The Financial System and the Economy
March 29, 2017 | Author: Umkc Economists | Category: N/A
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THE FINANCIAL SYSTEM AND THE ECONOMY PRINCIPLES OF MONEY AND BANKING
Éric Tymoigne
THE FINANCIAL SYSTEM AND THE ECONOMY PRINCIPLES OF MONEY AND BANKING
FIRST DRAFT
ÉRIC TYMOIGNE
© August 2016 by Eric Tymoigne. All rights reserved.
TABLE OF CONTENTS PREFACE ....................................................................................................................................................................... V CHAPTER 1: BALANCE-SHEET MECHANICS ......................................................................................................................................... 1 WHAT IS A BALANCE SHEET? ............................................................................................................................................. 2 BALANCE SHEET RULES..................................................................................................................................................... 4 CHANGES IN THE BALANCE SHEET ....................................................................................................................................... 6 Net cash flow ........................................................................................................................................................ 6 Net addition to assets and liabilities ..................................................................................................................... 7 Net income ............................................................................................................................................................ 8 Net capital gain ..................................................................................................................................................... 8 CHAPTER 2: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS................................................... 10 BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM ............................................................................................................. 11 FOUR IMPORTANT POINTS .............................................................................................................................................. 12 Point 1: The Federal Reserve notes are a liability of the Fed. ............................................................................. 12 Point 2: The Fed does not earn any cash flow in USD ......................................................................................... 13 Point 3: The Fed does not lend reserves and does not rely on the taxpayers ..................................................... 14 Point 4: Banks cannot do anything with reserve balances unless they are dealing with other Fed account holders ................................................................................................................................................................ 16 CAN THE FED BE INSOLVENT OR ILLIQUID? ......................................................................................................................... 17 CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET .................................................20 THE MONETARY BASE AND THE MONEY SUPPLY ................................................................................................................... 21 RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐BORROWED ...................................................................................... 23 HOW DOES THE MONETARY BASE CHANGE? ....................................................................................................................... 27 CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? .......................................................................................... 29 CHAPTER 4: MONETARY-POLICY IMPLEMENTATION .............................................................................................................. 33 WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY? ..................................................................................... 34 TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS .................................................................................................. 37 A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET ........................................................................................... 40 TARGETING FFR AFTER THE GREAT RECESSION ................................................................................................................... 41 CHAPTER 5: FAQS ABOUT CENTRAL BANKING.............................................................................................................................47 Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? ...................................... 48 Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT TARGETING RESERVES IS POSSIBLE? ........................................................... 49 Q3: IS TARGETING THE FFR INFLATIONARY? ...................................................................................................................... 51 Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED? ............................................................................................... 52 Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES?..................................................................................................... 53 Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY ....................... 54 Q7: IS THERE A ZERO LOWER BOUND? .............................................................................................................................. 55 Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE POLICY? ..................................................................................... 59 Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE INTEREST RATES AND QE? ............................................................... 60 Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY? ............................................................................................................ 60 Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION? ....................................................................................................... 62 Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS) ............................ 63 CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS........................................................................................ 66 MONETARY POLICY AND THE U.S. TREASURY ..................................................................................................................... 67
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Treasury’s involvement in monetary policy during the 2008 crisis ..................................................................... 69 Other examples of Treasury’s involvement in monetary policy .......................................................................... 72 FISCAL POLICY AND THE FED ........................................................................................................................................... 74 A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES ............................................................................ 76 TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION. ............................................................ 77 TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT? ............... 79 CHAPTER 7: LEVERAGE ..............................................................................................................................................................................84 WHAT IS LEVERAGE? .................................................................................................................................................... 85 WHAT ARE THE ADVANTAGES OF LEVERAGE? ..................................................................................................................... 86 WHAT ARE THE DISADVANTAGES OF LEVERAGE? ................................................................................................................. 86 Interest‐rate risk ................................................................................................................................................. 86 Higher sensitivity of capital to credit and market risks ....................................................................................... 87 Refinancing Risk and Margin Calls ...................................................................................................................... 87 Impact On mortgage debt ................................................................................................................................................ 87 Impact on security‐based debt: Margin call risk .............................................................................................................. 89
EMBEDDED LEVERAGE ................................................................................................................................................... 89 BALANCE‐SHEET LEVERAGE, SOME DATA ........................................................................................................................... 91 THE FINANCIALIZATION OF THE ECONOMY ......................................................................................................................... 92 CHAPTER 8: THE PRIVATE BANKING BUSINESS .......................................................................................................................... 96 THE BALANCE SHEET OF A BANK ....................................................................................................................................... 97 WHAT DO BANKS DO? ................................................................................................................................................. 100 WHAT MAKES A BANK PROFITABLE? ............................................................................................................................... 100 RISKS ON THE BANK BALANCE SHEET ............................................................................................................................... 103 BANKING ON THE FUTURE ............................................................................................................................................ 105 EVOLUTION OF BANKING SINCE THE 1980S ..................................................................................................................... 107 CHAPTER 9: BANKING REGULATION ................................................................................................................................................. 111 EXAMPLES OF BANK REGULATIONS ................................................................................................................................. 112 Reserve requirement ratios ............................................................................................................................... 112 Capital adequacy ratios .................................................................................................................................... 113 CAMELS rating .................................................................................................................................................. 114 Underwriting requirements ............................................................................................................................... 115 WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT? ............................................. 115 Deregulation, competition and concentration ............................................................................................................... 115 Deenforcement and desupervision ................................................................................................................................ 118 Regulatory arbitrage....................................................................................................................................................... 119
THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS ..................................................................................... 120 Laissez faire, laissez passer: Crises as Random events ...................................................................................... 120 Save capitalism from itself: Crises as internal contradictions ........................................................................... 122 CHAPTER 10: MONETARY CREATION BY BANKS ........................................................................................................................ 127 MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES ....................................................................................... 128 WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? .......................................................................................................... 132 Point 1: The bank is not lending anything it has: when providing credit services, the bank swaps promissory notes with its clients ......................................................................................................................................... 132 Point 2: The bank does not need any reserves to provide credit services ......................................................... 132 Point 3: The bank is not using “other people’s money”: it is not a financial intermediary between savers and investors ............................................................................................................................................................ 133 point 4: The bank’s promissory note is in high demand .................................................................................... 134 HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION .......................................................................................... 135
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INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES ............................................................................................................................................................................... 138 WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? .................................................................................... 140 MOVING IN STEP ........................................................................................................................................................ 141 LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS .......................................................................... 142 TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL INTERMEDIATION. ....................................................................................................................................................... 142 CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ................................................................................... 147 THE REAL EXCHANGE ECONOMY .................................................................................................................................... 148 Money supply is a veil ....................................................................................................................................... 148 Finance and the economy ................................................................................................................................. 149 Conclusions ....................................................................................................................................................... 151 THE MONETARY PRODUCTION ECONOMY ........................................................................................................................ 152 Money is everything .......................................................................................................................................... 152 Why monetary incentives matter? And what are other implications? ............................................................. 153 Finance and the economy ................................................................................................................................. 154 Beyond incentives: the role of macroeconomic forces ...................................................................................... 155 Conclusions ....................................................................................................................................................... 157 CONCLUSION ............................................................................................................................................................. 157 CHAPTER 12: INFLATION ......................................................................................................................................................................... 160 THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION ..................................................................................... 161 INCOME DISTRIBUTION AND INFLATION: A NON‐MONETARY VIEW OF INFLATION ..................................................................... 164 TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION ................................................................ 168 CHAPTER 13: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ....................................................... 171 A PRIMER ON CONSOLIDATION ...................................................................................................................................... 172 THE THREE SECTORS OF THE ECONOMY ........................................................................................................................... 173 SOME IMPORTANT IMPLICATIONS .................................................................................................................................. 175 point 1: The beginning of the economic process requires that someone goes into debt. ................................. 175 point 2: Not all sectors can record a surplus at the same time ......................................................................... 176 point 3: Public debt and domestic private net wealth ...................................................................................... 180 point 4: Business cycle and sectoral balances ................................................................................................... 182 CONCLUSION ............................................................................................................................................................. 184 TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS ................. 184 TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING ...................................................................................... 185 CHAPTER 14: FINANCIAL CRISES......................................................................................................................................................... 190 DEBT DEFLATION ........................................................................................................................................................ 191 Step 1: Overindebtedness and distress sales ..................................................................................................... 192 Step 2: Distress sales and deflation, the “Dollar Disease” ................................................................................ 192 Step 3: Deflation and debt liquidation; the “Debt Disease” .............................................................................. 192 Step 4: Prices and profit and net worth, the “Profit Disease” ........................................................................... 193 Step 5: the “Amplifier effect” ............................................................................................................................ 194 Step 6: Pessimism .............................................................................................................................................. 194 Step 7: Interest‐rate spread .............................................................................................................................. 195 Conclusion ......................................................................................................................................................... 196 ORIGINS OF DEBT DEFLATION ........................................................................................................................................ 197 Real exchange economy: Efficient markets and imperfections ......................................................................... 197 Monetary production economy: The financial instability hypothesis ............................................................... 198 Financial fragility ............................................................................................................................................................ 199
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The Financial instability hypothesis ................................................................................................................................ 200
HOW TO DEAL WITH FINANCIAL CRISES ............................................................................................................................ 202 TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET ............................................................................................ 203 TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW .................................................................................... 204 CHAPTER 15: MONETARY SYSTEMS ................................................................................................................................................... 207 FINANCIAL INSTRUMENTS ............................................................................................................................................. 208 A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENTS ........................................................................................... 209 AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT CIRCULATE AMONG BEARERS? .................................................................. 210 FAIR VALUE AND PURCHASING POWER ............................................................................................................................ 212 ACCEPTANCE OF MONETARY INSTRUMENTS ..................................................................................................................... 214 TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST ............................................................................ 216 WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS ............................................................................... 218 CHAPTER 16: FAQS ABOUT MONETARY SYSTEMS ...................................................................................................................... 222 Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? .................................................. 223 Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? ........................................................................................... 224 Q3: IS MONEY WHAT MONEY DOES? .............................................................................................................................. 225 Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS ZERO? ............................................................................................................... 227 Q5: IS MONETARY LOGIC CIRCULAR? .............................................................................................................................. 228 Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? ......................................................... 228 Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? .............................................................................. 229 Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND‐PLAY BANKNOTES AND COINS? WHAT ABOUT BITCOINS? .................................................................................................................................. 229 Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS? .................................................................................. 230 Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE? ................................................. 232 Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED? ...... 232 Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? .................................................................................................. 232 CHAPTER 17: HISTORY OF MONETARY SYSTEMS ....................................................................................................................... 235 MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM ................................. 236 MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL ...................................... 237 TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS .......................... 239 SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT ..................... 240 GLOSSARY ................................................................................................................................................................. 242 ABOUT THE AUTHOR ................................................................................................................................................... 248
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PREFACE This text is the preliminary draft for a textbook that is the result of an extensive revision of posts published on the blog neweconomicperspectives.org. Why write a new money and banking text when there are already so many available? There are three main reasons. First, texts usually do not have a coherent theme that runs through them and that ties together all the chapters. Second, the monetary and banking chapters usually leave a lot to be desired because they present outdated views or are too limited in their presentation of the topic. Three, the macroeconomic sections usually do not use what was presented in the previous chapters, leave aside important debates in academia, and only briefly deal with balance sheet interrelationships to analyze macroeconomic issues. This preliminary text deals with these three issues. Throughout the text, the concept of balance sheet is central and used to analyze all the topics presented. Not only are balance sheets relevant to understand financial mechanics, but also they force an inquirer to fit a logical argument into double‐entry accounting rules. This is crucial because if that cannot be done there is an error in the logical argument. The monetary and banking aspects and their relation to the macroeconomy are analyzed extensively in this text by relying on the literature that has been available for decades in non‐mainstream journals, but that has been mostly ignored until recently. Gone is the money multiplier theory, gone in the financial intermediary theory of banks, gone is the idea that central bank control monetary aggregates, gone is the idea that finance is neutral in any range of time, and gone is the idea that nominal values are irrelevant. Preoccupations about monetary gains, solvency and liquidity are central to the dynamics of capitalism, and finance is not constrained by the amount of saving. The chapters dealing with monetary systems are also much more developed than a typical textbook. As such, the “money” chapter, usually first in M&B texts, only comes much later in the form of three chapters, once balance‐sheet mechanics and financial concepts, such as present value, have been well understood. In addition, the link between macroeconomic topics and banking theory is fully established to analyze issue of inflation, economic growth, financial crisis, and financial interlinkages. Of course, all this is still work in progress. There are many chapters missing for a full text and some of the chapters will need to be rewritten to account for comments by my students and others. Below is a list of missing Chapters that will be added between January and June 2017 (some of this is already included in the book but is underdeveloped): 1. Overview of the financial system (how financial companies differ because of different balance sheets) 2. Financial state of different macroeconomic sectors, flow of funds analysis (who is a net creditor? Etc.) 3. Federal Reserve System institutional analysis 4. Interest rate and interest rate structure 5. Pricing of securities 6. Securitization 7. Derivatives 8. Monetary policy in action (issues surrounding interest‐rate rules, transmission channels, etc.) v
9. International monetary arrangements and exchange rates 10. Modeling (theory of the circuit, including the money supply in models, stock‐flow coherency, portfolio constraints, capital gains, using models, etc.) In the second draft, the first five Chapters above will be Chapters 2, 3, 4, 5 and 6 respectively; Chapter 1 will still be about balance sheet mechanics and will be expanded. The Chapter 2 in the text below will be included in Chapter 3 above. Securitization and derivative will be included after studying banks in details (i.e. after Chapter 10 below). International arrangement will come toward the end of the book. In order to use this preliminary edition, it is recommended that institutional analysis be done first by the instructor. Any text will do for that purpose but the lecturer can emphasize how the structure of balance sheets differs between financial companies in order to explain what each financial company does. I wish to thank all the readers of the posts that form the basis of this preliminary text. Their comments were very helpful to improve clarity of the text and correct some mistakes. Many thanks to Stavros N. Karageorgis for carefully reading and editing the draft.
