Money – Page 3 – From the outside

Alternative monetary and financial systems

We probably tend to take the monetary and financial system we have today for granted, somewhat like the air we breathe. I was also challenged during the week to describe a non-money future and my response was judged a failure to look outside the square. The best I could offer was to note that Star Trek imagines a society in which unlimited cheap energy coupled with replicators has made money redundant.

By chance, I came across a couple of articles in recent weeks that offer interesting perspectives on what money is and its role in the economy.

One was by Tyler Cowen marking the 75th anniversary of Bretton Wood’s but more imaginatively subtitled “Every era’s monetary and financial institutions are unimaginable until they are real”. The other was an interview with a German philosopher Stefan Heidenreich discussing his book titled “Money: For a Non-money Economy”.

The Bretton Woods agreement of course is not the system we have today but Cowen makes the point that the system we operate under today would appear equally unlikely to previous generations:

“Currencies are fiat, the ties to gold are gone, and most exchange rates for the major currencies are freely floating, with periodic central bank intervention to manipulate exchange rates. For all the criticism it receives, this arrangement has also proved to be a viable global monetary order, and it has been accompanied by an excellent overall record for global growth.
Yet this fiat monetary order might also have seemed, to previous generations of economists, unlikely to succeed. Fiat currencies were associated with the assignat hyperinflations of the French Revolution, the floating exchange rates and competitive devaluations of the 1920s were not a success, and it was hardly obvious that most of the world’s major central banks would pursue inflation targets of below 2%. Until recent times, the record of floating fiat currencies was mostly disastrous”

Cowen’s main message is that the lesson of history suggests that it is brave to assume that the monetary and financial institution status quo will hold forever – so what comes next?

This brings us to Stefan Heidenreich.

“Stefan Heidenreich believes that some day, money will seem like an ancient religion. In his recent book Money: For a Non-money Economy, the German philosopher and media theorist speculates on how the money-based global economy could soon transition to an entirely different system based on the algorithmic matching of goods and services. Such a system could match people with what they need at a given moment without relying on the concept of a stable, universal price — and, just possibly, do away with the vast inequities caused by the market.
If you find the idea of an economy without money hard to imagine, you’re not alone. As the saying goes, it’s easier to imagine the end of the world than the end of capitalism. But that very difficulty proves Heidenreich’s main point: We have to imagine what may sound like wild possibilities now in order to steer the future before it’s upon us. Getting rid of money could lead to what he calls a “leftist utopia” of equal distribution — or it could enable mass surveillance and algorithmic control on a whole new scale. Faced with the second option, Heidenreich says, we have no choice but to try to envision the first.”
“The Economy of the Future Won’t Rely on Money” Elvia Wilk (Medium 30 November 2018) https://medium.com/s/story/the-economy-of-the-future-wont-rely-on-money-5a703e0ad30b

It is not obvious to me that Heidenreich’s “matching” proposal provides a workable alternative to what we have today but that is not the point. The bigger point raised by both Cowen and Heidenreich is that what we have today is unlikely to be the system that governs our economic interactions in 50 years time so what is the alternative?

Tony

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.

The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

One is to protect the savings of financially unsophisticated individuals and small businesses.
The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit 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”
Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.
According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:
“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”
Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (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. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

Senior unsecured debt
Non preferred senior debt (Tier 3 capital?)
Subordinated debt (i.e. Tier 2 capital)
Additional Tier 1 (AT1)
Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony

What is the value of information in the money market?

“Debt and institutions dealing with debt have two faces: a quiet one and a tumultuous one …. The shift from an information-insensitive state where liquidity and trust prevails because few questions need to be asked, to an information-sensitive state where there is a loss of confidence and a panic may break out is part of the overall system: the calamity is a consequence of the quiet. This does not mean that one should give up on improving the system. But in making changes, it is important not to let the recent crisis dominate the new designs. The quiet, liquid state is hugely valuable.”
Bengt Holmstrom (2015)

The quote above comes from an interesting paper by Bengt Holmstrom that explores the ways in which the role money markets play in the financial system is fundamentally different from that played by stock markets. That may seem like a statement of the obvious but Holmstrom argues that some reforms of credit markets which based on the importance of transparency and detailed disclosure are misconceived because they do not reflect these fundamental differences in function and mode of operation.

Holmstrom argues that the focus and purpose of stock markets is price discovery for the purpose of allocating risk efficiently. Money markets, in contrast are about obviating the need for price discovery in order to enhance the liquidity of the market. Over-collateralisation is one of the features of the money market that enable deep, liquid trading to occur without the need to understand the underlying risk of the assets that are being funded .

“The design of money market policies and regulations should recognise that money markets are very different from stock markets. Lessons from the latter rarely apply to the former, because markets for risk-sharing and markets for funding have their own separate logic. The result is two coherent systems with practices that are in almost every respect polar opposites.”

