive Money have thought about it.
Nick, the capitalisation and funding of banks is a can of worms. And it has been extensively discussed by all sorts of people ever since Lehman. Even the IMF had a go at it with their Chicago Plan Revisited paper – have you read that?
The institutional combination of 100 per cent reserve banks and 100 per cent capital banks reminds me a bit of the Chicago Plan.
Except Nick has added the wrinkle that the capital banks offer a medium of exchange facility embedded in the capital structure.
So it looks like the Chicago Plan – but with competing medium of exchange facilities, perhaps.
Which is probably not necessary and probably not workable.
(As if the Chicago Plan is workable in the first place)
JKH, how nice to encounter you here! Yes, Nick’s idea looks very like the Chicago Plan. Plus ca change.
JKH, could you check my comment at December 30, 2013 at 01:21 AM? Thanks!
Let me try this explanation of what Nick is saying.
Someone wants a loan from the bank he is describing.
The bank creates a new DD. The person creates a new loan. The bank exchanges the DD for the loan. The bank then forces the person to buy new equity canceling the DD.
Now the person either has to sell the equity for currency or convince someone to exchange the equity for something.
Thoughts?
“But the Bank of Canada can never go insolvent. Because it has a 100% capital ratio.”
JKH, the Bank of Canada does not have a 100% capital ratio, right?
“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.”
I disagree that Bank of Canada currency is medium of account (MOA). As long as demand deposits have a fixed 1 to 1 conversion (relative pricing), I’d say MOA = currency and demand deposits. Also, currency and demand deposits = medium of exchange (MOE).
Once the demand deposits are converted to shares without a fixed 1 to 1 conversion (relative pricing), they stop being MOA. I doubt if they are MOE either.
“Unlike a bank with only 10% capital, where a 10% drop in the value of its assets means it is bust.”
I don’t believe bust is the best way to describe that. It is about losses. Assume a 20% drop in assets with 10% capital and then 100% capital. With 10% capital, the shareholders should lose everything. Next, the depositors should lose evenly. With 100% capital, everyone is a shareholder (or everyone is a depositholder). The losses should be spread evenly.
You seem worried about bank runs and insolvency. I’d say the big picture is more about the loss of 1 to 1 convertibility between currency and demand deposits.
Comment in spam?
Nick is right to mention the Modigliani Miller theory which basically says that altering capital ratios has little or no effect on bank funding costs. However, I have a slight quibble with Nick’s claim that taxpayers shouldn’t have to “subsidise someone’s desire for absolute safety+liquidity in a chequing account”.
Strikes me that the most suitable accounts for checking (and indeed instant access to cash, e.g. via ATMs) are those 100% reserve accounts. Indeed that is Kotlikoff and Positive Money policy, I’m pretty sure.
In contrast, what taxpayers should not have to “subsidise” is depositors’ desire to have their cake and eat it: that is, depositors’ desire have their money invested or loaned on (so they can earn interest) while being excused the normal risks involved in investment. Thus where a depositor wants interest, they should be told: “put your money into a mutual fund of your choice, or invest your money some other way”.
ATR,
What you’re advocating is the use of taxpayers’ money to make assets that are inherently not very liquid a bit more liquid so as to achieve “enough liquidity in money markets” as you put it. My answer to that is that I strongly object to any taxpayer funded subsidy unless there are VERY CLEAR reasons for the subsidy. And I don’t see any clear reasons in this case.
In particular, under a Kotlikoff / Positive Money regime, private sector entities are free to satisfy their desire for liquidity by keeping as much money as they want in their “100% reserve” accounts, as Nick calls them (or “safe accounts” as Positive Money calls them).
If some private sector entity fails to keep the right proportion of its assets in the form of cash, that’s their fault. There’s no reason for taxpayers to rescue them.
This comment answers some recent questions above in chronological order.
ATR,
You say, “if you think giving banks the ability to create what is accepted as medium of exchange (deposits) is valuable, then you might justify the taxpayer backstopping it so that it actually works.”
That’s like saying “if you think cars are valuable, taxpayers should back car manufacturers”. I suggest that if some private sector entity thinks it can provide us with something we want, and without the help of government subsidies, then fine. But if customers aren’t prepared to pay the full costs of the product, then that entity needs to go back to the drawing board, or go out of business.
Moreover, there’s an alternative to privately produced money: central bank produced money. And the latter is inherently cheaper to produce. That’s because a private bank has to get collateral off those it lends to, check up on the value of that collateral, etc etc. The costs of doing that are significant. (Positive Money actually advocates a total ban on privately produced money, with central bank money taking it’s place.) And if you want to know why private banks manage to create money despite their system being inherently more expensive than central bank’s system, I can answer that.
