People want money

This post draws on a FT article titled “People want money” which led me to an interesting paper by Gary Gorton and George Pennacchi titled “Financial Intermediaries and Liquidity Creation”.  I took the following points away from the Gorton/Pennacchi paper:

• The modern financial markets based economy relies on “money” to facilitate the bulk of its economic activity and bank deposits are the dominant form of money
• There is however a continuous search for ways to expand the domain of what matches the liquidity of “money” while offering a better return
• History has seen a variety of instruments and commodities operate as money but a critical issue is whether they retain their “moneyness” during adverse economic conditions (I think this is something that the crypto currency advocates don’t seem to fully grasp)
• Gorton/Pennacchi argue that the liquidity of an instrument and hence its capacity to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty – This I think is their big idea
• The role of a bank has traditionally been characterised as one of credit intermediation between savers and borrowers but Gorton/Pennacchi argue that the really critical role of banks is to provide a liquid asset in the form of bank deposits that serves as a form of money
• Note that other functions offered by banks can be replicated by non-banks (e.g. non-banks are increasingly providing payment functions for customers and offering loans)  but the capacity to issue liabilities that serve as money is unique to banks
• The challenge is that banks tend to hold risky assets and to be opaque which undermines the liquidity of bank deposits/money (as an aside, Gorton/Pennacchi offer some interesting historical context in which opacity was useful because people trusted banks and the opacity helped shield them from any information which might undermine this trust)
• There are a variety of ways to make bank deposits liquid in the sense that Gorton/Pennacchi define it (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern to them
• This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does (note that the insured deposit a preferred claim on a bank’s assets also means the government can underwrite deposit insurance with very little risk of loss)
• A lot of the regulatory change we have seen to date (more equity, less short term funding) contribute to that outcome without necessarily being expressed in terms of improving the liquidity of bank deposits in the way Gorton/Pennacchi frame the desired outcome

A lot of the above is not necessarily new but I do see some interesting connections with the role of banks in the money creation process and how this influences the debate about what is the optimum capital structure for a bank

• It has been argued that more (and more) equity is a costless solution to the problem of how much is enough because the cost of equity will decline as the percentage of equity in the balance sheet increases
• This conclusion depends in turn on the Modigliani and Miller (M&M) thesis that the value of a firm is independent of its financing structure
• The Money Creation analysis however shows that banks are in fact unique (amongst private companies) in that one of the things they produce is money (or bank deposits to be more precise) – Gorton/Pennacchi explicitly call this out as a factor that means that M&M does not apply to banks in the simplistic way proponents of very high capital assert (most other critiques of higher bank capital just focus on the general limitations of M&M)
• If you accept Gorton/Pennacchi’s argument that bank deposits need to be risk free in the minds of the users if they are to serve as money (the argument makes sense to me) then it follows that the cost of deposits does not change incrementally with changes in the financing structure in the way that M&M assume
• In practice, bank deposits are either assumed to be risk free or they lose that risk free status – the risk trade-off is binary – one or the other, but not a smooth continuum assumed by M&M
• That implies that all the real risk in a bank balance sheet has to reside in other parts of the loss hierarchy (i.e. equity, other loss absorbing capital and senior instruments)
• And this will be even more so under Basel III because the government is developing the capacity to impose losses on all these stakeholders without having to resort to a formal bankruptcy and liquidation process (i.e. via bail-in and TLAC)
•  Critics of bail-in argue that you can’t impose losses on liabilities but here I think they are conflating what you can’t do to depositors (where I would very much agree) with what can and does happen to bondholders relatively frequently
• Bondholders have faced losses of principal lending to a range of counterparties (including sovereigns) so I don’t see why banks should be special in this regard – what matters is that bondholders understand the risk and price it appropriately (including not lending as much as they might otherwise have done)
• I would also argue that imposing the risk of bail in onto bondholders is likely to be a much more effective risk discipline than requiring banks to hold arbitrarily large equity holdings that mean they struggle to earn an adequate equity like return

Gorton and Pennacchi’s paper did not explicitly raise this point but I also see an interesting connection with the Basel III Net Stable Funding Ratio (NSFR) requirement that does not get much attention;

• The NSFR places great value on having a high level of depositor funding but, the greater the share of deposits in the liability stack, the more exposed those deposits are to any volatility in the value of the bank’s assets
• So holding too many deposits might in fact be counterproductive and less resilient than an alternative structure in which there is slightly more long term wholesale funding and less retail deposits
• This line of analysis also calls into question the logic underpinning the Open Bank Resolution regime in NZ where deposits can be bailed in pro rata with senior unsecured liabilities
• The NZ regime allows some de minimis value of deposits to be excluded from bail in but there is no depositor preference such as Australia has under the Banking Act
• The RBNZ seems to assume that applying market discipline to deposits is desirable on Moral Hazard grounds but Gorton/Pennacchi’s thesis seems to me to imply the exact opposite

Tell me what I am missing …

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk. View all posts by From the Outside