From “Understanding the role of debt in the financial system” Bengt Holmstrom (BIS Working Papers No 479 – January 2015)

Holmstrom appears to have written the paper in response to what he believes are misconceived attempts to reform credit markets in the wake of the recent financial crisis. These reforms have often drawn on insights grounded in our understanding of stock markets where information and transparency are key requirements for efficient price discovery and risk management. His paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why he believes that information insensitivity is the natural and desired state of the money markets.

Holmstrom notes that one of the puzzles of the GFC was how people traded so many opaque instruments with a seeming ignorance of their real risk. There is a tendency to see this as a conspiracy by bankers to confuse and defraud customers which in turn has prompted calls to make money market instruments more transparent. While transparency and disclosure is essential for risk pricing and allocation, Holmstrom argues that this is not the answer for money markets because they operate on different principles and serve a different function.

“I will argue that a state of “no questions asked” is the hallmark of money market liquidity; that this is the way money markets are supposed to look when they are functioning well.”
“Among economists, the mistake is to apply to money markets the lessons and logic of stock markets.”
“The key point I want to communicate today is that these two markets are built on two entirely different, one could say diametrically opposite, logics. Ultimately, this is because they serve two very different purposes. Stock markets are in the first instance aimed at sharing and allocating aggregate risk. To do that effectively requires a market that is good at price discovery.

“But the logic behind transparency in stock markets does not apply to money markets. The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.”

“Why does this matter? It matters because a wrong diagnosis of a problem is a bad starting point for remedies. We have learned quite a bit from this crisis and we will learn more. There are things that need to be fixed. But to minimise the chance of new, perhaps worse mistakes, we need to analyse remedies based on the purpose of liquidity provision. In particular, the very old logic of collateralised debt and the natural, but sometimes surprising implications this has for how information and risk are handled in money markets, need to be properly appreciated.”

There is a section of the paper titled “purposeful opacity” which, if I understood him correctly, seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggled with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between debt and equity markets.

The other useful insight was the way in which over-collateralistion (whether explicit or implicit) anchors the liquidity of the money market. His discussion of why the sudden transition from a state in which the creditworthiness of a money market counter-party is taken for granted to one in which doubt emerges also rings true.

The remainder of this post mostly comprises extracts from the paper that offer more detail on the point I have summarised above. The paper is a technical one but worth the effort for anyone interested in the question of how banks should finance themselves and the role of debt in the financial system.

Money markets versus stock markets

Holmstrom argues that each system displays a coherent internal logic that reflects its purpose but these purposes are in many respects polar opposites.

Stock markets are primarily about risk sharing and price discovery. As a consequence, these markets are sensitive to information and value transparency. Traders are willing to make substantial investments to obtain this information. Liquidity is valuable but equity investors will tend to trade less often and in lower volumes than debt markets.

Money markets, in contrast, Holmstrom argues are primarily about liquidity provision and lending. The price discovery process is much simpler but trading is much higher volume and more urgent.

“The purpose of money markets is to provide liquidity. Money markets trade in debt claims that are backed, explicitly or implicitly, by collateral.

“People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. Without symmetric information adverse selection may prevent trade from taking place or in other ways impair the market (Akerlof (1970)).”

“Trading in debt that is sufficiently over-collateralised is a cheap way to avoid adverse selection. When both parties know that there is enough collateral, more precise private information about the collateral becomes irrelevant and will not impair liquidity.”

The main purpose of stock markets is to share and allocate risk … Over time, stock markets have come to serve other objectives too, most notably governance objectives, but the pricing of shares is still firmly based on the cost of systemic risk (or a larger number of factors that cannot be diversified). Discovering the price of systemic risk requires markets to be transparent so that they can aggregate information efficiently.

Purposeful opacity

“Because debt is information-insensitive … traders have muted incentives to invest in information about debt. This helps to explain why few questions were asked about highly rated debt: the likelihood of default was perceived to be low and the value of private information correspondingly small.”

Panics: The ill consequences of debt and opacity

“Over-collateralised debt, short debt maturities, reference pricing, coarse ratings, opacity and “symmetric ignorance” all make sense in good times and contribute to the liquidity of money markets. But there is a downside. Everything that adds to liquidity in good times pushes risk into the tail. If the underlying collateral gets impaired and the prevailing trust is broken, the consequences may be cataclysmic”

“The occurrence of panics supports the informational thesis that is being put forward here. Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt … A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility”

These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested (see Morris and Shin (2012) for the general mechanism and Goldstein and Pauzner (2005) for an application to bank runs).

Would transparency have helped contain the contagion?