Frances,
You suggest (December 31, 2013 at 02:58 PM) that a Nick No.2 / Kotlikoff regime bars people from having a “a safe place to put money and a secure payments transmission mechanism”. I don’t see where you get that idea from. Certainly under the regimes advocated by Kotlikoff and Positive Money, depositors are explicitly given the option of 100% safe 100% reserve accounts which they can use for “transmission” purposes.
Next, you ask: “So where are these 100% reserve banks that “always exist”? They don’t at the moment.”. In the UK there is an absolutely HUGE 100% reserve bank. It has absorbed £100bn of savers’ money. It’s National Savings and Investments. It has 20 million customers: a third the entire UK population. Admittedly NSI’s main asset is government debt rather than base money, but base money and govt debt are very similar.
Frank Restly,
You ask, “why would the average Joe on the street ever want to buy into the shares of an individual bank when there are more diversified means of investing available to him?” The answer is that under a Kotlikoff or Positive Money regime, the main option offered to Joe is not buying shares in a bank: Joe is given the option of having his money kept in a 100% safe / full reserve manner, or he can invest in a mutual fund of his choice and run by the bank. But of course Joe is free to ignore the bank’s mutual funds and opt for some entirely different investment.
And that pretty much answers Frances’s question just after your comment.
Frances,
Re your longish comment (December 31, 2013 at 04:04 PM), your first paragraph seems to advocate a system under which private banks are forced to hold a sufficiently large stock of reserves that failure is very unlikely. My answer to that is that those reserves are effectively the property of bank shareholders, thus you are effectively advocating a big rise in capital requirements.
Certainly raising capital ratios from the current ridiculous 3% or so the 25% or so advocated by Martin Wolf and others would be a big improvement. And I accept that one doesn’t get a big further improvement in safety by going from 25% to 100%. But I suggest that if taxpayer exposure is to be completely and totally ruled out, the ratio needs to be 100%.
Re your 2nd paragraph and your claim that “What you would end up with would not be a bank in any normal sense..”, you are quite right. That is, the mutual fund accounts in banks are (as Frank rather suggested) no different to conventional mutual funds. That’s why Matthew Klein’s article on Kotlikoff’s ideas was entitled “The best way to save banking is to kill it”. That is, Kotlikoff and Positive Money’s proposals essentially involve destroying the existing banking system and setting up something entirely different. Klein’s article is here:
http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html
In your 3rd paragraph, you say “if the risk-tolerant investors did not provide sufficient share capital to compensate for the loss of the deposits of the risk-averse, then . . there would be a fall in bank lending..” Quite right. In fact I’d go further: bank lending would definitely fall, and the effect would be deflationary.
But Positive Money has a simple solution to that: counteract the deflationary effect by creating and spending central bank money into the economy. Moreover, as PM rightly points out, central bank money is “debt free”, to use their phraseology.
So the net effect is that the private sector has more money, and thus doesn’t need to borrow so much from banks. I.e. private debt declines, and given the huge increase in private debts over the last ten years, is that a bad thing?
JKH and Too Much Fed,
Yes, Nick’s No.2 idea and Kotlikoff’s ideas are similar to the Chicago Plan. Re JKH’s claim that these sort of proposals are not “workable”, any particular reasons for that claim?
TMF:
There’s no double counting. Think of it as a single new financial instrument: “DD Capital”
I think Nick is viewing capital for a central bank in quite a different theoretical sense separate from the legal institutional definition.
Happy New Year all!
Rescued TMF and JKH from spam.
JKH: “Which is probably not necessary and probably not workable.”
100% capital ratios are very probably overkill, so not strictly necessary. But what’s the downside?
And why isn’t it workable? Suppose my stockbroker works for TD, and I own shares in TD. And I need to pay Harry $1,000 for the car I want to buy from him. I phone my stockbroker and say “Sell $1,000 worth of my TD shares, and give Harry $1,000”.
Frances: “Suppose that all risk-averse depositors moved their funds to 100% reserve banks. As that is most depositors, that would create a sizeable funding gap”
Assume you are right about depositors being so risk-averse.
It is not a funding gap. It is a risk-bearing gap.
Right now, it is taxpayers who are providing the insurance to take the downside risk to bank lending. Look what happens when things go bad. Iceland, Ireland, etc. (And we still may not have seen the worst of it). It’s time for taxpayers to revolt against banks. Banks destroy whole countries, by making promises they can’t deliver, to idiots who demand that their risky investments be absolutely safe, and expecting the taxpayer to pick up the tab when things go bad.
If banks won’t reform, let’s destroy them. This rather conservative economist wants to join the mob with pitchforks.
