Monday, 28 April 2014

Martin Wolf Proposes the Death of Banking

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The distinguished economic journalist Martin Wolf has suggested (£) that banks should be stripped of their ability to create money when they lend. Endorsing “100% reserve banking” as outlined by, among others, the IMF, Lawrence Kotlikoff and Positive Money UK, he calls for all money to be created by the state and banks to be reduced to pure intermediaries. He explains how this would work thus:
First, the state, not banks, would create all transactions money, just as it creates cash today. Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.
Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.
Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.
Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish.
 The three proposals Wolf cites are actually very different from each other. The IMF’s paper “Chicago Plan Revisited” is a strict 100% reserve banking proposal, in which all deposits, irrespective of the risk appetite of the depositor, are backed by central bank reserves. It is accompanied by a full debt jubilee plan to eliminate household debt, leaving banks to lend only for business investment.
I’ve previously written a detailed critique of the IMF’s paper. To summarise, though, the paper does not give sufficient consideration to the implications for commercial banking. There are four principal problems:
·         banks would have to clear all lending decisions with the central bank in advance in order to obtain funding: lending decisions would therefore in reality be made by government (the IMF’s paper regards the central bank as part of government) .
·         banks would have to borrow from the central bank to fund lending – they could not borrow from each other, even though they would have large amounts of idle money lying around on their balance sheets earning nothing.
·         banks would have to pay fees to the central bank for the reserves required to back deposits, even though deposits are a cost for them (the IMF in effect proposes permanently negative interest on REQUIRED reserves).
·         margins on what little lending remained after the debt jubilee would be painfully low, because the paper assumes that businesses would alternatively be able to obtain finance in the capital markets at similar rates to the yield on government bonds.
This cannot in any way be considered a profitable business model.  In my critique I concluded that this proposal would mean the death of commercial banking:
As far as I can see, in this model it is virtually impossible for private banks to be profitable. In which case they would soon cease to exist, and government would be forced to create state banking facilities to replace them. The question is, why did the authors stop short of recommending full nationalisation of the banking system, since that is the only way the model could work in the longer term? The authors think that private banks funding long-term investment projects is a Good Thing, but they offer no explanation for this belief. Could it be that they have retained private banks in their model because recommending a move to a wholly state-owned system would not be taken seriously by most economists and politicians?
But such a strict 100% reserve banking approach is not actually what Wolf is suggesting, despite his comment that the IMF researchers' approach “could work well”. His idea is much closer to the other two proposals, both of which I have also written about.
Kotlikoff envisages a disintermediated banking system in which banks “market” various types of funds but do not themselves do credit intermediation or maturity transformation. Depositors who want no risk would place their money in money funds fully backed by safe assets (government debt): they would have guaranteed safety but very little return on their investment. Depositors wanting higher returns would have a range of funds to choose from representing varying amounts of risk: capital allocation (lending) would be done by the funds in accordance with their portfolio management strategies. The US banking system is already well down the disintermediation road anyway, so to an American customer base it would make complete sense for banks simply to market funds rather than compete with them.
But there is a problem. The functions that distinguish “banks” from other financial institutions are credit intermediation (deposit-taking and lending) and maturity transformation (borrowing short, lending long). Once banks no longer do either of these, they cannot be regarded as banks. They are simply shops. Once again, we are faced with the death of commercial banking.
The third proposal, from Positive Money UK, is actually the closest to Wolf’s ideas. Though there are differences. Rather than backing deposits with central bank reserves as Wolf suggests, Positive Money UK simply cut out the middleman. They propose that transaction accounts should be on the books of the central bank. Commercial banks would only hold risk-bearing investment accounts, from which they could lend. It’s a neat idea, and unlike the other two proposals – both of which completely ignore the crucial role of banks in facilitating payments - it does recognise that transaction accounts and interest-bearing time or sight deposits serve very different purposes. Both Wolf and Positive Money UK envisage banks charging customers fees for payments and account management. This does, of course, mean the end of “free while in credit” banking.