“A strong believer in the informational efficiency of markets would argue that, once trading in credit default swaps (CDS) and then the ABX index began, there was a liquid market in which bets could be made both ways. The market would find the price of systemic risk based on the best available evidence and that would serve as a warning of an imminent crisis. Pricing of specific default swaps might even impose market discipline on the issuers of the underlying debt instruments”

Shadow banking

“The rapid growth of shadow banking and the use of complex structured products have been seen as one of the main causes of the financial crisis. It is true that the problems started in the shadow banking system. But before we jump to the conclusion that shadow banking was based on unsound, even shady business practices, it is important to try to understand its remarkable expansion. Wall Street has a hard time surviving on products that provide little economic value. So what drove the demand for the new products?”

“It is widely believed that the global savings glut played a key role. Money from less developed countries, especially Asia, flowed into the United States, because the US financial system was perceived to be safe … More importantly, the United States had a sophisticated securitisation technology that could activate and make better use of collateral … Unlike the traditional banking system, which kept mortgages on the banks’ books until maturity, funding them with deposits that grew slowly, the shadow banking system was highly scalable. It was designed to manufacture, aggregate and move large amounts of high-quality collateral long distances to reach distant, sizable pools of funds, including funds from abroad.”

“Looking at it in reverse, the shadow banking system had the means to create a lot of “parking space” for foreign money. Securitisation can manufacture large amounts of AAA-rated securities provided there is readily available raw material, that is, assets that one can pool and tranche”

“I am suggesting that it was an efficient transportation network for collateral that was instrumental in meeting the global demand for safe parking space.”
“The distribution of debt tranches throughout the system, sliced and diced along the way, allowing contingent use of collateral”
“Collateral has been called the cash of shadow banking (European repo council (2014)). It is used to secure large deposits as well as a host of derivative transactions such as credit and interest rate swaps.”
There is a relatively recent, but rapidly growing, body of theoretical research on financial markets where the role of collateral is explicitly modelled and where the distinction between local and global collateral is important

“Viewed through this theoretical lens, the rise of shadow banking makes perfectly good sense. It expanded in response to the global demand for safe assets. It improved on traditional banking by making collateral contingent on need and allowing it to circulate faster and attract more distant capital. In addition, securitisation created collateral of higher quality (until the crisis, that is) making it more widely acceptable. When the crisis hit, bailouts by the government, which many decry, were inevitable. But as just discussed, the theory supports the view that bailouts were efficient even as an ex ante policy (if one ignores potential moral hazard problems). Exchanging impaired collateral for high-quality government collateral, as has happened in the current crisis (as well as historically with clearing houses), can be rationalised on these grounds.”

Some policy implications

A crisis ends only when confidence returns. This requires getting back to the no-questions-asked state ….
Transparency would likely have made the situation worse

“By now, the methods out of a crisis appear relatively well understood. Government funds need to be committed in force (Geithner (2014)). Recapitalisation is the only sensible way out of a crisis. But it is much less clear how the banking system, and especially shadow banking, should be regulated to reduce the chance of crisis in the first place. The evidence from the past panic suggests that greater transparency may not be that helpful.”

“The logic of over-capitalisation in money markets leads me to believe that higher capital requirements and regular stress tests is the best road for now.”

“Transparency can provide some market discipline and give early warning of trouble for individual banks. But it may also lead to strategic behaviour by management. The question of market discipline is thorny. In good times market discipline is likely to work well. The chance that a bank that is deemed risky would trigger a panic is non-existent and so the bank should pay the price for its imprudence. In bad times the situation is different. The failure of a bank could trigger a panic. In bad times it would seem prudent to be less transparent with the stress tests (for some evidence in support of this dichotomy, see Machiavelli (1532)).”

“On money, debt, trust and central banking”

Is the title of an interesting paper by Claudio Borio (Head of the Monetary and Economic Department at the BIS). This link will take you to the paper but my post offers a short summary of what I took away from it.

Overview of the paper

Borio’s examination of the properties of a well functioning monetary system:

stresses the importance of the role trust plays in this system and of the institutions needed to secure that trust.
explores in detail the ways in which these institutions help to ensure the price and financial stability that is critical to nurturing and maintaining that trust.
focuses not just on money but also the transfer mechanisms to execute payments (i.e. the “monetary system”)

“My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. Logically, it makes little sense to talk about one without the other. But payments have too often been taken for granted in the academic literature, old and new. In the process, we have lost some valuable insights.”
Borio: Page 1

In the process, he addresses several related questions, such as

the relationship between money and debt,
the viability of cryptocurrencies as money,
money neutrality, and
the nexus between monetary and financial stability.

Borio highlights three key points he wants you to take away from his paper

First, is the fundamental way in which the monetary system relies on trust and equally importantly the role that institutions, the central bank in particular, play in ensuring there is trust in the system. At the technical level, people need to trust that the object functioning as money will be generally accepted and that payments will be executed but it also requires trust that the system will deliver price and financial stability in the long run.