By “not workable”, I was referring to the Chicago Plan in general and specifically to the case of the IMF version. I’ll have to get back on that.
Generally, relating to Nick’s idea in this post specifically:
Just on an accounting feature first: the entire balance sheet should be marked to market for accounting purposes – so that the aggregate checking liability (which is based on the market value of the capital) corresponds as much as possible to the aggregate asset value (which is based on a sum of asset market values). Even then, there would be an accounting “slush” since it would be virtually impossible for those two valuations to be perfectly matched up in real time. That accounting plug difference amounts to some weird liquidity/capital risk amount, but is probably obsolete as quickly as it gets recorded, due to market value volatility on both sides of the balance sheet. The stock market’s valuation is never quite the same as the internal valuation of the sum of the pieces of the rest of the balance sheet.
More substantially, regarding risk: the checking feature has a fundamentally negative impact on the quality of bank capital. It is completely at odds with the usual purpose of capital, which is to be available to cover losses. One of the most important characteristics of qualifying capital is that it be permanent – with the intended exception that it should be available to be used to cover losses. But a checkable feature introduces liquidity risk to the institution in respect of a funding position that is normally considered to mitigate liquidity risk – because it usually has no maturity or liquidity obligation. The idea is that the bank not be under pressure to sell assets in order to repay capital funding for liquidity purposes. The capital needs to be there for book loss purposes, without the additional pressure of forced asset sales. Forced asset sales expose the bank to additional deterioration in asset value, with a self-feeding dynamic in the deterioration of capital adequacy.
Thus, checkable capital exposes the bank to liquidity risk on its capital funding, which is a non-starter for normal capital qualification. For example, those liquidity risk differences in the design of capital instruments become very important in the differentiation of tier 1 and tier 2 capital and the qualification for tier 2 capital versus non-capital funding. The bank doesn’t want to be short embedded put options in the capital structure (nor do its regulators want that). Checkable capital is a short put option exposure.
From a liquidity risk management perspective, normal capital funding improves the liquidity position of the bank – just like extension of term on demand deposits to time deposits. Turning that liquidity risk characteristic upside down becomes problematic for capital adequacy purposes. It is possible to experience a liquidity run on checkable capital. The fact that the bank can’t become “insolvent” doesn’t mean there can’t be a run with this sort of capital design. And that also depends on how you define insolvency exactly. You might (re)define it in terms of forced shutdown of the bank. And because there is no guarantee that the bank can sell assets quickly enough to meet a bank run, there would have to be a “capitalizer of last resort” – a central bank that was willing to lend capital – due to liquidity risk on capital funding, which would be quite pronounced due to the checkable feature. And a central bank capitalizer of last resort could end up holding the bag in terms of deteriorating asset value if the bank couldn’t liquidate assets quickly enough to satisfy exiting check writers – not dissimilar to the US financial crisis run dynamics on Bear and Lehman. That could force a shutdown and a declaration of insolvency of a sort.
“Remember the Modigliani Miller Theorem. The cost of financing is independent of debt/equity ratios. The MM is false, of course, because it ignores liquidity and bankruptcy. But by eliminating bankruptcy, and by making bank shares as liquid as deposits, that suggests that financing costs should fall.”
The design of checkable capital makes that capital extremely illiquid from a bank asset-liability management perspective (i.e. liquidity risk from the perspective of the share issuer – not the shareholder). Normal shares are liquid to the holder as a result of a market place that is created for that purpose – not because the holder has a put option back to the issuer. The checking put option is fundamentally capital unfriendly because it is potentially detrimental to the capital adequacy of the bank.
Capital depositors will know this. That can increase the risk of a bank run – especially in periods of quickly deteriorating bank asset value – like the financial crisis – where in this case a capitalizer of last resort may suddenly have to absorb that equity risk because everybody else is getting out. And the fact that speculators may be willing to come in at near zero isn’t going to provide the central bank with much comfort in that regard. So the MM implication is not clear, IMO, because the equity characteristic has been so distorted by the unusual capital liquidity risk characteristic.
The big problem in analyzing all this is to assess the liquidity characteristic of the capital instrument and what that means for effective risk to the institution and then to the capital holder as ultimate feedback.
JKH: “The stock market’s valuation is never quite the same as the internal valuation of the sum of the pieces of the rest of the balance sheet.”
Sure. The stock market’s valuation of bank stocks will never agree with the accountant’s measure of the value of those stocks. That is true for any stock. So what? I send a letter (a cheque) to my broker, who works for TD, telling him to sell $1,000 worth of my TD stocks on the stock market, and transfer $1,000 to Harry’s account.