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CHAPTER 1: After reading this chapter you should understand: What a balance sheet is Why a balance sheet changes How a balance sheet changes
CHAPTER 1: BALANCE‐SHEET MECHANICS The U.S. financial system is extremely complicated. Figure 1.1 provides an overview of that system that consists of three main categories; financial markets, financial companies and regulatory and supervisory institutions. While most parts of that system will be at least mentioned in this draft, the draft focuses mostly on the Federal Reserve System and depository institutions. International Financial Markets (Foreign Exchange Markets, Eurocurrencies, Eurobonds, Foreign Bonds) Capital Markets: Securities with a maturity superior to one year (Stocks, Bonds, Asset-Backed Securities) Financial Markets
Money Markets: Securities with a maturity of one year or less (BAs, CDs, CPs, Federal funds loans, RPs, bills)
Primary Market Organized Exchanges Secondary Market OTC Markets
Insurance Markets (Forwards, Futures, Options, Swaps) Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE) Financial-Market Companies Security Firms (Investment Banks, Brokerage Firms) Commercial Banks Depository Institutions Thrift Institutions (Credit Unions, Savings Banks, Savings and Loan Associations) Financial Sector
Financial Companies Financial Investment Companies (Hedge Funds, Pension Funds, Mutual Funds, Real Estate Investment Trusts) Insurance Companies (Life Insurance Companies, Property and Casualty Insurance Companies, Monolines) Finance Companies (Business Finance Companies, Consumer Finance Companies, Sales Finance Companies, SPEs) Government Financial Agencies
Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA, SLMA) Government Loan Guarantee Programs and Government Loan Programs (ExIm Bank, FHA, FCA, GNMA, SBA, VA, DLP) Federal Reserve System (Fedwire, Discount Window, Open Market Trading Desk)
Private: National Associations (SIFMA, FINRA, NBA, NFA), Organized Exchanges, Clearing Systems (OC Corp., CHIPS), Credit-Rating Agencies Regulatory and Supervisory Institutions Government: Department of Housing and Urban Development (FHFA), Department of Labor, Department of Treasury (OCC, OTS), Independent Federal Agencies (CFTC, FCA, FDIC, Federal Reserve Board, Reserve Banks, Fedwire, FTC, NCUA, SEC, CFPB), Interfederal agencies (FFIEC, FSOC), State Banking and Insurance Commissioners CBOE: Chicago Board Options Exchange, CBOT: Chicago Board of Trade, CFPB: Consumer Financial Protection Bureau, CFTC: Commodity Futures Trading Commission, DLP: Direct Loan Program, Ex-Im Bank: Export-Import Bank, FAMC: Federal Agricultural Mortgage Corporation (“Farmer Mac”), FCA: Farm Credit Administration, FCS: Farm Credit System, FDIC: Federal Deposit Insurance Corporation, FFIEC: Federal Financial Institution Examination Council, CHIPS: Clearing House Interbank Payment System, FHA: Federal Housing Administration, FHFA: Federal Housing Finance Agency, FHLBS: Federal Home Loan Banks System, FHMLC: Federal Home Loan Mortgage Corporation (“Freddie Mac”), FNMA: Federal National Mortgage Association (“Fannie Mae”), FSA: Farm Service Agency, FSOC: Financial Stability Oversight Council, FTC: Federal Trade Commission, GNMA: Government National Mortgage Association (“Ginnie Mae”), FINRA: Financial Industry Regulatory Authority, NASDAQ: National Association of Securities Dealers Automated Quotation System, NBA: National Bankers Association, NCUA: National Credit Union Administration, NFA: National Futures Association, NYSE: New York Stock Exchange, OC Corp.: Option Clearing Corporation, OCC: Office of the Comptroller of the Currency, OTC: Over-the-Counter, OTS: Office of Thrift Supervision, SBA: Small Business Administration, SEC: Securities and Exchange Commission, SIFMA: Securities Industry and Financial Markets Association, SLMA: Student Loan Marketing Association (“Sallie Mae”), SPE: Special Purpose Entity, VA: Department of Veteran Affairs.
Figure 1.1. The U.S. financial sector The core of the financial system consists of financial documents and among them are balance sheets. Balance sheets provide the foundation upon which most of an M&B course can be taught: monetary creation by banks and the central bank, nature of money, financial crises, securitization, financial interdependencies, you name it, it has to do with one or several balance sheet(s). As Hyman P. Minsky used to note, if you cannot put your reasoning in terms of a balance sheet there is a problem in your logic.
WHAT IS A BALANCE SHEET? It is an accounting document that records what an economic unit owns (its “assets”) and owes (its “liabilities”). The difference between its assets and liabilities is called net worth, or equity, or capital (Figure 1.2).
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CHAPTER 1: BALANCE‐SHEET MECHANICS
Figure 1.2 A balance sheet
There are many different ways to classify assets and liabilities. For our purposes, a balance sheet can be detailed a bit according to Figure 1.3. Financial assets are claims on other economic units; non‐financial assets (aka real assets) may be reduced to physical things (cars, buildings, machines, pens, desks, inventories, etc.) but may also include intangible things (goodwill among others). Demand liabilities are liabilities that are due at the request of creditors (cash can be withdrawn from bank accounts at will by account holders); contingent liabilities are due when a specific event occurs (life insurance payments to a widow); dated liabilities are due at specific periods of time (interest and principal mortgage payments are due every month).
Figure 1.3 A simple balance sheet
Balance sheets can be constructed for any economic unit. That unit can be a person, a firm, a sector of the economy, a country, anybody or anything with assets and liabilities. Table 1.1 shows the balance sheet of all U.S. households (and non‐profit organizations) in the United States. In 2014, U.S. households owned $98.3 trillion worth of assets and owed $14.2 trillion worth of liabilities, making net worth equal to $84.1 trillion (98.3 – 14.2). Households held $29.2 trillion of non‐financial assets and $69.1 trillion of financial assets. Their two main liabilities were mortgages ($9.4 trillion) and consumer credit (credit card debts, student debts, healthcare debts, etc.) ($3.3 trillion).
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Table 1.1 Balance sheet of households and NPOs. Source: Financial Accounts of the United States
BALANCE SHEET RULES A balance sheet follows double‐entry accounting rules so a balance sheet must always balance, that is, the following must always be true: Assets = Liabilities + Net Worth The practical, and central, implication is that a change in one item on the balance sheet must be offset by at least one change somewhere else so that a balance sheet stays balanced. 4
CHAPTER 1: BALANCE‐SHEET MECHANICS Start with a very simple balance sheet. The only asset is a house worth $100k that was purchased by putting down 20k and asking for $80k from a bank (Figure 1.4).
Figure 1.4 A simple balance sheet
What is the impact of a bank forgiving $40k of principal on the mortgage? The value of mortgage went down by 40k and the value of net worth went up by 40k so that the accounting equality is preserved (Figure 1.5)
Figure 1.5 Effect of forgiving some of the mortgage principal Going back to the first balance sheet, what is the impact of the value of the house going up by $20k? The asset value went up by $20k and the net worth went up by $20 and here again the accounting equality is preserved. (Figure 1.6).
Figure 1.6 Effect of higher house price Sometimes, to get to the point more quickly and to highlight the changes, economists prefer to use so‐called “T‐accounts” (because the shape of the table looks like a T) that record only the changes in the balance sheet (Δ means “change in”). The offsetting accounting entry is shown more clearly. It comes from opposite changes in two items on the right side of the balance sheet (Figure 1.7), and a change in asset and net worth by the same amount (Figure 1.8). Of course, these are not the only 5
CHAPTER 1: BALANCE‐SHEET MECHANICS two ways the offsetting is done to preserve the accounting equality. We will encounter other cases as we move forward. The point is that one must change at least two things in a balance sheet to make sure that the equality A = L + NW is preserved. One must always ask: what is (are) the offsetting entry change(s)? This has practical implications when studying how banks and central bank operate. Household ΔLiabilities and Net Worth Mortgage: ‐$40 Net worth: +$40 Figure 1.7 T‐account that records the decline of the mortgage principal ΔAssets
Household ΔAssets ΔLiabilities and Net Worth House: +$20 Net worth: +$20 Figure 1.8 T‐account that records the higher house value
CHANGES IN THE BALANCE SHEET One can classify factors that change a balance sheet in four categories: ‐
Cash inflows and outflows: net cash flow.
‐
Purchases and sales of assets, issuance and repayment of debts: Net acquisition of assets and liabilities.
‐
Incomes and expenses: net income.
‐
Capital gains and capital losses: net change in the market value of assets and liabilities.