Second, he draws attention to the “elasticity of credit” (i.e. the extent to which the system allows credit to expand) as a key concept for understanding how the monetary system works. It is well understood that allowing too much credit expansion can cause serious economic damage in the long run but elasticity of credit, he argues, is essential for the day to day operations of the payment system.

Third, the need to understand the ways in which price and financial stability are different but inexorably linked. As concepts, they are joined at the hip: both embody the trust that sustains the monetary system. But the underlying processes required to achieve these outcomes differ, so that there can be material tensions in the short run.

These are not necessarily new insights to anyone who has being paying attention to the questions Borio poses above, but the paper does offer a good, relatively short, overview of the issues.

I particularly liked the way Borio

presented the role elasticity of credit plays in both the short and long term functioning of the economy and how the tension between the short and long term is managed,
covered the relationship between money, debt and trust (“we can think of money as an especially trustworthy type of debt”), and
outlined how and why the monetary system should be seen, not as an “outer facade” but rather as a “cornerstone of an economy”

The rest of this post contains more detailed notes on some, but not all, of the issues covered in the paper.

Elements of a well functioning monetary system

The standard definition of money is based on its functions as
1) Unit of account
2) Means of payment
3) Store of value

Borio expands the focus to encompass the “monetary system”as a whole, introducing two additional elements. Firstly the need to consider the mechanisms the system uses to transfer the means of payment and settle transactions. Secondly, the ways in which the integrity of the chosen form of money as a store of value is protected.

” In addition, compared with the traditional focus on money as an object, the definition crucially extends the analysis to the payment mechanisms. In the literature, there has been a tendency to abstract from them and assume they operate smoothly in the background. I believe this is one reason why money is often said to be a convention …. But money is much more than a convention; it is a social institution (eg Giannini (2011)). It is far from self-sustaining. Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening”
Borio: Page 3

The day to day operation of the monetary system

Borio highlights two aspects of the day to day operations of the monetary system.

The need for an elastic supply of the means of payment
The need for an elastic supply of bank money more generally

In highlighting the importance of the elasticity of credit, he also draws attention to “the risk of overestimating the distinction between credit (debt) and money”.

The central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled.

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”
Borio: Page 5

“…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.
Borio: Page 9

Once you understand the extent to which our system of money depends on credit relationship you understand the extent to which trust is a core feature which should not be taken for granted. The users of the monetary system are relying on some implied promises that underpin their trust in it.

“Price and financial instability amount to broken promises.”
Borio: Page 11

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

The relationship between price and financial stability

While, as concepts, price and financial stability are joined at the hip, the processes behind the two differ. Let’s look at this issue more closely

The process underpinning financial instability hinges on how “elastic” the monetary system is over longer horizons, way beyond its day-to-day operation. Inside credit creation is critical. At the heart of the process is the nexus between credit creation, risk-taking and asset prices, which interact in a self-reinforcing fashion generating possibly disruptive financial cycles (eg Borio (2014)). The challenge is to ensure that the system is not excessively elastic drawing on two monetary system anchors. One operates on prices – the interest rate and the central bank’s reaction function … The other operates on quantities: bank regulatory requirements, such as those on capital or liquidity, and the supervisory apparatus that enforces them.
Borio: Page 12

Given that the processes underlying price and financial stability differ, it is not surprising that there may be material tensions between the two objectives, at least in the near term. Indeed, since the early 1980s changes in the monetary system have arguably exacerbated such tensions by increasing the monetary system’s elasticity (eg Borio (2014)). This is so despite the undoubted benefits of these changes for the world economy. On the one hand, absent a sufficiently strong regulatory and supervisory apparatus – one of the two anchors – financial liberalisation, notably for banks, has provided more scope for outsize financial cycles. On the other hand, the establishment of successful monetary policy frameworks focused on near-term inflation control has meant that there was little reason to raise interest rates – the second anchor – since financial booms took hold as long as inflation remained subdued. And in the background, with the globalisation of the real side of the economy putting persistent downward pressure on inflation while at the same time raising growth expectations, there was fertile ground for financial imbalances to take root in.
Borio: Page 16

Borio concludes that the monetary system we have is far from perfect but it is better than the alternatives

Borio concludes that the status quo, while far from perfect, is worth persisting with. He rejects the cryptocurrency path but does not explicitly discuss other radical options such as the one proposed by Mervyn King, in his book “The End of Alchemy”. The fact that he believes “… the distinction between money and debt is often overplayed” could be interpreted as an indirect rejection of the variations on the Chicago Plan that have recently reentered public debate. It would have been interesting to see him address these alternative monetary system models more directly.

In Borio’s own words ….