“The capital needs to be there for book loss purposes, without the additional pressure of forced asset sales.”
There are no forced asset sales. If I sell my TD shares someone else buys them. The market price of TD shares may fall, but that does not force TD to sell its assets. People sell TD shares the whole time. The only difference here is that I can buy cars with my TD shares; I can sell TD shares for cars, and not just Bank of Canada notes.
“Thus, checkable capital exposes the bank to liquidity risk on its capital funding, which is a non-starter for normal capital qualification.”
No it doesn’t. If TD shares became more liquid (more like money) that does not expose TD to more liquidity risk.
“Normal shares are liquid to the holder as a result of a market place that is created for that purpose – not because the holder has a put option back to the issuer.”
There is no put option back to the issuer. If you want to sell your TD shares to withdraw currency from your TD chequing account, TD does not buy your TD shares; it sells them on the stock market on your behalf. TD is your broker.
“The bank has $100 in loans, and $100 in chequable demand deposits, but those demand deposits are themselves shares in the bank.”
Nick, is that what we’re discussing or not?
Here’s the simplest way to think about it.
I start a company. I sell shares in Nick’s Loan Company, and lend out the proceeds. The shares in NLC are traded on the TSX.
Some of the shareholders deposit their shares with me, for safekeeping. I keep a record of who owns how many shares.
Suppose both Fred and Harry have deposited NLC shares with me. And Fred wants to buy Harry’s car for $1,000. Fred sends me an email, telling me he wants to pay Harry $1,000. I check the current stock price of NLC on the TSX, and transfer $1,000 worth of NLC shares from Fred’s account to Harry’s account.
Suppose Fred wants $1,000 cash. I sell $1,000 worth of NLC shares on the TSX, deduct that number of shares from Fred’s account, and give Fred $1,000 cash.
Now suppose Sue starts up Sue’s Loan Company, and does the same as Nick. Sometimes Nick’s clients buy cars from Sue’s clients, and sometimes vice versa. Nick and Sue start a clearing house, so they only need to use the TSX for the net balance.
We have a banking system.
JKH: It’s my sentence immediately after the bit you quoted that matters: “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.“
This is silly.
I can’t invest my time in a discussion where I’m short an option to change the basic institutional framework that started the discussion.
There is a discussion in the US about moving some money market funds to floating NAVs. Floating NAV is equivalent to 100% capital. Read this and you’ll see how hard it is to get any reform:
https://www.fidelity.com/mutual-funds/news-analysis/money-market-funds-statement
JKH: you did not understand the basic institutional framework that started the discussion. Maybe because I did not explain it clearly enough? Whatever.
Vaidas: interesting. Sort of supports Frances’ point. They do really like that fixed nominal NAV. It looks like money illusion to me.
Nick: it is the illusion of safety. Floating NAVs would be very stable for such funds. Reminds me of people who buy extended warranties for their microvawe ovens.
MMF industry fears that an occasional flash crash with floating NAVs will scare people away from their product.
Vaidas,
Had a quick look at that Fidelity article. Fidelity, as operators of money market funds are not exactly impartial, any more than Lloyd Bankfiend is impartial. Both want the freedom to 1, attract money by making an attractive promise to depositors, namely that depositors will get $X back for every $X deposited, 2 freedom to invest in a less than 100% way, and 3, have the taxpayer pick up the tab when that doesn’t work.
As to the idea that a floating net asset value (NAV) is a big problem, conventional mutual funds cope with NAV no problem, as indeed does every corporation quoted on the stock exchange.
Re the fact that floating NAVs would scare some people away from the product: yes of course some people would be scared away. But I answered that point above. The answer is that the “scaring away” would certainly have a deflationary effect: i.e. all else equal, unemployment would rise. But that’s easily dealt with by have the government / central bank create money and spend it into the economy. That way everyone (including the municipalities which Fidelity lends to) would have more money, and thus wouldn’t need to borrow so much.
Ralph, I support the floating NAVs. Link does not equal endorsement.
“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.”
“I start a company. I sell shares in Nick’s Loan Company, and lend out the proceeds. The shares in NLC are traded on the TSX.”
Sell shares.
Assets – $1,000 in currency
Liabilities – $0
Equity – $1,000
Make $1,000 loan and swap.
Assets – $1,000 in loans
Liabilities – $0
Equity – $1,000
If person wants demand deposits.
Assets – $1,000 in currency plus $1,000 in loans
Liabilities – $1,000 in demand deposits
Equity – $1,000
No problem.
Someone else walks in and wants $1,000 in loans. Are you going to tell the person you have to wait for Nick’s loan company to sell more equity?