The last three categories are recorded more carefully in other accounting documents than the balance sheet, but this section focuses on their relation to the balance sheet.
NET CASH FLOW Cash inflows and cash outflows lead to a change in the outstanding value of monetary balances held by an economic unit, that is, a change in the quantity of physical currency or funds in a bank account held on the asset side. Some assets lead to cash inflows while some liabilities and capital (dividend payments) lead to cash outflows. If the cash inflows are greater than the cash outflows, monetary assets held by an economic unit go up. The economic unit can use them to buy assets or pledge them to leverage its balance sheet (see Chapter 7). If net cash flow is negative, then monetary‐asset holdings fall and the economic unit may have to go further into debt to pay some of its expenses (Figure 1.9).
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Figure 1.9 Balance sheet and cash flow
Going back to the balance sheet of Figure 1.4, assume that a salary of $40k is earned and that part of the salary is used to service a 30‐year fixed‐rate 10 % mortgage. Assuming linear repayment of principal to simplify (actual mortgage servicing is calculated differently), Figure 1.10 shows what the cash flow structure looks like.
Figure 1.10 Balance sheet and cash flows, an example
The balance sheet at the beginning of the following year is shown in Figure 1.11 (assuming all cash flows involve actual cash transfer instead of electronic payments). Quite a few things have changed in the balance sheet. There is a net inflow of cash of $29.3k, the principal of the mortgage fell by the amount of principal repaid, and the change in net worth accounts for these two changes.
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Figure 1.11 Balance sheet after the cash‐flow impacts
NET ADDITION TO ASSETS AND LIABILITIES Net cash flow records the net addition of monetary balances but there are many other assets on the balance sheets. Overtime, assets loss value via depreciation, or destruction, or repayment of principal; some assets are sold while others assets are purchased. The net change in the monetary value of assets (acquisitions minus loss of value and sales) impacts the balance sheet. Depreciation is counted as an expense and so impacts net income. Similarly, liabilities on the balance sheet are progressively repaid (principal repayment) or reduced in other ways, while new liabilities are issued by an economic unit. The net issuance of liabilities (new liabilities – principal reductions) also impacts the balance sheet of their issuers. They also impact the balance sheet of the creditors given that the liabilities of someone are the financial assets of someone else. Current net worth = Previous net worth + Net addition to assets and liabilities of the period Figures 1.4 shows the impact of acquiring non‐financial assets (the house) and incurring new liabilities (the mortgage). Figure 1.5 shows the impact of a decline in the principal amount of the mortgage.
NET INCOME Net income leads to a change in net worth: Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income of the period Net income can be positive or negative so net worth may rise or fall depending on what the value of net income is. In the previous example (Figures 1.10 and 1.11), net cash flow and net income are the same thing; however, not all incomes necessarily lead to cash inflows (see Chapter 4 and Chapter 10). There is a debate about whether one should record capital gains and losses in the income statement. For the purpose of this section, the two are clearly separated.
NET CAPITAL GAIN The value of assets and liabilities change merely because of changes in their market prices even though their quantities has not changed (no net addition). If accounting is done on a “mark‐to‐ 8
CHAPTER 1: BALANCE‐SHEET MECHANICS market” basis, i.e. by valuing balance‐sheet items on the basis of their current market value, these changes are accounted in the balance sheet. Some assets see their prices go up (capital gains) while other see their prices go down (capital losses) and the difference between capital gains and capital losses (net capital gains) affects the net worth accordingly: Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income of the period + Net acquisition of assets and liabilities of the period + Net capital gains of the period The example of Figure 1.3 is a simple illustration of the impact of capital gains. The effect of a change in the market prices of assets and liabilities may not be recorded in the balance sheet if they are valued on a cost basis. For financial assets, there are three options to record their value. Level 1‐valuation uses the available market price. Level‐2 valuation, for assets that do not have an active market, uses a proxy market as a point of reference. Level‐3 valuation, also called mark‐to‐model (or more cynically “mark‐to‐myth”), uses an in‐house model to give a dollar value to the asset. During the 2008 crisis, major financial institutions argued that the market prices of some assets did not reflect their true value because of a panic in markets. The Securities and Exchange Commission allowed them to move to level‐2 or level‐3 valuation to avoid recording capital losses on their assets. Many analysts have been critical of that decision and considered it to be a convenient way to hide major losses of net worth by financial institutions. Summary of Major Points 1‐ A balance sheet is one of the important financial documents used to record the financial state of an economic unit 2‐ Assets represent what is owned and liabilities represent what is owed by an economic unit 3‐ Net worth or capital or equity is the difference between the monetary value of assets and liabilities 4‐ A balance sheet must balance, i.e. at all time the following must be true: Assets = Liabilities + Net Worth 5‐ A balance sheet follows double‐entry accounting rules: a change somewhere leads to at least one offsetting change somewhere else to ensure that the balance sheet stays balanced. Keywords Balance sheet, non‐financial assets, financial assets, demand liability, time liability, contingent liability, net worth, capital, net income, net cash flow, net capital gain, net acquisition of assets and liabilities, level‐1 valuation, level‐2 valuation, level‐3 valuation Review Questions Q1: What does a balance sheet do? Q2: If the value of assets goes up and the value of liabilities goes down, what happens to net worth? Q3: If the value of assets and liabilities changes by the same amount, what happens to net worth? Q4: If outstanding assets depreciate faster than the acquisition of new assets, what happens to the value of assets? To the value of net worth? Q5: If an economic unit takes on new debt faster than it repays outstanding principal, what happens to the level of liabilities? Of net worth? 9
CHAPTER 2:
After reading this Chapter you should understand: What the main components of a central‐bank balance sheet are How a central bank provides reserves That a central bank does not rely on taxpayers That a central bank does not lend reserves That a central bank does not use any domestic monetary instruments That a central bank does not earn any cash flow in the domestic currency That banks cannot buy anything with reserve balances from the public
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS The Federal Reserve System (the Fed) is a typical central bank. It provides the currency of the nation, it is the depository and fiscal agent of the Treasury, it provides advances of funds to banks, and it intervenes in financial markets. In order to understand how all this is done, it is important to understand the balance sheet of the Fed. This Chapter applies the insights of Chapter 1 to study the balance sheet mechanics of the Fed.
BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM Table 2.1 shows the actual balance sheet of the Federal Reserve System. It sums the assets, liabilities, and capital of all twelve Federal Reserve banks and consolidates them (i.e. removes what Fed banks owe to each other). The main asset is Treasury securities that amounted to about $718 billion in January 2005.
Table 2.1 Actual balance sheet of the Federal Reserve System Source: Board of Governors of the Federal Reserve System (Series H.4.1)
The main liability is outstanding Federal Reserve notes (FRNs) issued—that is, held outside the twelve Federal Reserve banks’ vaults—that amounted to $718 billion in January 2005. This line in the balance sheet includes all FRNs issued regardless who owns them. A distant second liability was reserve balances (“deposits of depository institutions”) that amounted to $31 billion.
11
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Capital consists mostly of the annual net income of the Fed (“surplus” line) and the shares that banks must buy when becoming members of the Federal Reserve System (the “capital paid in” line). These shares are not tradable, cannot be pledged (banks cannot use them as collateral and they cannot be discounted), do not provide a voting right to banks, and pay an annual dividend representing 6% of net income of the Fed. Any left‐over net income is transferred to the U.S. Treasury and the Secretary of the Treasury can use the funds only for two purposes: to increase Treasury’s gold stock or to reduce outstanding amount of Treasuries.1 For analytical purposes, it is best to rearrange the balance sheet of the Fed according to Figure 2.1. Through this book, a lot will be done with L1, L2 and L3 as well as A1 and A2 because they are all central to the understanding of domestic monetary policy operations. In addition, L1 only contains the FRNs held by banks, the domestic public and foreigners. Indeed, for analytical purposes, economists like to measure the outstanding value of FRNs in circulation, that is, FRNs held outside the vaults of private banks (“vault cash”), of the Federal Reserve banks, and of the U.S. Treasury. FRNs held by the Treasury are included in L3, FRNs held by the Federal Reserve banks are included nowhere (they have not been issued so they are not a liability yet). Assets A1: Securities A2: Domestic private banks’ promissory notes A3: Foreign‐denominated assets A4: Coins and Treasury currency
Liabilities and Net Worth L1: Federal Reserve notes in circulation and vault cash L2: Reserve balances (Checking account due to banks) L3: Treasury’s account and Federal Reserve notes held by Treasury
A5: Other assets (buildings, furniture, L4: Accounts due to foreigners and etc.) others L5: Other liabilities (including equity capital)
Figure 2.1 A simplified balance sheet of the Federal Reserve System
FOUR IMPORTANT POINTS POINT 1: THE FEDERAL RESERVE NOTES ARE A LIABILITY OF THE FED. One immediately notes that the central bank does not own any cash or a bank account in US dollar, i.e. there are no domestic monetary instruments on its asset side besides a few Treasury currency items (United States notes, etc.) and some coins. The Fed does not use coins to spend, it acts as coin dealer on behalf of the Treasury,2 that is, Fed buys all new coins from the U.S. Mint at face value and sells them to banks at their request by debiting their reserve balances. The Fed also buys back coins that banks have in excess by crediting their reserve balances. Gold certificate account (first line under assets) are just electronic entries to record the safe keeping of some of the gold stock owned by the U.S. Treasury; The Fed does not own any gold.3 The Fed does own some foreign monetary instruments (SDR accounts, accounts at foreign central banks, foreign currency). 12
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS What the U.S. population considers to be “money,” the Federal Reserve notes (FRNs), is recorded as a liability on the balance sheet of the Fed. FRNs are a specific security issued by the Fed and the Fed owes the holders of the FRNs. Chapter 15 studies what is owed. FRNs are secured by some of the assets of the Federal Reserve banks, most of them are Treasuries (Figure 2.2)
Figure 2.2. Level and composition of the assets pledged against the FRNs out of the Federal Reserve vaults, trillions of dollars Source: Board of Governors of the Federal Reserve System (Series H4.1) Note: USTS means U.S. Treasury security, MBS means mortgage‐backed security.
POINT 2: THE FED DOES NOT EARN ANY CASH FLOW IN USD When the Fed receives a net income in US dollars it does not receive any cash flow, i.e. no monetary asset goes up. What goes up is net worth. How does that occur? Suppose that banks request an advance of funds of $100 repayable the next day with a 10% interest. Today the following is recorded: Fed ΔAssets Promissory notes of banks: +$100
ΔLiabilities and Net Worth Reserve balances: +$100
The Fed just typed an entry on each side of its balance sheet, one to record the crediting of reserve balances and one to record the Fed is now a creditor of private banks by holding a claim on banks. The next day banks must pay back $100 and an additional $10. The full repayment of the principal leads to: Fed ΔAssets Promissory notes of banks: ‐$100 13
ΔLiabilities and Net Worth Reserve balances: ‐$100
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS What about the $10 payment? It leads to an additional decrease in reserve balances and the offsetting operation is an increase in net worth at the Fed (and a decrease in net worth at private banks) Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$10 Net worth: +$10
These two T‐accounts are normally consolidated into one: Fed ΔAssets Promissory notes of banks: ‐$100
ΔLiabilities and Net Worth Reserve balances: ‐$110 Net worth: +$10
Here we go! The Fed records an income gain! How does it transfer that to the Treasury? Easy! A Fed employee types the following on a keyboard: Fed ΔAssets
ΔLiabilities and Net Worth Treasury’s account: +$10 Net worth: ‐$10
The transfer of funds between accounts is like keeping scores by changing amounts recorded on the liability side. Banks lost 10 points, Treasury gained 10 points.