The monetary system is the cornerstone of an economy. Not an outer facade, but its very foundation. The system hinges on trust. It cannot survive without it, just as we cannot survive without the oxygen we breathe. Building trust to ensure the system functions well is a daunting challenge. It requires sound and robust institutions. Lasting price and financial stability are the ultimate prize. The two concepts are inextricably linked, but because the underlying processes differ, in practice price and financial stability have often been more like uncomfortable bedfellows than perfect partners. The history of our monetary system is the history of the quest for that elusive prize. It is a journey with an uncertain destination. It takes time to gain trust, but a mere instant to lose it. The present system has central banks and a regulatory/supervisory apparatus at its core. It is by no means perfect. It can and must be improved.55 But cryptocurrencies, with their promise of fully decentralised trust, are not the answer.
Paraphrasing Churchill’s famous line about democracy, “the current monetary system is the worst, except for all those others that have been tried from time to time”.
Page 18

The topic is not for everyone, but I found the paper well worth reading.

Tony

“The Origin of Financial Crises” by George Cooper

There are a lot of books on the topic of financial crises but this one, written in 2008, stand the test of time. At the very least, it offers a useful introduction to Minsky’s Financial Instability Hypothesis. There is also an interesting discussion of the alternative approaches adopted by central banks to the problem of financial stability.

George Cooper argues that our financial system is inherently unstable and that this tendency is accentuated by a combination of factors

The belief that market forces will tend to produce optimal allocations of capital, and
Monetary policy that seeks to smooth (and ideally eliminate) business cycle fluctuations in economic activity

Cooper draws heavily on Hyman Minsky’s Financial Instability Hypothesis (FIH) which he argues offers much better insight into the operation of the financial system than the the Efficient Market Hypothesis (EMH) which tended to be the more influential driver of economic policy in the years preceding the Global Financial Crisis.

Cooper uses these competing theories to explore what makes prices within financial markets move. The EMH maintains that the forces of supply and demand will cause markets to move towards equilibrium and hence that we must look to external forces to understand unexpected shocks and crises. Minsky’s FIH, in contrast, argues that financial markets can be driven by internal forces into cycles of credit expansion and asset inflation followed by credit contraction and asset deflation.

Cooper identifies the following ways in which financial systems can become unstable

Markets characterised by supply constraints tend to experience price inflation which for a period of time can drive further increases in demand
Monetary policy which is oriented towards mitigating (and in some cases pre-empting) economic downturns can also amplify market instability (i.e. the Greenspan put makes the market less resilient in the long run)
Credit creation by private sector banks contributes to money supply growth; this in turn can facilitate growth in demand but there is no mechanism that automatically makes this growth consistent with the economy’s sustainable growth path

The point about some asset markets being prone to instability is particularly pertinent for banks that focus on residential property lending. Classical economic theory holds that increased prices should lead to increased supply and reduced demand but this simple equilibrium model does not necessarily work for property markets. Property buyers more often reason that they need to meet the market because it will only get more expensive if they wait. Many of them will have already seen this happen and regret not meeting the market price previously as they contemplate paying more to get a property that is not as nice as ones they underbid on. The capacity of home builders to respond to the price signal is frequently constrained by a myriad of factors and there is a long lead time when they do respond.

The argument Cooper makes rings very true for Australia and is very similar to the one that Adair Turner made in his book titled ”Between debt and the devil”. Cooper’s (and Minsky’s) argument that the pursuit of stability is not a desirable objective and that the system benefits from a modest amount of stress is similar to the argument made by Nassim Taleb in “Antifragility”.

Cooper also discusses the different philosophies that central banks bring to the challenge of managing financial stability. The dominant view is one that focuses on the risk that sees the management of inflation risk as a dominant concern while placing greater trust in the capacity of the market to self correct any instability. The European Central Bank, in contrast, seems to have placed less faith in the market and perhaps been closer to Minsky.

Some quotes from the book will give a sense of the ideas being discussed:

“Through its role in asset price cycles and profit generation, credit formation (borrowing money for either consumption or investment) lies at the heart of the financial market’s fundamental instability”.

“Hyman Minsky said that “stability creates instability” referring to our tendency to build up an unsustainable stock of debt in times of plenty only for that debt to then destroy the times of plenty”

“For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today’s problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses”

“Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability. We should not let the merits of the former blind us to the risks of the latter.”

I have made some more detailed notes on the book here.

Tony

Worth Reading “The Money Formula” by Paul Wilmott and David Orrell.

The full title of this book, co-written by Paul Wilmott and David Orrell, is “The Money Formula: Dodgy Finance, Pseudo Science, and How Mathematicians Took over the Markets“. There are plenty of critiques of modelling and quantitative finance by outsiders throwing rocks but Wilmott is a quant and brings an insider’s technical knowledge to the question of what these tools can do, can’t do and perhaps most importantly should not be used to do. Consequently, the book offers a more nuanced perspective on the strengths and limitations of quantitative finance as opposed to the let’s scrap the whole thing school of thought. I have made some more detailed notes which follow the structure of the book but this post focuses on a couple of ideas I found especially interesting or useful.