If there is a 100% capital requirement, I don’t see the need to suspend the fixed 1 to 1 conversion of demand deposits to currency.
Comment in spam?
Why does the spam filter block me whenever I post about assets, liabilities, and equity?
[I don’t know. Sorry. But I fished it out. NR]
Nick,
“There is no put option back to the issuer. If you want to sell your TD shares to withdraw currency from your TD chequing account, TD does not buy your TD shares; it sells them on the stock market on your behalf. TD is your broker.”
What precludes share dilution by the issuer? Obviously, if all shares were voting shares then the stakeholders would have some control over new share issuance, but if all shares are nonvoting, then isn’t this scenario ripe for fraud?
Ralph,
“But that’s easily dealt with by have the government / central bank create money and spend it into the economy.” You go on to reference the phrase “The best way to fix banking is to kill it”. But your solution seems to render banks irrelevant and unnecessary making this exercise a waste of time. There would be no need for banks as credit intermediaries or safe place to store liquid assets. If you happen to lose $10,000 because you dropped your wallet, then just have the government / central bank give you a replacement $10,000. If you happen to lose your job paying $40,000 a year, then just have the government / central bank give you $40,000 a year.
Also, I asked and wasn’t given a response to the issue of whether deposits as equity shares would be voting shares and thus have some measure of control over the board of directors and investment committee for a bank. Frances wrote that the big “halls of power” newspaper headline would be “FAT CATS WALK AWAY WITH MILLIONS WHILE GRANNIES LOSE OUT”. I think the newspaper headline that would shake the foundations of power would be “GRANNIES BINGO CLUB TO SERVE AS NEW BOARD OF DIRECTORS”.
You and Nick have laid out the case for the taxpayer very well. In fact your “just have the central bank print money” precludes the need for taxpayers all together. But you haven’t made a compelling case for the investor / depositor.
JKH said: “TMF:
There’s no double counting. Think of it as a single new financial instrument: “DD Capital””
I’m still thinking there are two financial instruments involved there.
And, “I think Nick is viewing capital for a central bank in quite a different theoretical sense separate from the legal institutional definition.”
I seem to remember reading somewhere that central banks have very little capital compared to their assets.
ralph at 5:25 a.m., I’m not sure what you are asking.
Historical note:
From the 1840’s to the 1970’s, there was in Canada a type of safe banks: the Quebec Savings Bank. They offered chequing and savings accounts. Their only permissible assets were government bonds. Their customer base was limited to a single city or judicial district.
Only two were chartered:
1) the Banque d’épargne de la Cité et du District de Montréal-Montreal City and District Savings Bank was founded in 1846 and obtained a federal charter in 1871. It became a Schedule 2 bank in 1965 and renamed Banque Laurentienne in 1987.
http://fr.wikipedia.org/wiki/Banque_Laurentienne
2) the Caisse d’épargne Notre-Dame de Québec. Founded in 1848, it became the federally chartered Banque d’économie de Québec in 1870. In 1968, it was bought by the Mouvement Desjardins so that it would have direct access to the clearing system ( at the time credit unions were not admitted into the system and had to clear the cheques through a bank) and renamed Banque Populaire. In 1970, it was merged into Banque Provinciale which merged with Banque Canadienne Nationale in 1979 to form Banque Nationale.
http://www.nbc.ca/bnc/cda/content/0,2662,divId-2_langId-1_navCode-10683,00.html
They were known for their solidity. But of course they missed the great prosperity of the Golden Thirties as they could not profit from the mortgage and consumer finance expansion.
OK, Nick.
Now I think I understand what you’re saying.
(BTW, I think Frances initially had the same reaction to the post as I did. Otherwise, neither of us would have started to talk about bank runs. The idea of a bank run is pretty much irrelevant here, as you’ve said, but it’s an easy mistake for somebody to make who knows banking, just reading your post.)
The key to understanding the setup as you envisage it is your comment @ December 31 6:10 a.m.
That’s the explanation that should have been in the post, IMO.
That said, I think the post is misleading relative to that comment, and that there is a conflict of description between your December 31 6:10 a.m. and what is in the post.