POINT 3: THE FED DOES NOT LEND RESERVES AND DOES NOT RELY ON THE TAXPAYERS In Table 2.1, there is a line labeled “loan” on the asset side, and one will often hear and read—even in Fed documents—that the Fed lends reserves to banks. In the balance sheet of Figure2.1, there is no “loan” but instead there is “A2: Domestic private banks’ promissory notes.” This textbook will not the use the words “loan,” “lender,” “borrower,” “lending,” “borrowing,” when analyzing banks (private or Fed) and their credit operations. Banks do not lend money—they are not money lenders—and customers do not borrow money from banks. Words like “advance,” “creditor,” “debtor,” are more appropriate words to describe what goes on in banking operations. The word “lend” (and so “borrow”) is really a misnomer that has the potential of confusing—and actually does confuse—people about what banks do. “Lending” means giving up an asset temporarily: “I lend you my car for a few days” is represented as follows in terms of a balance sheet: Dr. T ΔAssets Car: ‐$100 Claim on borrower of car: +$100
ΔLiabilities and Net Worth
Alternatively, if someone goes to see a loan shark for his gambling habits and borrows $1000 cash, then the balance sheet of the loan shark changes as follows
14
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Loan shark ΔAssets Cash: ‐$1000 Claim on gambler: +$1000
ΔLiabilities and Net Worth
The loan shark loses cash temporarily—he does lend cash—and if the gambler does not repay quickly with hefty interest, the loan shark comes with a baseball bat and breaks his legs (or worse!). “To lend” is really not a proper verb to explain what the Fed does because reserve balances and FRNs are not assets of the Fed, they are its liabilities. As shown in point 2, when the Fed provides reserve balances to banks, the Fed gives to banks its own promissory note (reserve balances) and banks give to the Fed their own promissory notes. What the Fed does is to swap/exchange promissory notes with banks. This is one way for banks to obtain reserves balances. Chapter 4 and Chapter 10 explain why banks are so interested in the Fed’s promissory note and how they obtain reserves. Figure 2.3 shows what the banks’ promissory note looks like.
Figure 2.3 Template of the promissory note issued by banks to the Discount Window Source: Federal Reserve Bank Services (Operating circular No. 10)
15
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS In this legal document (and others attached to it), a bank recognizes that it is indebted to the Fed because the Fed provided an advance of funds, that is, credited the bank’s reserve balance. Now the bank promises to comply with the terms of the contract that details time table for repayment, interest, collateral requirements, covenants, what happens in case of default, etc. The Fed keeps a copy of this document in its vault; it is an asset for the Fed (A2 in Figure 2.1) because the bank made a legal promise to the Fed. The Fed can force the bank to comply with the demands of the promise. The main point is that, when the Fed provides funds to banks, the Fed does not give up something it first had to acquire. The Fed does not use “tax payers’ money” (or anybody else’s money) as we often heard during the 2008 financial crisis when large emergency advances had to be provided to many financial institutions. When the Fed provides/advances funds to banks, it just credits the accounts of banks by keystroking amounts. Chapter 10 shows that the same logic applies to private banks.
POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES UNLESS THEY ARE DEALING WITH OTHER FED ACCOUNT HOLDERS One may also note that nobody in the U.S. population has a bank account at the Federal Reserve. Only domestic banks, foreign central banks, and other specific institutions (such as the International Monetary Fund and some government‐sponsored enterprises) have an account at the Fed.4 When banks use their accounts at the Fed to make or to receive a payment, the only other institutions that can receive the funds (or make a payment to banks) are those that also hold an account at the Fed. Banks cannot use their reserve balances to buy something from an economic unit that does not have an account at the Fed because funds cannot be transferred. Similarly, you and I cannot make electronic payments to a person who does not hold a bank account. This is what happens when banks spend $100 from their reserve balances: Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$100
This T‐account is incomplete because it lacks the offsetting accounting entry. What are the possibilities? Below are three of them: 1‐ Banks ask for FRNs: Fed ΔAssets
ΔLiabilities and Net Worth FRNs: +$100 Reserve balances: ‐$100
2‐ Banks settle taxes (theirs or that of the US population): Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$100 Treasury’s account: +$100
3‐ Banks participate in an offering of securities by a government‐sponsored enterprise:
16
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$100 GSEs’ account: +$100
You may think of other ways to transfer $100 worth of funds on the liability side of the Fed. Once again, the Fed is basically keeping scores by transferring funds among account holders and keeping a tab. The main point is that banks cannot buy anything with reserve balances from anyone in the domestic economy except from each other and other Fed account holders. Banks as a whole cannot use reserve balances to acquire any security issued by the private sector or any goods and services (one bank could use its reserve balance to buy such things from another bank). More reserves do not provide banks more purchasing power in the domestic economy to buy existing bonds, stocks, houses, etc. If banks wanted buy something from someone in the domestic economy with Fed currency, they would have to get more vault cash first (case 1 above). Chapter 10 shows that banks do not operate that way to make payments. Nor do banks lend cash (they are not the loan shark of point 2).
CAN THE FED BE INSOLVENT OR ILLIQUID? No. The Fed cannot “run out of dollars” because it is the issuer of the dollar. The Fed could have a negative net worth and still be able to operate normally and meet all its creditors’ demands. The main role of net worth in a private balance sheet is to protect the creditors (the holders of the liabilities). Think of the house example in Chapter 1. The house was funded by $80k of funds obtained from a bank and $20k down. If the mortgagor defaults, the bank can foreclose and sell the house. With a net worth of 20k, the home price can fall by 20% before the bank is unable to recover the funds advanced to the mortgagor. If the down‐payment had been 0% (mortgage was $100k), when the bank forecloses it does not have any financial buffer against a fall in house price. For the Fed, this is financially irrelevant, although politically it may raise some eyebrows in Congress. It can meet all payments due denominated in USD at any time, no matter how big they are.
17
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS
Summary of Major Points 1‐ The main liability of the Federal Reserve System is the cash we have in our wallet, Federal Reserve notes. 2‐ The main asset of the Federal Reserve System is Treasury securities. 3‐ Lending means temporarily giving up an asset; as such the Federal Reserve System does not lend reserves because reserves are its liability. 4‐ To credit the account of its account holders, the Federal Reserve System swaps promissory notes with them. 5‐ To obtain an advance from the Fed, private banks must provide collateral to back their promissory note. 6‐ Paying interest to the Fed increases its net worth and debits the Fed accounts of whomever is paying the interest. There is no cash flow gain, i.e. no increase in monetary balances on the asset side of the Fed’s balance sheet. 7‐ Banks can only transfer funds in/out of their Fed accounts from/to other Fed account holders, in the same way you and I can only transfer funds from our checking account to another checking account. As such private banks cannot buy anything with their reserve balances from the public. 8‐ The Federal Reserve System issues the U.S. currency so it cannot run out of U.S. currency and can pay any debt it owes denominated in the U.S. dollar. Keywords Currency in circulation, Federal Reserve note, reserve balance, loan, lending, advance, swapping. Review Questions Q1: Do the Federal Reserve banks own any domestic monetary instruments? Q2: Do the Federal Reserve banks use coins to buy assets? Q3: Why do the Federal Reserve banks not lend reserves? Q4: Why is it not possible for private banks to buy things from the public by using their reserve balances? Q5: What can private banks buy with their reserve balances? Q6: When private banks pay an interest to the Federal Reserve banks, how do Federal Reserve banks record this income gain? Is there any gain of cash flow? Q7: Why is it not possible for the Federal Reserve System to be insolvent? Suggested Readings Check the “General Information” https://www.frbdiscountwindow.org/
tag
of
the
Discount
Window
website:
Check “About the Fed” here: http://www.federalreserve.gov/aboutthefed/default.htm Check the website of the Board of Governors of the Federal Reserve System, especially the following: http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm. Table 5 contains an interactive section about the balance sheet of the Fed.
18
CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS
Database Exploration How to retrieve time series data about the balance sheet of the Fed? Step 1: Go to Series H.4.1: http://www.federalreserve.gov/releases/h41/ Step 2: Click on “PDF” and look for Table 5. Use it as a reference point to select data. Step 3: Click on “Data download program.” Step 4: Select option A “Build your package.” Step 5: In “2. Category” select “Assets” and “Liabilities and Capital.”
Step 6: Continue with the subcategories and components. You can select more or less details relative to Table 5. Step 7: Continue with other miscellaneous selections (frequency, time frame, etc.) and download. Tip: Always download “total assets” and “total liabilities” so you can sum all the components of each category and make sure they equal the total. If not, you forgot a component. 1 For detail see Section 7 of Federal Reserve Act. 2
See Current FAQs: “What is the role of the Federal Reserve with respect to banknotes and coins?” at http://www.federalreserve.gov/faqs/currency_12626.htm 3 See Current FAQs: “Does the Federal Reserve own or hold gold?” at http://www.federalreserve.gov/faqs/does‐the‐ federal‐reserve‐own‐or‐hold‐gold.htm 4 A recent working paper released by the Bank of England proposes to expand the access to accounts at the Bank of England to the general population. Staff Working Paper No. 605, “The macroeconomics of central bank issued digital currencies” by John Barrdear and Michael Kumhof.
19
CHAPTER 3:
After reading this Chapter you should be able to understand: What reserves and monetary base are What the most common means to obtain reserves for banks are How the composition of reserves has changed over time How reserves and monetary base are injected into, and removed from, the economy
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET The previous Chapter explained how the balance sheet of the Fed works. The current Chapter begins to study the details of how the Fed operates in the economy in terms of monetary policy. To understand what the Fed does, it is first necessary to define the monetary base and see how it relates to the Fed’s balance sheet. The Chapter quickly looks at the difference between monetary base and money supply, and also looks more carefully at what reserves are.
THE MONETARY BASE AND THE MONEY SUPPLY The monetary base (aka “high‐powered money”) is defined as: Monetary Base = Reserve balances + vault cash + currency in circulation In its widest meaning, “in circulation” refers to any monetary instrument not held by its issuer; Federal Reserve Notes (FRNs) outside the Federal Reserve banks and any Treasury‐issued cash outside the Treasury. Economists prefer to use a narrower definition. Currency in circulation is any currency outside vaults of private banks (“vault cash”), of the Treasury, and of the Fed—what is held by “the public.”
Figure 3.1 Monetary base, billions of dollars Sources: Board of Governors of the Federal Reserve System (H3 and H6 series) Technically, cash means currency and coins. The Fed and Treasury use the word “currency” to mean paper money only. Currency in circulation includes mostly FRNs, but also some Treasury currency (United States notes, silver certificates) and national bank notes (issued prior to the creation of the Fed in 1913) that the Treasury still agrees to take at face value at any time.1 The distinction between coins and currency is mostly statistical and does not have any analytical power. Chapter 15 shows that the material of which something is made is irrelevant to determine if it is a monetary instrument. This book uses the word cash and currency interchangeably. To simplify, the U.S. monetary base can be reduced to (see Figure 2.1 for meanings of L1 and L2): 21
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Monetary base = L1 + L2 That is, the monetary base is the sum of reserve balances and FRNs held by entities other than the Fed and the Treasury. Until recently, currency in circulation was the largest component of the monetary base and it grew steadily to almost $1.4 trillion today, most of which are FRNs,2 and between one‐half and two‐thirds of the value of currency in circulation is held abroad.3 The global financial crisis led a large increase in reserve balances from about $24 billion on average from January 1959 to August 2008 to about $2.5 trillion today (Figure 3.1).