But once again, there is a problem. Banks are not fund managers. People who want to put money at risk for a return don’t generally put it in banks: they invest it in funds or manage their own portfolio. People put money in banks for two reasons:
·         because they want safety AND a return
·         because they need liquidity (including access to payments systems)
Wolf recognises the second of these, but not the first. I fear that the “investment accounts” he and Positive Money UK envisage would disappear like the morning mist once the deposit insurance that time and sight deposit accounts currently enjoy is removed. Positive Money UK's proposal therefore probably means the end of commercial banking, unless they could find other sources of funding. In Wolf's world, commercial banks could survive for a while as pure deposit-takers, but as mobile money platforms reduced their fees to undercut the banks now forced to charge transaction fees, and quasi-banks offered supposedly safe liquid depositary services for a better return than the banks now unable to pay interest on safe deposits, they would eventually wither and die.
But it is perhaps more likely that commercial banks would find ways of lending without relying on customer deposits for funding. Since heavy reliance on wholesale funding is now penalised by regulators, asset-backed securities issuance seems the most obvious choice: Santander UK already funds quite a bit of its lending with covered bonds. But there is another possibility too – and that is a vast increase in the amount of equity that banks hold. Equity is funding: if banks are prevented from using debt to fund lending, they are forced to use equity. Weirdly, we might find banks choosing to adopt Admati& Hellwig’s proposal for much larger equity cushions, just so they can lend at all. After all, as Northern Rock discovered, relying on asset-backed securities issuance for funding has a very big problem: asset-backed securities are by nature illiquid and there is no guarantee that anyone will buy them anyway. At least shareholders’ funds are money you already have, rather than money you hope to receive. Though - returning to my definition of banks' distinguishing functions as being credit intermediation and maturity transformation - if banks only lend shareholders' funds, can they really be said to be banks at all?
This brings me to the heart of Wolf’s proposal. Wolf thinks banks should only be able to lend money they already have, not money they hope to receive: in the absence of loanable deposits, this tends to force banks down the equity funding route because of the inherent illiquidity of other forms of stable funding. But as I explained in my critique of the IMF paper, money creation through bank lending is an inevitable consequence of double entry accounting, and preventing it is by no means as simple as Wolf suggests. Completely eliminating fractional reserve lending means removing banks’ responsibility for lending decisions. Yet again, we face the death of commercial banking.
But my bigger concern is this. Wolf’s idea amounts to replacing a demand-driven money supply creation mechanism with central planning of the money supply by a committee.  Central banks’ record on producing accurate forecasts of the economy is dismal, and their response to economic indicators is at times highly questionable. Put bluntly, they get it wrong – very wrong, at times: consider the ECB raising interest rates into an oil price shock in 2011. Is the entire lifeblood of the economy to be dependent on the whims of such as these?
Some people suggest an algorithm-driven mechanism whereby the money supply automatically adjusts in response to economic indicators such as NGDP or money velocity. This is a neat idea, but it suffers from the problem of accuracy and timeliness of information. GDP is a flawed measure which is subject to constant revision. So is inflation. So is money velocity. And all of them are lagging indicators. How can the future money supply needs of the economy be accurately estimated using these?
Personally I would prefer the money supply to respond to demand rather than be decided by a committee, or an algorithm for that matter.  I don’t in theory have a problem with removing the link between bank lending and money creation: bank lending is by nature pro-cyclical, so the money supply does tend to expand when it really should contract and vice versa. But until someone can identify a better indicator of demand for money, bank lending – or perhaps better, lending activity in the financial system as a whole, including non-bank lending – is the best we have and certainly a lot better than the MPC. The system we have is undoubtedly flawed, but Wolf’s alternative is a whole lot worse.
Related reading:
The shoebox swindle – Coppola Comment
The shoebox shortage – Coppola Comment
The nature of money – Coppola Comment
Do we really care who creates money? – Coppola Comment
The negative carry universe – FT Alphaville
Image: Comely Bank cemetery, Edinburgh
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