To illustrate that, let me do just a little accounting (please don’t scream) for what I think corresponds to the type of transaction that you describe in your December 31, 6:10 a.m. comment:
(I’m thinking that if you make it through all this that you may actually agree with it, and also see my point about how one could get confused by what’s in your post versus what’s in your comment)
So:
Somebody writes a check on his BMO share account
BMO sells those shares on behalf of its client
BMO debits (reduce) check writer’s ownership of shares
BMO credits (increases) share buyer’s ownership of shares
This is just a book transaction in the share records for the bank
It does nothing to change the bank’s capital position
Also:
BMO credits the check writer with funds from the proceeds of the sale
BMO will get credit in its reserve account for the same transaction, assuming the share buyer banks elsewhere
BMO instantaneously debits the check writer for those same funds to cover the cheque
BMO also pays reserves to TD to cover the cheque clearing
So at the end of all that, BMO’s balance sheet is exactly the same
No change
No potential for a “run” on BMO liquidity
At the other end, TD gets a reserve credit and credits the check receiver’s account with TD shares
That actually expands TD’s balance sheet
But somewhere in the system, the original buyer of the check writer’s shares has been debited for money funds at some sort of bank, which involves a balance sheet contraction – THAT probably depends on the interface between your system and a system that does offer “permanent” demand deposit accounts for money balances.
(This sort of reconciliation was a problem I had (and I think Frances did as well) in analyzing the IMF Chicago Plan proposal from the perspective of coherent institutional arrangements.)
Anyway, that’s all too complicated but somehow the various system balance sheets all get resolved. It’s a side issue for purposes here.
The relevant point here is that the cheque is not written on the capital account as is suggested in your post. The cheque is written on money funds that come from the sale of a client’s shares. And therefore this is not a checkable capital account.
And we know this because the cheque is not actually moving capital from one bank to another – because BMO’s capital position remains unchanged as the result of a share sale transaction that is quite separate from the chequing transaction.
So therefore I think to call it a single demand-capital checking account as you did in the post is somewhat misleading.
Moreover, in a way there’s nothing new here in terms of this “checkable” feature. You can accomplish exactly the same thing in the real world as what you described in the comments, using a checkable deposit account at BMO that never has any money in it overnight but is just used to cover checks written by selling stock. It’s just an administrative arrangement with your broker. In other words, there’s nothing unique in that arrangement that reflects a “checkable demand deposit-capital” account that is different from that which can be constructed in the case of a normal bank.
You are selling shares and getting money for them and somehow making sure that money covers a check you have written. It amounts to the same thing as what can be accomplished through normal accounts with the right administrative set up. You’re simply funding your checking writing by selling stock, through a particular administrative arrangement that can be set up in the real world to replicate what you’ve designed in your counterfactual world. So there’s nothing really new there in that arrangement.
You said in your comment:
“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…. 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.”
What you are describing is the operation of a broker custody account for holding bank shares – not a deposit account that appears on the bank’s balance sheet.
You know what’s next, but to summarize:
What is on-balance sheet is the actual equity capital position that corresponds to the original issuance of BMO shares. I.e., if you own actual BMO shares, those shares correspond to a balance sheet “liability” in the sense that they were originally issued by the bank, and appear on the right hand side of the balance sheet as a balance sheet item. I.e. they are on the same side of the balance sheet as normal non-equity deposit liabilities. The capital they originally contributed when issued is recorded on balance sheet at original book value (the amount of money originally received in exchange for the shares when they were issued), plus their share of any retained earnings since then. Since that original issue point, they have been traded around in the market at some price that isn’t necessarily the same as the original issue price – due to the effect on book value of retained earnings and the effect of other aspects of market valuation. Simply put, there is a difference between the balance sheet capital value that corresponds to those shares, versus the actual shares and their value as they trade in the market and move around various broker custody accounts.
So, the medium of exchange for the cheque that is written is IN GENERAL is not BMO shares. This was another confusing point in your post – because you refer to them as the medium of exchange, but that only works arguably if the cheque recipient also banks at BMO, which is an exception to the rule. In the normal course, you have instructed that the shares be sold for some other form of currency and it is the latter that covers the checking obligation – not the shares themselves.
So the transaction as you describe it above does nothing to change the balance sheet position of BMO with respect to shares they have issued and the corresponding capital that appears on the books. Nothing. It involves a transfer of ownership of shares between two counterparties to a sell and a buy – but that is not the same as the transfer of funds in the checking transaction, because the counterparty pairs are different for the two transactions.
P.S.
The checking facility transfers liquidity from share seller to cheque recipient, who then uses that liquidity to acquire TD shares – MAYBE – because you still need another banking system to allow the issuance of money deposits of more than momentary duration – and that system must allow for transfers from and to your system. This is what was confusing about the IMF paper – how exactly that happens in terms of the clearing system interconnections.
JKH,
Nice analysis.
I like the point about what exactly the medium of exchange is here. I think this ambiguity exists to a certain extent within existing banking arrangements, but this scenario brings it out more clearly.
Actually, I think Nick should have left out the medium of exchange stuff here, as it rather distracts from the question of 100% capital funded loan books.