Figure 3.2 Money supply (M1 aggregate), billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.6)
The monetary base is not the same thing as the money supply. Money supply means monetary instruments held by non‐bank economic units and outside the Treasury and other official foreign institutions. There are several ways to measure that, and monetary aggregate M1 is the narrowest (Figure 3.2): M1 = Currency in circulation + Private‐bank checking accounts of non‐banks, non‐federal, non‐ official foreign economic units + others M1 relates to the Fed’s balance sheet only via part of L1. Since 1959, FRNs in circulation has represented a growing proportion of the monetary base (Figure 3.2). From 20% in the 1960s to 30% in the early 1990s. The 1990s recorded a rapid growth in the share of FRNs in circulation that peaked at 56% of the monetary base in 2007 and has been around 40% to 50% since the late 1990s. The proportion of demand accounts represented about 80% of the monetary base in the 1960s, but this share fell quickly and almost continuously following the emergence of alternatives to demand accounts. The share of demand accounts in the monetary base reached 20% of the monetary base right before the 2008 financial crisis. Since the crisis, the share of demand accounts has increased sharply to reach 40% of the monetary base. Traveler’s checks have always been an insignificant 22
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET component of the money supply. For reasons related to monetary policy detailed in Chapter 5 (Question 1), the growth rate of M1 increased in 2009. It is important to make a distinction between the money supply and the monetary base because the central bank has no direct influence on the money supply. The Fed does not deal with the public directly, private banks do. Even for FRNs, private banks are in charge of injecting FRNs into the economy, and they do so only if customers want to withdraw cash. In a 2010 interview4 Chairman Bernanke noted regarding the announced purchase of $600 billion of Treasuries (aka “quantitative easing”): One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. Translated in the terms of what was presented above, Bernanke states that L2 has gone up dramatically but that M1 has not changed. The Fed did not issue FRNs to the public (L1 did not increase), it just credited the accounts of banks by buying Treasuries from them and, as Chapter 2 shows, banks cannot do much with reserve balances. One should note that the Treasury’s account at the Fed (L3) and its accounts at private banks (called Treasury Tax and Loans accounts (TT&Ls)) are not part of the monetary base or the money supply. They are “funds.” The outstanding value of the Treasury’s accounts is not counted in any definition of the monetary base or the money supply.
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐ BORROWED Within the monetary base, reserves are central to monetary‐policy operations so this section studies a bit more carefully the reserve‐side of the monetary base. Total quantity of reserves is: Total reserves = Reserves balances + applied vault cash = L2 + part of L1 Applied vault cash are the FRNs that banks decide to use to calculate the quantity of reserves they report to the Fed (the rest of vault cash is called “surplus vault cash”). From the 1990s and until the Great Recession, applied vault cash had represented the majority of total reserves and peaked to about 80% of total reserves. Since August 2008, reserves balances have been, by far, the main component of total reserves (Figure 3.3). It is possible for reserve balances (L2) to be negative, that is, the Fed allows banks to have an overdraft; however, the Fed expects that banks close any overdraft at the end of each day. If a bank cannot do so, the Fed charges a very high interest rate because the overdraft is a form of uncollateralized advance, contrary to Discount Window advances. If the overdraft persists, the Fed may take a closer look at how the bank runs its business.
23
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET
Figure 3.3 Decomposition of total reserves in terms of forms, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3) Total reserves can be decomposed into other categories than those based on the form reserves take. One may also be interested in knowing how banks obtained their reserves. The Fed is the monopoly supplier of reserves and there are two ways for the Fed to provide reserves: -
Discount Window operations: advances funds by swapping promissory notes with banks (see Chapter 2): “borrowed reserves”
-
Open‐market operations: Fed buys some financial assets from banks either permanently (“outright purchases”) or temporarily (“repurchase agreements”): “non‐borrowed reserves” Total reserves = borrowed reserves + non‐borrowed reserves
Non‐borrowed reserves have been the main source of reserves for banks (Figure 3.4) because the Fed discourages the use of the Discount Window (interest rate is higher and Fed may increase supervision if a bank comes to the Window too often). The stigma of going to the Window is so strong that, during the 2008 crisis, the Fed had to change its Discount Window procedures to entice banks that desperately needed reserves to come. Non‐borrowed reserves was negative during most of 2008 and peaked at about ‐$330 billion in October 2008 just about at the same time as borrowed reserves reached their peak value (Figure 3.5). Non‐borrowed reserves is measured by total reserves minus borrowed reserves. Borrowed reserves is measured by A2 in Figure 2.1. For reasons related to monetary developments discussed in Chapter 4, total reserves became smaller than A2 during the 2008 financial crisis. The central bank provided a lot of advances but removes most of the reserve injection that resulted from the advance.
24
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET
Figure 3.4 Decomposition of total reserves in terms of sources, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)
Figure 3.5. Borrowed and non‐borrowed reserves during the 2008 financial crisis Sources: Board of Governors of the Federal Reserve System (Series H.3) Finally, the total quantity of reserves can be decomposed in terms of the reasons why banks hold reserves. Banks in the United States must have a certain proportion of reserves relative to the outstanding value of the bank accounts they issued: 25
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET -
Required reserves: The quantity of reserves banks must hold in proportion of the bank accounts they issued.
-
Excess reserves: whatever quantity of reserves that banks have in excess of required reserves. Total reserves = Required reserves + excess reserves
Up until the 2008 crisis, banks held reserves mostly because they had to do so (Figure 3.6). Excess reserves was virtually zero (Chapter 4 explains why). Up until the crisis, the quantity of reserves was also relatively stable over decades and averaged $40 billion (Figure 3.7). One may sometimes encounter the word “free reserves,” which just means the difference between excess reserves and borrowed reserves. Throughout this series, the most important categorization will be the last one: excess versus required reserves.
Figure 3.6 Decomposition of total reserves in terms of uses, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)
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CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET
Figure 3.7 Decomposition of total reserves in terms of uses until august 2008, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)
HOW DOES THE MONETARY BASE CHANGE? The monetary base goes up or down depending on what happens to the other items in the balance sheet of the Fed. Following the point that balance sheets must balance we have (using Figure 2.1): L1 + L2 = A1 + A2 + A3 + A4 + A5 – L3 – L4 – L5 So monetary base will be injected when: ‐
-
27
The Fed buys something (i.e. acquires an asset) from banks or the public -
Higher A1: Buying securities (T‐bills, T‐bonds, etc.)
-
Higher A2: Advances of Federal Funds
-
Higher A3: Buying foreign currency from private banks
-
Higher A5: Buying a pizza, a building, or a service from someone
The other Fed account holders spend in the US economy and when the Fed pays dividends to banks -
Lower L3: Treasury spends
-
Lower L4: US exports, government‐sponsored enterprises buy mortgages from banks
-
Lower L5: Fed pays dividends to member banks
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Monetary base is reduced when the opposite transactions occur. Buying coins from the Treasury does not change the monetary base because L3 goes up by the same amount as A4; it is an intra‐ federal government transaction. Let us go through two examples: Case 1: The Federal Reserve buys T‐Bills worth $100 from banks Fed ΔAssets ΔA1: +$100
ΔLiabilities and Net Worth ΔL2: +$100
Banks ΔAssets T‐bills: ‐$100 Reserve balances: ‐$100
ΔLiabilities and Net Worth
You have just witnessed the creation of monetary base: The central bank credits the account of banks by typing “100” on the keyboard of a computer. The Fed could also have printed bank notes (ΔL1 = +$100) but purchases from banks are done electronically because of convenience. Case 2: Dr. T pays his income taxes worth $1000. Assume that Dr. T still mails his income‐tax paperwork with a check payable to the United States Treasury. The Treasury receives the check and brings it to the Fed. To simplify, the following ignores Treasury’s tax and loan accounts (TT&Ls) because that just complicates the analysis without adding any insights at this point (see Chapter 6). The Fed sends the check to the bank of Dr. T. and so the bank debits the bank account of Dr. T by $1000. Bank of Dr. T. ΔAssets
ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000
What is the offsetting operation on the bank’s balance sheet? The $1000 have to go to the Treasury. Given that we assumed that the Treasury only has an account at the Fed we know that the offsetting operation cannot be (it would be if TT&Ls had been included): Bank of Dr. T. ΔAssets
ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000 TT&Ls: +$1000
The Treasury only has an account at the Fed so the following will occur when the $1000 are transferred (which would be the second step if TT&Ls were included in the analysis): Fed ΔAssets
ΔLiabilities and Net Worth Treasury’s account: +$1000
But that again begs the question: What is the offsetting accounting entry on the balance sheet of the Fed? It cannot be “Account of Dr. T: ‐$1000” because Dr. T does not have an account at the Fed. The answer is that when the Fed receives the check, it has a claim on Dr. T.’s bank. The bank settles that claim by giving up reserves and the funds are transferred into the account of the Treasury.
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CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Interbank claims (claims among private banks, and between the Fed and private banks) are always settled with transfers of reserves. Bank of Dr. T. ΔAssets Reserve balances: ‐$1000
ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000
Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$1000 Treasury’s account: +$1000
You have just witnessed the destruction of monetary‐base: taxes destroy monetary base. The central bank deleted $1000 in the reserve balance and keystroked $1000 in the account of the Treasury. Of course, if the Treasury spends then reserve balances are credited, and if Treasury spends more than its taxes then there is a net injection of reserves: fiscal deficits (government spending larger than taxes) lead to a net injection of reserves. Keep that in mind for Chapter 4. As a side note, one may note that Dr. T’s balance sheet changes as follows when taxes are paid: Dr. T. ΔAssets Account of Dr. T.: ‐$1000
ΔLiabilities and Net Worth Net worth: ‐$1000
An alternative accounting would be if Dr. T had owed a known dollar amount of taxes for a while, i.e. if the Treasury held some tax receivables against Dr. T. In that case, instead of net worth, it would be tax receivables that would go down by $1000.
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? Yes, it technically can because the monetary base is composed of liabilities of the Fed. In practice though, the Fed’s ability to inject reserves is constrained by the operational requirements of monetary policy. Chapter 4 shows that if the central bank issues reserves regardless of the needs of banks, it is not be able to achieve a specific policy interest rate it sets for itself unless it changes its operational procedures. At the origins of the Fed, some constraints were also put on the types of securities that the Fed could buy or that banks could pledge as collateral with their promissory notes to get an advance from the Discount Window. There was a fear that the Fed would over issue monetary base given its broad monetary power. Here is the language of the preamble of the 1913 Fed Act states: To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. “Elastic currency” just means that the Fed is able to add and remove monetary base at the will of banks and the public, that is, in response to the needs of the economy. However, until 1932, the 29
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Fed operated under the Real Bills Doctrine (RBD). What that meant was that the Fed ought to only accept securities that “self liquidate” in A1 and as collateral for A2 (see Figure 2.1). Self‐liquidating securities are those that are issued and destroyed in relation to economic activity. Firms issue securities to produce goods and services (see Chapter 10) and repay them when firms sell their production. The idea was that by tying monetary‐base creation to the financing of economic activities, the Fed would avoid inflationary tendencies that could come from an elastic currency. Monetary base (and so money supply as the thought of the time—erroneously—went) would grow in‐sync with production. In practice, RBD never worked out well for both theoretical and practical reasons. WWI led to a large holdings of Treasuries by the Fed. The Great Depression led to the elimination of the doctrine, and the 1932 Banking Act widened dramatically the types of securities the Fed could accept if needed (Table 3.1).