I am not a quant so my comments should be read with that in mind but the core idea I took away is that, much as quants would want it otherwise, markets are not determined by fundamental laws, deterministic or probabilistic that allow risk to be measured with precision. These ideas work reasonably well within their “zone of validity” but a more complete answer (or model) has to recognise where the zones stop and uncertainty rules. Wilmott and Orrell argue market outcomes are better thought of as the “emergent result of complex transactions”. The role of money in these emergent results is especially important, as is the capacity of models themselves to materially reshape the risk of the markets they are attempting to measure.

The Role of Money

Some quotes I have drawn from Chapter 8, will let the authors speak for themselves on the role of money …

“Consider …. the nature of money. Standard economic definitions of money concentrate on its roles as a “medium of exchange,” a “store of value,” and a “unit of account.” Economists such as Paul Samuelson have focused in particular on the first, defining money as “anything that serves as a commonly accepted medium of exchange.” … ” Money is therefore not something important in itself; it is only a kind of token. The overall picture is of the economy as a giant barter system, with money acting as an inert facilitator.” (emphasis added)

“However … money is far more interesting than that, and actually harbors its own kind of lively, dualistic properties. In particular, it merges two things, number and value, which have very different properties:number lives in the abstract, virtual world of mathematics, while valued objects live in the real world. But money seems to be an active part of the system. So ignoring it misses important relationships. The tension between these contradictory aspects is what gives money its powerful and paradoxical qualities.” (Emphasis added)

The real and the virtual become blurred, in physics or in finance. And just as Newtonian theories break down in physics, so our Newtonian approach to money breaks down in economics. In particular, one consequence is that we have tended to take debt less seriously than we should. (emphasis added)

“Instead of facing up to the intrinsically uncertain nature of money and the economy, relaxing some of those tidy assumptions, accepting that markets have emergent properties that resist reduction to simple laws, and building a new and more realistic theory of economics, quants instead glommed on to the idea that, when a system is unpredictable, you can just switch to making probabilistic predictions.” (emphasis added)

“The efficient market hypothesis, for example, was based on the mechanical analogy that markets are stable and perturbed randomly by the actions of atomistic individuals. This led to probabilistic risk-analysis tools such as VaR. However, in reality, the “atoms” are not independent, but are closely linked … The result is the non-equilibrium behaviour … observed in real markets. Markets are unpredictable not because they are efficient, but because of a financial version of the uncertainty principle.” (emphasis added)

The Role of Models

Wilmott & Orrell devote a lot of attention to the ways in which models no longer just describe, but start to influence, the markets being modelled mostly by encouraging people to take on more risk based in part on a false sense of security …

“Because of the bankers’ insistence on treating complex finance as a university end-of-term exam in probability theory, many of the risks in the system are hidden. And when risks are hidden, one is led into a false sense of security. More risk is taken so that when the inevitable happens, it is worse than it could have been. Eventually the probabilities break down, disastrous events become correlated, the cascade of dominoes is triggered, and we have systemic risk …. None of this would matter if the numbers were small … but the numbers are huge” (Chapter 10 – emphasis added)

They see High Frequency Trading as the area likely to give rise to a future systemic crisis but also make a broader point about the tension between efficiency and resilience..

“With complex systems, there is usually a trade-off between efficiency and robustness …. Introducing friction into the system – for example by putting regulatory brakes on HFT – will slow the markets, but also make them more transparent and reliable. If we want a more robust and resilient system then we probably need to agree to forego some efficiency” (Chapter 10 – emphasis added)

The Laws of Finance

Wilmott and Orrell note the extent to which finance has attempted to identify laws which are analogous to the laws of physics and the ways in which these “laws” have proved to be more of a rough guide.

“… the “law of supply and demand” …states that the market for a particular product has a certain supply, which tends to increase as the price goes up (more suppliers enter the market). There is also a certain demand for the product, which increases as the price goes down.”

“… while the supply and demand picture might capture a general fuzzy principle, it is far from being a law. For one thing, there is no such thing as a stable “demand” that we can measure independently –there are only transactions.”

“Also, the desire for a product is not independent of supply, or other factors, so it isn’t possible to think of supply and demand as two separate lines. Part of the attraction of luxury goods –or for that matter more basic things, such as housing –is exactly that their supply is limited. And when their price goes up, they are often perceived as more desirable, not less.” (emphasis added)

This example is relevant for banking systems (such as Australia) where residential mortgage lending dominates the balance sheets of the banks. Even more so given that public debate of the risk associated with housing seems often to be predicated on the economics 101 version of the laws of supply and demand.