Thanks JKH: “The key to understanding the setup as you envisage it is your comment @ December 31 6:10 a.m.
That’s the explanation that should have been in the post, IMO.”
I have updated the post to put that bit in. If both you and Frances misunderstood me, it clearly wasn’t clear enough. That economics vs Finance/banking/whatever communication problem again.
JKH: “So, the medium of exchange for the cheque that is written is IN GENERAL is not BMO shares. This was another confusing point in your post – because you refer to them as the medium of exchange, but that only works arguably if the cheque recipient also banks at BMO, which is an exception to the rule. In the normal course, you have instructed that the shares be sold for some other form of currency and it is the latter that covers the checking obligation – not the shares themselves.”
I think I am following you here. This is a bit of an aside from the main point of my post, but it interests me theoretically, so I’m going to talk about it.
Start with an economy with currency as the only medium of exchange.
Now introduce one regular bank. Just like today’s banks, but there is only one bank. And it is a SMALL bank. Call it SB for Small Bank. 99% of the people use currency. Only 1% of the population banks there.
I would say that chequable demand deposits at SB are not medium of exchange. Because 99% of the time, if I pay for anything by cheque, the recipient of the cheque takes that cheque to SB and withdraws currency. It is more like a credit card, which just postpones payment in some ultimate medium of exchange.
If Small Bank becomes a single Big Bank, and 99% of the population bank there, then demand deposits at BB are medium of exchange, because 99% of the time no currency is needed.
If Small Bank is joined by lots of other small banks, that have a central clearing house, and 99% of the people have chequing accounts, then demand deposits at all the SB’s are medium of exchange, because 99% of the time no currency is needed, because net transactions between banks are much smaller than the gross transactions, because so many cancel at the end of each day.
Back to my post: if all banks are like my 100% capital version 2 banks, and if they have a central clearing house, and if at the end of each day the net settlements between them are “small” relative to gross transfers of funds, then I want to say that shares in those banks are medium of exchange, just like bank monies today are medium of exchange.
(There is some fuzziness here: what does “small” mean? why one “day”? But I think that fuzziness is the same as the fuzziness in calling regular DDs “medium of exchange” in the current system.)
Nick Edmonds: “I like the point about what exactly the medium of exchange is here. I think this ambiguity exists to a certain extent within existing banking arrangements, but this scenario brings it out more clearly.”
Damn! I wrote my above comment, and now read yours, and see you have already said my closing point!
Ah well. I think I will write a post on this. Simply because it interests me.
But as you say, whether we call bank shares “medium of exchange” doesn’t really matter much. Except to total wonks like me.
JKH: “This is what was confusing about the IMF paper – how exactly that happens in terms of the clearing system interconnections.”
Yep. Let me try to think this through. Thoughts so far:
Imagine a banking system where all banks are like my 100% capital #2 banks.
Most gross transactions between BMO customers and TD customers will cancel out at the end of the day, just like today.
Suppose BMO customers buy $100 more from TD customers than vice versa, so it doesn’t net out to zero. What happens then? Either:
1. BMO sells $100 worth of BMO shares on the TSX, and gives TD $100
or
2. BMO gives TD $100 worth of BMO shares (by mutual agreement between BMO and TD as to the share price)
or
3. BMO borrows $100 from TD (by mutual agreement)
or
4. BMO borrows $100 from the BoC and gives it to TD.
Nick your 7:34 –
I think I understand what you’re saying, but I approach it from a different starting point, while ending up with a medium of exchange answer.
In looking at the medium of exchange issue in the context of your post, I ask what happens when a transaction occurs that transfers funds from one bank to another bank – say BMO to TD.
A checking transaction is one such transaction.
So I’ll go through that transaction in 3 different cases and then return to the MOE comparison at the end.
So you write a check to me drawn on BMO and I deposit it with TD.
Case 0 – existing banks as normal:
Your deposit account is debited, mine is credited, BMO’s reserve account is debited, TD’s reserve account is credited.
Case 1 – your system as you describe it in your comment (with BMO and TD converted to all equity banks):
You write a check to me drawn on your equity account at BMO and I deposit the check at TD
BMO sells your BMO stock to Nick Edmonds, who banks with Royal
Your BMO equity account is debited
Nick’s BMO equity account is credited
Nick pays you a check drawn on Royal
You now have money funds with BMO (this is where a normal demand deposit account seems to appear, at least momentarily)
Royal pays BMO with reserves
BMO debits your money funds/account for the check you wrote to me
BMO pays TD with reserves through the clearings
(This is essentially the same example I used in my last comment)
Case 2 – your system the way I THOUGHT you described it in the post (with BMO and TD converted to all equity banks):
You write a check to me drawn on your equity account at BMO and I deposit the check at TD
TD charges BMO for reserves through the clearings
BMO debits your equity account to cover the check you wrote to me
Nick is not involved because there is no market sale of stock
Now, the difference between Case 1 and Case 2:
In Case 1, BMO still has the capital position it started with – just that the ownership of shares changed from you to Nick Edmonds.