Table 3.1 Holdings of securities by the Fed, 1915‐1950 Source: Marshall’s Origins of the Use of Treasury Debt in Open Market Operations: Lessons for the Present One of the problems of RBD is that it relied on private indebtedness (issuances of securities by companies to finance production, “real bills”) for monetary policy to work. During a recession, banks did not have enough real bills to sell or pledge to the Fed because economic activity is moribund so private issuance plunges. This is problematic because the scarcity of real bills limited the ability of banks to obtain reserves, just at the time when banks desperately needed additional reserves to counter bank runs (people running to banks to ask for cash) and make interbank payments. More recently, Dodd‐Frank Act of 2010 amended the Federal Reserve Act to constrain the capacity of the Fed to use “emergency powers,” that is, its ability to accept any type of securities from anybody. This was a reaction to the advances provided to AIG; AIG was not part of the Federal 30
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Reserve System. It was also a reaction to the opaqueness of the Discount Window operations during the crisis and how questionable some of the transactions were. The Fed needs to be able to fight panics and the ensuing liquidity crisis when everybody (including every banks) is trying to get their hands on the currency. This is, indeed, why the Fed was created. It can only do so by being able to buy, or accept as collateral, a wide verity of securities. This leads us to a final important point. Given that the Fed provides a safety valve in the financial system, this safety may lead to moral hazard. Financial‐market participants may take more risks knowing that, if things go south, the Fed will intervene to avoid a collapse of the financial system. As a consequence the Fed must do two things: -
The Fed should also have ample regulatory and supervisory powers, and it should use them. That is what the last bit of the preamble is all about.
-
The Fed should discourage moral hazard and promote safe banking practices by accepting only securities that are of quality (that is based on sound underwriting and not in default) and from solvent institutions: The Fed exists to squash banking liquidity crises (temporary inability to access funds), not to keep insolvent banks alive (permanent inability to pay creditors).
Unfortunately, these two conditions have not been met recently and moral hazard has increased dramatically. The alternative is Andrew Mellon’s advice to Hoover: “liquidate labor, liquidate stocks, liquidate farmers, and liquidate real estate…it will purge the rottenness out of the system.” However, the cleansing properties of market mechanisms do not work properly, especially so in times of financial crisis and panic (see Chapter 14). Summary of Major Points 1‐ Banks hold reserves mostly because they are required to do so. 2‐ The Fed provides reserves to banks mostly by buying short‐term Treasuries from them, either temporarily or permanently. 3‐ Currently, the Fed is able to provide as many reserves as needed by banks. 4‐ Until 1932, the Fed was limited in its ability to provide reserves to banks because of constraints on the type of assets it could buy or take as collateral from them. Keywords Total reserves, required reserves, excess reserves, free reserves, borrowed reserves, non‐borrowed reserves, reserve balances, vault cash, overdraft, applied vault cash, surplus vault cash, Real Bills Doctrine, elastic currency Review Questions Q1: When a bank borrows reserves from another bank is that classified as borrowed reserves? Q2: Is all vault cash part of total reserves? Q3: Are excess reserves those that are not wanted by banks? Q4: What is the impact of a fiscal deficit on the monetary base? Q5: When the Fed sells Treasuries to banks, what happens to the monetary base? Q6: What are the two types of operations that the Fed uses to provide reserves to banks? 31
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET 1 See the following link for an explanation of the role of the Fed in terms of coins and notes: http://www.federalreserve.gov/paymentsystems/coin_about.htm 2 See http://www.federalreserve.gov/faqs/currency_12773.htm 3 Board of Governors of the Federal Reserve System, Currency and coins services: http://www.federalreserve.gov/paymentsystems/coin_about.htm 4 See the following 2010 interview with 60 minutes: https://www.youtube.com/watch?v=LxSv2rnBGA8
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CHAPTER 4: After reading this Chapter you should be able to understand: What monetary policy is all about Why monetary policy is done How the Federal Reserve implements monetary policy How monetary policy operations changed following the Great Recession How monetary policy can be conceptually analyzed
CHAPTER 4: MONETARY POLICY IMPLEMENTATION Chapter 2 examined the balance sheet of the Fed and Chapter 3 provided important information about the meaning of reserves and other basic concepts and their relation to the balance sheet of the Fed. This Chapter examines how a central bank implements monetary policy.
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY? While the details of operating procedures have changed through time, the federal funds rate (FFR) has progressively gained in importance as a relevant operating tool (that is, as a means to implement monetary policy) since the 1920s. The FFR is the yearly rate of interest at which participants in the federal funds market lend and borrow federal funds (“fed funds” for short) to each other overnight. For example, if the FFR is at 3% it means that if a bank borrowed $100 continuously for a year at that rate it would have to pay a $3 of interest. The equivalent daily rate is 0.0081% so if a bank borrows $100 in the evening, it has to repay the $100 plus $0.0081 of interest payment the next morning. While that does not seem much, when tens of billions of dollars are involved daily even such small interest rate can bring substantial income to the lender of fed funds.1 Fed funds are the dollar value of the accounts at the Federal Reserve (L2, L3, and L4 in the balance sheet presented in Figure 2.1). Holders of these accounts include private banks, the U.S. Treasury, government‐sponsored enterprises, the International Monetary Fund, securities firms, among others. Some of these account holders need more funds (usually banks)2 while others usually have more than needed. The fed funds market3 allows these participants to meet and make deals.
Figure 4.1 Daily average of FFR (grey line) and FFR target (black line), percent Source: Federal Reserve Bank of New York. The Fed is highly interested in the FFR and aims at targeting that rate, that is, the Fed wants to make sure that the FFR prevailing in the market does not deviate too much from the FFR desired by the 34
CHAPTER 4: MONETARY POLICY IMPLEMENTATION Fed (the FFR target) (Figure 4.1). Most of the time the Fed targets a specific number but sometimes it targets a range. This is the case today with a range of 0.25‐0.5%. From the late 1970s until 1991, the Fed also had a range that was as high as 16%‐22% in mid‐1981 and as wide as 13%‐20% in early 1980 (Figure 4.2). Since 1994, the FFR target has been public information as the Fed has committed to be more transparent. The Fed is highly interested in this interest rate for two main reasons. First, the FFR is a cost for banks so if the cost changes, the interest rates they charge to customers change. Second, market participants make portfolio choices (that is, buy or sell assets) with the aim of maximizing the rate of return on assets. They compare portfolio strategies and choose those that provide the highest yield. While making these portfolio choices, financial‐market participants take into account future monetary policy (that is, future FFR targets), which ends up impacting the current interest rate of a wide range of securities. Regarding the cost side of FFR, banks need reserves for four purposes (see Chapter 10 for further explanation): ‐
Cash withdrawals by customers: people get cash from banks.
‐
Reserve requirements: banks must keep a certain quantity of reserves that is a proportion of the dollar amount in the bank accounts they issued.
‐
Interbank debt settlements: paying debts due to other banks.
‐
Payments to other Fed account holders: for example tax payments leads to a drainage of reserves.
Figure 4.2 Monthly FFR average and target FFR range, 1979‐1990, percent Source: Transcripts of the FOMC meetings Note: After 1990, the FOMC targeted a FFR digit 35
CHAPTER 4: MONETARY POLICY IMPLEMENTATION By far, the largest day‐to‐day need for reserves is interbank settlements because banks that do not have enough reserves to make the necessary payments must get reserves to avoid default. They may get them either from other banks or other fed funds holders, or may go to the Fed. In any case, banks have to pay interest and the FFR is what banks pay to get reserves through the fed funds market (“non‐borrowed reserves”). This cost is then routinely passed on to their customers so that when the FFR rises, rates on mortgages, advances to students, credit cards, etc. also go up (see prime bank rate in Figure 4.3). In terms of portfolio choices, say that in 2016 you have $1000 and you want to figure out a way to make the highest gains over the next two years. Say only two portfolio strategies are available. A “long‐term strategy” is to buy and hold for two years a 2‐year security that pays 5%. A “short‐term strategy” is to buy a 1‐year security that pays 3% and to reinvest the proceeds in 2017 into another 1‐year security. Your choice between the two strategies should depend on what you expect the 1‐ year rate to be in 2017. You are indifferent between the two strategies if they provide the same rate of return, which means that you expect a 1‐year yield of about 7% in 2017 (solve $1000*(1.05)2 = $1000*1.03*(1+x) where x is the expected one‐year rate in 2017). If you expect the 1‐year rate to be higher than 7%, the short‐term strategy is more profitable. In that case, financial‐market participants will sell outstanding 2‐year securities and buy 1‐year securities, which raises the 2‐year rate and lowers the 1‐year rate until the two strategies provide the same rate of return. For example, if the expected 1‐year rate is 8%, then if the 2‐year rate goes up to 5.2% the 1‐year rate is 2.5%. Generalizing the logic, a rising FFR (similar to 1‐year rate going up) raises the rates on longer‐term securities. Long‐term rates depend on expectations about future monetary policy and if FFR is expected to rise (fall), long‐term rates will rise (fall). There is a very high correlation between the FFR and all other interest rates. The correlation is about 0.99 for short‐term securities and about 0.8 for long‐term securities like T‐bonds (Figure 4.3). Beyond expectations about future FFR, the interest rate on securities, especially of longer terms to maturity, is also influenced by inflation risk, tax risk, credit risk, liquidity risk, among others, which makes the link between FFR and longer‐term securities less strong. By influencing all interest rates, the Fed hopes to influence the willingness of the private sector to spend on goods and services; the ultimate goal being to influence inflation and employment. For example, if the Fed thinks that inflationary pressures are building up, the reasoning goes at follows: Higher expected inflation by the Fed leads to a higher FFR target, which raises the FFR, which raises other rates, which discourages private economic units from seeking external funds and raises thriftiness, which slows down spending on goods and services, which lowers inflation (see Chapter 12). There are a lot of steps between FFR and inflation/employment, and one may doubt it works well, but that is the logic behind the intervention of the Fed in the fed funds market. The Fed has a dual mandate, that is, its goal is to achieve both price stability (currently defined unofficially as achieving a 2% inflation rate) and full employment (defined as being at an unemployment rate at which inflation is stable, the “NAIRU”). Other central banks, like the European Central Bank, only focus on price stability.