The Power (and Danger) of Ideas

A recurring theme throughout the book is the ways in which economists and quants have borrowed ideas from physics without recognising the limitations of the analogies and assumptions they have relied on to do so. Wilmott and Orrell credit Sir Issac Newton as one of the inspirations behind Adam Smith’s idea of the “Invisible Hand” co-ordinating the self interested actions of individuals for the good of society. When the quantum revolution saw physics embrace a probabilistic approach, economists followed.

I don’t think Wilmott and Orrell make this point directly but a recurring thought reading the book was the power of ideas to not just interpret the underlying reality but also to shape the way the economy and society develops not always for the better.

Economic laws that drive markets towards equilibrium as their natural state
The “invisible hand” operating in markets to reconcile individual self interest with optimal outcomes for society as a whole
The Efficient Market Hypothesis as an explanation for why markets are unpredictable

These ideas have widely influenced quantitative finance in a variety of domains and they all contribute useful insights; the key is to not lose sight of their zone of validity.

…. Finance … took exactly the wrong lesson from the quantum revolution. It held on to its Newtonian, mechanistic, symmetric picture of an intrinsically stable economy guided to equilibrium by Adam Smith’s invisible hand. But it adopted the probabilistic mathematics of stochastic calculus.” (emphasis added) Chapter 8

Where to from here?

It should be obvious by now that the authors are arguing that risk and reward cannot be reduced to hard numbers in the ways that physics has used similar principles and tools to generate practical insights into how the world works. Applying a bit of simple math in finance seems to open up the door to getting some control over an unpredictable world and, even better, to pursue optimisation strategies that allow the cognoscenti to optimise the balance between risk and reward. There is room for more complex math as well for those so inclined but the book sides with the increasingly widely held views that simple math is enough to get you into trouble and further complexity is best avoided if possible.

Wilmott and Orrell highlight mathematical biology in general and a book by Jim Murray on the topic as a source for better ways to approach many of the more difficult modelling challenges in finance and economics. They start by listing a series of phenomena in biological models that seem to be useful analogues for what happens in financial markets. They concede that a number of models used in mathematical biology that are almost all “toy” models. None of these models offer precise or determined outcomes but all can be used to explain what is happening in nature and offer insights into solutions for problems like disease control, epidemics, conservation etc.

The approach they advocate seems have a lot in common with the Agent Based Modelling approach that Andrew Haldane references (see his paper on “Tails of the Unexpected“) and that is the focus of Bookstabber’s book (“The End of Theory”).

In their words …

“Embrace the fact that the models are toy, and learn to work within any limitations.”

Focus more attention on measuring and managing resulting model risk, and less time on complicated new products.”

“… only by remaining both skeptical and agile can we learn. Keep your models simple, but remember they are just things you made up, and be ready to update them as new information comes in.”

I fear I have not done the book justice but I got a lot out of it and can recommend it highly.

Swiss money experiment

Last month I posted a review of Mervyn King’s book “The end of Alchemy”. One of the central ideas in King’s book was that all deposits must be backed 100% by liquid, safe assets. It appears that the Swiss are being asked to vote on a proposal labeled “Sovereign Money Initiative” that may not be exactly the same as King’s idea but comes from the same school of money philosophy.

It is not clear that there is any popular support for the proposal but it would be a fascinating money experiment if it did get support. Thanks to Brian Reid for flagging this one to me.

Tony

“The End of Alchemy” by Mervyn King

Anyone interested in the conceptual foundations of money and banking will I think find this book interesting. King argues that the significant enhancements to capital and liquidity requirements implemented since the GFC are not sufficient because of what he deems to be fundamental design flaws in the modern system of money and banking.

King is concerned with the process by which bank lending creates money in the form of bank deposits and with the process of maturity transformation in banking under which long term, illiquid assets are funded to varying degrees by short term liabilities including deposits. King applies the term “alchemy” to these processes to convey the sense that the value created is not real on a risk adjusted basis.

He concedes that there will be a price to pay in foregoing the “efficiency benefits of financial intermediation” but argues that these benefits come at the cost of a system that:

is inherently prone to banking crises because, even post Basel III, it is supported by too little equity and too little liquidity, and
can only be sustained in the long run by the willingness of the official sector to provide Lender of Last Resort liquidity support.

King’s radical solution is that all deposits must be 100% backed by liquid reserves which would be limited to safe assets such as government securities or reserves held with the central bank. King argues that this removes the risk/incentive for bank runs and for those with an interest in Economic History he acknowledges that this idea originated with “many of the most distinguished economists of the first half the twentieth century” who proposed an end to fractional reserve banking under a proposal that was known as the “Chicago Plan”. Since deposits are backed by safe assets, it follows that all other assets (i.e. loans to the private sector) must be financed by equity or long term debt

The intended result is to separate

safe, liquid “narrow” banks issuing deposits and carrying out payment services
from risky, illiquid “wide” banks performing all other activities.