But in Case 2, BMO has lost that capital.
And that’s where I think both Frances and I came in with the same concern about bank runs – because we were interpreting it as case 2 rather than case 1.
(I’m just guessing in the case of Frances – could be wrong on that).
Now, in terms of medium of exchange:
Given the existence of a system of banks – i.e. a collection of banks – rather than a single bank – and given a central clearing bank for those banks, it seems to me that it is better to analyze MOE as a hierarchical system – MOE for the banks and MOE for bank customers.
MOE for the banks is reserves for all cases – 0, 1, and 2 – it looks to me.
The question is what is MOE for bank customers in each of these cases?
I’d say:
Case 0 – normal demand deposits
Case 1 – at least “momentary” demand deposits, because the BMO had to sell your stock to get the reserves to pay TD, and at the point it got those reserves, it effectively had to credit you with “momentary” demand deposits in order to balance the books (since you no longer have stock with BMO) before paying TD. Then it wiped both its own reserves and your money credit off its books when it paid TD.
Case 2 – equity capital, because BMO would pay TD with reserves it already had on the books, and it then wiped both its own reserves and your equity credit off its books when it paid TD. It lost equity capital when it paid TD. So that suggests to me that capital was the MOE for the bank customer (you).
And I’d say that case 2 is the “pure” checkable equity capital case that corresponds to the “pure” checkable demand deposit case in case 0, with corresponding MOE in each case – whereas case 1 is really case 0 with an administrative arrangement as I described earlier
Jacques Rene: thanks for that comment. So 100% reserve banks did once exist. (100% government of Canada bonds, especially short term bonds, is pretty much equivalent to 100% currency reserves. But this would not be true for a Eurozone government bond.)
yuck – I confused my 1,2 ordering somewhat compared to your original 1,2 Nick
JKH,
I think in your Case 1 there, it also needs to have you purchasing TD shares from a third party, i.e. the mirror of NR’s sale of BMO shares to me. Also, presumably now I have bought BMO shares, I now also bank with BMO (as well as Royal).
Nick E.,
Right. I just didn’t follow through the settlement procedure on that counterparty side of things.
That said, the unambiguous “need” to purchase TD shares is not clear to me. If that were the case, nobody would be able to escape Nick’s 100 per cent capital system and switch to risk free deposits offered in another part of the banking system. Also, it should be the case that TD has the option of issuing new shares if they want to expand their balance sheet and risk taking capacity. Maybe there’s an asymmetry option in settlement procedure to allow for contraction or expansion of the 100 per cent capital system balance sheet in that sense – i.e. allowing for redemption or new issuance (along the lines of my # 2 system). I haven’t thought that through at this point. But I think you’re correct insofar as reflecting consistent treatment for both counterparties with what Nick R. has described so far.
I don’t see how in case 2 the bank would still create money (and if it doesn’t who does?). Let’s say customer A goes to BMO bank and takes out a car loan for 1000 BMO shares. BMO creates 1000 new shares and receives customer A’s loan as asset. The 1000 shares get transferred to the car seller who also banks at BMO. Some time later BMO asks for the first loan payment. Out of shares A goes delinquent. What happens to the value of the loan?
And when the share price is floating could it also go to zero? How would that be different than a bank becoming insolvent and not paying back its customer deposits?
Odie,
Customer A would earn income that could be credited to his bank account in the form of BMO shares. He’d service the loan just as people do now from normal deposits.
If the share price goes to zero, the equity holders are on the hook to absorb all the losses. The difference is that with normal banking, depositors are expected to be protected from losses – by the existence of a reasonable cushion of loss absorbing equity, deposit insurance, etc. The full capital/deposit structure of the normal bank is designed that way. If losses exceed the equity and deposit insurance limits, there’s going to be a problem with solvency. The capital structure of this bank is all equity capital – so anybody with an account is exposed to losses. So the equity account holders can absorb losses all the way down to zero asset value if necessary.
JKH, I’m not sure if Nick’s case 2 is a 100% capital requirement or a 0% capital requirement.
In terms of who gets the losses, aren’t a 100% capital requirement and a 0% capital requirement the same?
Here are some other problems.
1) By using these “shares”, there are going to be a lot of capital gains or capital losses to report on tax returns.
2) There are going to be fees for buying and selling the “shares”.