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION
Figure 4.3 FFR and other rates Source: Board of Governors of the Federal Reserve System (series H.15)
TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS While banks do need reserves, they also do not like to hold more reserves than they need because reserves did not use to pay any interest. Chapter 3 shows that, prior to the crisis, banks held very few reserves, and most of them were held because the Fed required it. Banks like to keep a bit of
37
CHAPTER 4: MONETARY POLICY IMPLEMENTATION excess reserves to avoid the overnight‐overdraft penalty rate (Chapter 2 explains that reserve balances can be negative). What happens if banks cannot get enough fed funds for their needs? Banks cannot create more than what is available, only the Fed can. If the Fed does not add more fed funds then the FFR rises steeply and quickly given that bank must have the reserves they need. A higher FFR does not incentivize banks to demand less fed funds; their demand for reserves is inelastic and mostly non‐ discretionary. What happens if banks have too much fed funds? Banks cannot destroy/remove fed funds, only the Fed can. If the Fed does not remove enough fed funds, the FFR will fall very quickly to 0% given that banks do not have any other use for the excess reserve balances they have. A lower FFR does not give banks an incentive to supply less fed funds. To minimize fluctuations in the FFR and keep it around the target, the Fed intervenes daily to add or to remove fed funds by adding or removing reserve balances according to the needs of banks. If the FFR is above target then the Fed adds reserves, if the FFR is below target the Fed removes reserve balances. The way the Fed does this is via open‐market operations that usually involve exchanging reserves with T‐bills with banks (Figure 4.4): ‐
If FFR FFRT, banks lend and borrow at too high an interest rate relative to what the Fed wants. Banks have too few reserves. To correct that the Fed buys T‐bills from banks by crediting their reserve balances. Fed ΔAssets T‐bills: +$100
ΔLiabilities and Net Worth Reserve balances: +$100
Banks ΔAssets T‐bills: ‐$100 Reserve balances: +$100
ΔLiabilities and Net Worth
The open‐market operations can be permanent (“outright purchase/sale” by the Fed) or temporary (“repurchase agreement” and “reverse repurchase agreement”: the Fed and banks agree to perform the opposite transaction the following morning). For banks to agree to trade with the Fed instead of putting reserves in the market—or for banks to get reserves from the Fed instead of
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION borrowing from other banks—the Fed has to provide incentives. The Fed also has to make trades that ensure that the FFR stays around its target. Suppose that a bank has $1000 worth of reserves that it is ready to supply in the fed funds market. Suppose that the FFR is currently at 3% (so a daily rate of 0.0081%), where the Fed wants it to be, but if the bank supplied the funds the FFR would fall to 2%. How can the Fed entice the bank not to dump the funds in the market? One way is to do something similar to the following: the Fed sell to the bank one T‐bill for $999.92 and promises to buy it back the next day for $1000. This provides a daily rate of return of 0.0081% to the bank. The Fed does something similar when banks borrow fed funds at a rate higher than what the Fed wants (FFR > FFRT). It buys T‐bills at a price consistent with FFRT. That forces those willing to lend fed funds to comply with the FFRT; otherwise, no bank will borrow from them given that the Fed offers to provide reserves at a lower rate.
Figure 4.4 Targeting the FFR: Open‐market operations
The Fed could do this all day long and FFR would be on target all the time, but practically the Fed only intervenes once a day and accepts that the FFR fluctuates around the target. Each day, the Fed anticipates the approximate need for reserves by estimating how the items that change the monetary base will change during the day (A1 through A5, L3, L4, and L5 of Figure 2.1). The Fed is basically applying a sort of buffer‐stock policy on reserves in the same way diamond cartels limit the supply of diamond to control diamond price (I am sorry to tell you that diamonds are not rare). The main difference between the Fed and diamond cartels is that the Fed has complete pricing power because it is the monopoly supplier of reserves. Beyond day‐to‐day intervention in the fed funds market to maintain a FFRT, the Fed also sometimes changes its FFRT. Given that the demand for reserves is almost perfectly inelastic and given how small the increments and decrements in the FFRT are (usually 25 basis points at a time, that is, 0.25 percentage point), when the Fed changes its FFRT, it usually does not do anything for the target to be reached. If the Fed decides to lower the FFRT, it does not have to inject reserves first for the target to be reached. If the Fed decides to raise the FFRT, it does not have reduce the quantity of
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION reserves to reach the target. The FFR will move quickly around the target following the announcement of a change.4 Another way to understand that point is to again go back to the point that banks cannot do much with reserve balances, so any reserves they have in excess they will supply in the fed funds market. If the Fed announces it will offer reserves at a lower FFRT, banks must comply with the new FFRT when they offer to lend reserves, otherwise nobody will borrow from them. If the Fed announces it offers reserves at a higher FFRT, banks with reserves to lend also raise at which they offer to lend reserves. Otherwise, they forego an income opportunity because banks that need reserves have nowhere else to go (only the Fed can create more reserves and it will do it only at a higher FFR). It is “the Fed’s way or the highway.”
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET The Fed supplies, at a cost equal to the FFR target, whatever quantity of reserves is needed (Figure 4.5). The demand for reserves is almost perfectly insensitive to changes in FFR.5 Banks must meet interbank payments, tax payments, reserve requirements and withdrawals regardless of what the FFR is, and banks have very little incentive to ask for more reserves when rates fall because, as explained in Chapter 3, banks cannot do much with them.
Figure 4.6 The federal funds market
The fact that the supply of reserves is horizontal seems to suggest that the Fed supplies an infinite quantity of reserves. That is not the case, all that is saying is that the Fed supplies whatever banks demand. If banks want more reserves (demand curve shifts to the right), the Fed supplies more. If banks want fewer reserves, the Fed removes reserves; the currency is “elastic.” The Fed does not proactively add or remove reserves: ‐
If the Fed adds reserves without consulting banks, the FFR falls to zero.
‐
If the Fed removes reserves without consulting banks, the FFR rises to infinity.
Thus, while the Fed does the injection and deletion of reserves, the Fed adds or removes only on a defensive basis to maintain the FFR on target.
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION What monetary policy is all about is setting the price of reserves and letting the quantity of reserve adjust. The FFR is a policy variable that does not reflect any scarcity or abundance of reserves, or the preference of banks for reserves. A low FFR can prevail with very few reserves because if banks do not need many reserves, the Fed does not supply many at a given FFRT. A high FFR can prevail with a very large quantity of reserves because if banks need lots, the Fed supplies lots at a given FFRT.
TARGETING FFR AFTER THE GREAT RECESSION As the financial crisis grew from 2007 onward, the Fed began to lower its interest rate target from late 2007 (Figure 4.1) and, from early 2008, to provide significant quantities of emergency funds to the financial system (Figure 4.6). At first, the Fed neutralized the impact of all emergency advances by selling Treasuries so its supply of Treasuries fell by 40% in about six months (Figure 4.6). The Fed provided reserves to bank X that was in difficulty, bank X paid its creditor bank Y, bank Y had excess reserves available to lend in the fed funds market, Fed drained all excess reserves by selling Treasuries to bank Y. This allowed the Fed to maintain a positive FFR while also helping struggling financial institutions. In September 2008, the collapse of Lehman Brothers led to a panic and the Fed responded by providing large amounts of emergency advances (A2 of Figure 2.1 went up a lot). No fed funds market participant was willing to lend reserves to anybody; the fed funds market froze and the FFR became highly volatile (Figure 4.1). Emergency advances by the Discount Window led to a very large increase in reserve balances by almost $1 trillion by early 2009. From September 2008 until the end of the year, in order to keep FFR positive, the Fed did try to neutralize some of the impact of its massive emergency operations by working with the Treasury (Chapter 6 delves into the Treasury‐ central bank coordination). However, in order to fight the recession (and so potential deflation and unemployment), the Fed also rapidly lowered its FFR target, eventually to reach zero (0‐0.25% range to be precise) by December 2008 (Figure 4.1). The Fed then wondered what it could do next to help lower interest rates further given that the FFR target was at 0% and given that the Fed did not intend to have a negative FFR target. Two things were done: 1‐ Promise not to raise the FFR target for a long time (“forward guidance”): this pushed expectations of a rise in FFR further in the future and so lowered other interest rates. 2‐ Outright purchases of long‐term securities with the goal of lowering long‐term interest rates (“credit easing” followed by “quantitative easing”). By buying long‐term securities, the Fed raised the price of these securities which lowered their yield. The Fed bought outright long‐term Treasuries but also long‐term private securities (Mortgage‐ backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae)6 (Figure 4.6, Table 4.1). It did so without neutralizing the impact on reserves so reserves balances increased rapidly beyond the needs of banks (see Chapter 3). As a consequence, if the Fed had continued to operate as it did before the crisis, the FFR would have stayed stuck at 0% for as long as there would have been a large quantity of excess reserves.
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION
Figure 4.6 Assets of Fed and excess reserves (white line), trillions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)
Table 4.1 Maturity distribution of securities, loans, and selected other assets and liabilities, January 20, 2016, millions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)
Currently, the Fed wants to be able to raise the FFR even though banks have ample quantities of excess reserves. To do so, it has changed its operating procedures by paying interest on reserve balances (L2). This theoretically puts a floor on the FFR because if banks can earn interest on their Fed accounts, they do not have an incentive to lend these reserves in the fed funds market if the FFR goes below the interest rate on reserve balances (IOR). The Fed and other central banks now operate under a “corridor” framework (Figure 4.7). In theory, the FFR can only fluctuate between the IOR and the discount window rate (DWR). The FFR target is 42
CHAPTER 4: MONETARY POLICY IMPLEMENTATION set in the middle of the corridor and the three rates (IOR, FFRT and DWR) move together. There is a horizontal band instead of a horizontal line. Banks have no incentive to lend reserves if FFR is below IOR so FFR cannot fall below that. Banks have no incentive to borrow in the fed funds market if the DWR is lower than FFR so FFR will not rise above the DWR.
Figure 4.7 Interest‐rate corridor
In practice, the corridor in the United States is porous. In terms of the floor, other Fed accounts do not qualify to receive interest so their holders have an incentive to keep lending fed funds in the market even if FFR is below IOR. Government‐sponsored enterprises (in L4), especially the Federal Home Loan Banks,7 were a major source of excess supply of fed funds. Since the end of 2015, the Fed has solved this problem 8 by indirectly paying interest to other account holders through an auction mechanism. Now the IOR is a true floor. In terms of the ceiling, access to the Discount Window is highly stigmatized and contains some non‐monetary costs in terms of increased supervision and loss of reputation. As a consequence, banks refrain from going to the Window even if DWR is inferior to FFR. The true ceiling in that case is the overnight‐overdraft penalty rate. During the 2008 financial crisis, the Fed dealt with this problem by providing fed funds through the Window via occasional auctions in which participants could bid anonymously. A corridor policy does not have to be implemented only in period of excess reserves. If a central bank wants to intervene less frequently in the overnight market, a corridor policy can be useful to limit the volatility of the overnight interbank rate. For example, the ECB has been operating that way since the beginning (Figure 4.8). It intervenes in the market only once a week and lets the ceiling and floor do the job of containing the overnight rate around the target overnight rate during the rest of the week. Narrowing the gap between the floor and the ceiling would reduce the volatility of the overnight rate. The Fed had been on a semi‐corridor since 2003 when the Fed decided to raise DWR above the FFRT and to move both in sync while IOR stayed at zero all the time.