At this point, King notes that the government could in theory simply stand back and allow the risk of unexpected events to impact the value of the equity and liabilities of the banks but he does not advocate this. This is partly because volatility of this nature can undermine consumer confidence but also because banks may be forced to reduce their lending in ways that have a negative impact on economic activity. So some form of central bank liquidity support remains necessary.

King’s proposed approach to central bank liquidity support is what he colloquially refers to as a “pawnbroker for all seasons” under which the central bank agrees up front how much it will lend each bank against the collateral the bank can offer;

King argues that

“almost all existing prudential capital and liquidity regulation, other than a limit on leverage, could be replaced by this one simple rule”.

which “… would act as a form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed and without the necessity of a penalty rate on its loans. The penalty, or price of the insurance, would be encapsulated by the haircuts required by the central bank on different forms of collateral”

leaving banks “… free to decide on the composition of their assets and liabilities… all subject to the constraint that alchemy in the private sector is eliminated”

Underpinning King’s thesis are four concepts that appear repeatedly

Disequilibrium; King explores ways in which economic disequilibrium repeatedly builds up followed by disruptive change as the economy rebalances
Radical uncertainty; this is the term he applies to Knight’s concept of uncertainty as distinct from risk. He uses this to argue that any risk based approach to capital adequacy is not built on sound foundations because it will not capture the uncertain dimension of unexpected loss that we should be really concerned with
The “prisoner’s dilemma” to illustrate the difficulty of achieving the best outcome when there are obstacles to cooperation
Trust; he sees trust as the key ingredient that makes a market economy work but also highlights how fragile that trust can be.

My thoughts on King’s observations and arguments

Given that King headed the Bank of England during the GFC, and was directly involved in the revised capital and liquidity rules (Basel III) that were created in response, his opinions should be taken seriously. It is particularly interesting that, notwithstanding his role in the creation of Basel III, he argues that a much more radical solution is required.

I think King is right in pointing out that the banking system ultimately relies on trust and that this reliance in part explains why the system is fragile. Trust can and does disappear, sometimes for valid reasons but sometimes because fear simply takes over even when there is no real foundation for doubting the solvency of the banking system. I think he is also correct in pointing out that a banking system based on maturity transformation is inherently illiquid and the only way to achieve 100% certainty of liquidity is to have one class of safe, liquid “narrow” banks issuing deposits and another class of risky, illiquid institution he labels “wide” banks providing funding on a maturity match funded basis. This second class of funding institution would arguably not be a bank if we reserve that term for institutions which have the right to issue “bank deposits”.

King’s explanation of the way bank lending under the fractional reserve banking system creates money covers a very important aspect of how the modern banking and finance system operates. This is a bit technical but I think it is worth understanding because of the way it underpins and shapes so much of the operation of the economy. In particular, it challenges the conventional thinking that banks simply mobilise deposits. King explains how banks do more than just mobilise a fixed pool of deposits, the process of lending in fact creates new deposits which add to the money supply. For those interested in understanding this in more depth, the Bank of England published a short article in its Quarterly Bulletin (Q1 2014) that you can find at the following link

He is also correct, I think, in highlighting the limits of what risk based capital can achieve in the face of “radical uncertainty” but I don’t buy his proposal that the leverage ratio is the solution. He claims that his “pawnbroker for all seasons” approach is different from the standardised approach to capital adequacy but I must confess I can’t see that the approaches are that different. So even if you accept his argument that internal models are not a sound basis for regulatory capital, I would still argue that a revised and well calibrated standardised approach will always be better than a leverage ratio.

King’s treatment of the “Prisoner’s Dilemma” in money and banking is particularly interesting because it sets out a conceptual rationale for why markets will not always produce optimal outcomes when there are obstacles to cooperation. This brings to mind Chuck Prince’s infamous statement about being forced to “keep dancing while the music is playing” and offers a rationale for the role of regulation in helping institutions avoid situations in which competition impedes the ability of institutions to avoid taking excessive risk. This challenges the view that market discipline would be sufficient to keep risk taking in check. It also offers a different perspective on the role of competition in banking which is sometimes seen by economists as a panacea for all ills.

I have also attached a link to a review of King’s book by Paul Krugman

Are banks a special kind of company (or at least different)?

This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.

You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.

The three distinctive features of banks I want to explore are:

The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.

Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.

Do banks create “money”? If so, how does that impact the economics of bank funding?

The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” . The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.

Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.

It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.

Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.

I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.

Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.

Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.

One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.

The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.

Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.

The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.

There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …

Tony

Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.

Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.

What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.

A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20

From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21

The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.