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CHAPTER 4: MONETARY POLICY IMPLEMENTATION
Figure 4.8 Corridor of ECB Source: Kahn’s Monetary Policy under a Corridor Operating Framework
Summary of Major Points 1‐ The Federal Reserve targets the cost of reserves not the quantity of reserves. It does so by setting the cost of providing advances (Discount Window operations) and by setting the cost at which banks lend to, and borrow from, each other (open‐market operations). 2‐ By setting directly the cost of reserves, the Federal Reserve can indirectly influence all other interest rates. The influence is the strongest on short‐term market rates and on interest rates that banks charge to their customers. 3‐ Through changes in interest rates, the Federal Reserve hopes to change spending habits and so to influence employment and inflation. 4‐ When the Fed changes its FFR target, it does not have to change the quantity of reserves to make the FFR move toward the target. In order to maintain the FFR around a given FFR target, the Fed intervenes daily to perform open‐market operations. 5‐ The Fed cannot supply fewer or more reserves than banks demand, otherwise it misses its FFR target. The Fed adds or removes reserves according to the demands of banks. 6‐ A high FFR can prevail with a large quantity of reserves and a low FFR can prevail with a small quantity of reserves. FFR is a policy variable not a market‐determined variable. 7‐ Quantitative easing led to a large increase in excess reserves. In order to be able to raise the FFR when it wants, the Fed changed its operating procedures by paying interest on reserves. Quite a few central banks now operate under a corridor framework. Keywords Federal funds rate, federal funds market, Discount Window rate, interest rate on reserves, corridor framework, quantitative easing, open‐market operation, outright purchase/sale, repurchase agreement, discount window operations, elastic currency. 44
CHAPTER 4: MONETARY POLICY IMPLEMENTATION
Review Questions Q1: If the Fed supplies more reserves than banks want, what happens to the FFR? What if supplies less? What will the Fed do to maintain the FFR on target? Q2: What does a horizontal supply of reserves means in terms of the supply of reserves and the federal funds rate? Q3: How can a corridor framework help reduce the volatility of the FFR? What would happen to the FFR if the discount rate, interest rate on reserves and FFR target were all equal? Q4: Why are the interest rates set by banks highly correlated with the FFR? Q5: Why are market rates correlated with the FFR? What happens if it is expected that the FFR will fall? Q6: If the Fed had not adopted a corridor framework, what would have been the problem for future monetary policy? Q7: How could a corridor fail to contain the FFR? Q8: What does it mean for the Fed to provide an elastic currency? Suggested readings “Come with me to the FOMC” by Governor Duke briefly presents what goes on during a meeting: https://www.federalreserve.gov/newsevents/speech/duke20101019a.htm Chapter 7 of Meulendyke’s U.S. Monetary Policy and Financial Markets is a detailed version of Duke’s speech, albeit a bit dated: https://research.stlouisfed.org/aggreg/meulendyke.pdf Kahn’s Monetary Policy under a Corridor Operating Framework provides a readable presentation of the corridor framework. More advanced readings are: Dow, S.C. (2006) “Endogenous money: structuralist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 35‐51, Northampton: Edward Elgar. Fullwiler, S.T. (2008) “Modern central bank operations—General principles,” http://www.cfeps.org/ss2008/ss08r/fulwiller/fullwiler%20modern%20cb%20operations.pdf Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy debate,” Review of Keynesian Economics, 1 (2): 171‐194. Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 17‐34, Northampton: Edward Elgar. Lavoie, M. (2010) “Changes in central bank procedures during the subprime crisis and their repercussions for monetary theory,” International Journal of Political Economy 39 (3), 3‐23. Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge: Cambridge University Press. Moore, B.J. (1991) “Money supply endogeneity: ‘reserve price setting’ or ‘reserve quantity setting’,” Journal of Post Keynesian Economics, 13 (3): 404‐413.
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Historical data about the federal funds market can be found at the Federal Reserve Bank of New York: https://apps.newyorkfed.org/markets/autorates/fed‐funds‐search‐result‐page 2 See “Who’s Borrowing in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueu at http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐borrowing‐in‐the‐fed‐funds‐market.html 3 See The Federal Funds Market: A Study by a Federal Reserve System Committee by the Federal Reserve System at https://fraser.stlouisfed.org/docs/meltzer/bog1959.pdf 4 This absence of a liquidity effect has been well documented. See Fullwiler, S.T. (2003) “Timeliness and the Fed’s Daily Tactics.” Journal of Economic Issues 37 (4): 851‐880 5 This graph ignores complications that comes from reserves requirements, which would flatten the demand for reserves at the FFRT. See Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy debate” Review of Keynesian Economics, 1 (2): 171‐194. 6The Federal National Mortgage Association (Fannie Mae) was a government agency created in 1938 to improve the liquidity of mortgages by acting as dealer of FHA/VA‐insured mortgages. Until the 1966 credit crunch, Fannie Mae remained a minor player in the secondary market for mortgages because it exclusively dealt in conforming mortgages. The crunch led Fannie Mae to enlarge its dealership to conventional mortgages and it became the largest player in the secondary mortgage market. In order to cope with this new state of affairs, Fannie Mae was split in 1968 into the Government National Mortgage Association (Ginnie Mae) and Fannnie Mae. Ginnie Mae took the previous role of Fannie Mae and is focused on maintaining a secondary market by providing guarantee on MBSs backed by FHA/VA‐insured mortgages. Fannie Mae was converted into a government‐sponsored enterprise by acting as a dealer of conventional mortgages. Federal Home Loan Mortgage Corporation (Freddie Mac) was created by an act of Congress in 1970 to compete with FNMA in the conventional mortgage market. 7 See “Who’s Lending in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueur from the Federal Reserve Bank of New York at: http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐lending‐in‐the‐fed‐funds‐ market.html 8 More details about the reverse repurchase agreement operations is available here: https://www.newyorkfed.org/markets/rrp_faq.html
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CHAPTER 5: After reading this Chapter you should be able to understand: Why targeting the quantity of reserves is not practically possible and goes against the purpose for which the Fed was created Why providing an elastic supply of currency is not by itself inflationary How quantitative easing impacts financial markets What a normalization policy is How central banks can set negative nominal interest rate Why central banks want interest rates to be negative What the impact of negative interest rates is on the profitability of banks What are some potential issues with fine tuning the economy with monetary policy
CHAPTER 5: FAQs ABOUT CENTRAL BANKING Previous Chapters studied the balance sheet of the Fed, definitions and their relation to the balance sheet of the Fed, and monetary‐policy implementation. This Chapter answers some FAQs about monetary policy and central banking. Each of them can be read independently.
Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? The Fed does not set the quantity of reserves and does not control the money supply (M1). It sets the cost of reserves; that is it. In terms of reserves, the Fed was created to provide an “elastic currency,” i.e. to provide monetary base according to the needs of the economic system in normal and panic times. It would be against this purpose to implement monetary policy by unilaterally setting the monetary base without any regard for the daily needs of the economic system. In terms of the money supply, the Fed has no direct influence. Even Federal Reserve notes (FRNs) are supplied through private banks, and banks supply only if customers ask for cash. The Fed does not force feed FRNs to the public, i.e. FRNs cannot be “helicopter dropped” via monetary policy. If the Fed did this, not only would it operate against the Federal Reserve Act, but also it would lead people to take the FRNs, bring them to banks, banks would have more reserves, FFR would fall, Fed would remove excess reserves to bring FFR back up—back to square one. The Fed may have an indirect influence on the money supply through changes in its FFR target because changes in the cost of credit may change the willingness of economic units to go into debt, but the link is tenuous (see Q10). Through its policy of Quantitative Easing, the Fed may have an indirect influence in two other ways. First, if the Fed buys long‐term Treasuries from banks, banks usually have an incentive to replenish their holdings of Treasuries because they allow to meet capital requirements (see Chapter 9) without compromising too much profitability and liquidity. Treasuries have a low‐capital weight, have a liquid market, and pay interest income. Banks will buy securities from non‐bank economic units by crediting the bank accounts of the latter (see Chapter 10). Second, if the Fed wants to buy securities from non‐central‐bank account holders, the Fed works through banks and the following occurs: Fed ΔAssets Securities: +$100
ΔLiabilities and Net Worth Reserve balances: +$100
Banks of sellers of securities ΔAssets ΔLiabilities and Net Worth Reserve balances: +$100 Account of sellers: +$100 Sellers of securities ΔAssets ΔLiabilities and Net Worth Account of sellers: +$100 Securities: ‐$100
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CHAPTER 5: FAQs ABOUT CENTRAL BANKING The money supply goes up by $100 when “account of sellers” increases by $100 (but it does not if only reserve balances go up by $100).
Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT TARGETING RESERVES IS POSSIBLE? In the 1970s, the Monetarist school of thought gained some influence in policy circles. Monetarists argued that there is a close relation between the quantity of reserves and the money supply, and that the role of a central bank is to control the quantity of reserves in order to influence the money supply and ultimately inflation (see the quantity theory of money in Chapter 12). The Fed, under the leadership of Paul Volcker, tried to implement a monetary‐policy procedure that aimed at more closely targeting reserves and monetary aggregates, with the hope of taming a double‐digit inflation rate. Practically, the Fed changed interest‐rate targeting from a narrow range to a wide range (see Chapter 4), which increased the level and volatility of the FFR dramatically (Figure 5.1). The Fed did not allow the FFR to move freely as a targeting of total reserves implies. There is an academic debate about how truly “Monetarist” the Volcker experiment was, and this debate is reflected in the FOMC discussions of the time MR. ROOS. Well, if the level of borrowing comes in higher than we would anticipate, [can’t] you reduce the level of the nonborrowed reserves path accordingly? Can’t you adjust your open market operations for the unexpected bulge in borrowing or the unexpectedly low borrowing if you ignore the effect on the fed funds market? Can’t you just supply or withdraw reserves to compensate for what has happened? […] CHAIRMAN VOLCKER. The Desk can’t [adjust] in the short run. It’s fixed. In a sense they could do it over time if people are borrowing more, as they may be now. They seem to be borrowing more than we would expect, given the differential from the discount rate. But in any particular week it is fixed. MR. ROOS. Do we have to supply the reserves? CHAIRMAN VOLCKER. We have to supply the reserves. MR. ROOS. [Why] do we have to supply the reserves? If we did not supply those reserves, we’d force the commercial banks to borrow or to buy fed funds, which would move the fed funds rate up. (FOMC meeting, September 1980, page 6) Mr. Roos was deeply dissatisfied with the Fed still using a FFR target, albeit in the form of a wide range. While the Fed had a total‐reserve growth target related to the 3‐month growth rate of M1, if banks needed more than what was targeted, the Fed would supply extra reserves in order to relieve pressures on the FFR. Roos argued against this lenient reserve targeting and was for a total abandonment of any FFR targeting and a strict targeting of total reserves. Here he is in 1981: I think there’s a very basic contradiction in trying to control interest rates explicitly or implicitly and achieving our monetary target objectives. And I would express 49
CHAPTER 5: FAQs ABOUT CENTRAL BANKING myself as favoring the total elimination of any specification regarding interest rates. (Roos, FOMC meeting, February 1981, page 54) Most Federal Open Market Committee members were against that position on the ground that the role of the Fed is precisely to promote an elastic monetary base. The Fed was not created to dictate what the quantity of reserves ought to be but to eliminate liquidity problems through smooth interbank‐debt clearing and settlement at par, lender of last resort, and interest‐rate targeting. In addition, banks mostly hold reserves because they are required to, so if the Fed does not supply enough reserves to meet the requirements then banks will break the law. The experiment was a monetary‐policy failure. The Fed was never able to reach its reserve or money targets and the experiment contributed to massive financial instability and a double‐dip recession. One may even doubt that it contributed significantly to the fall in long‐term inflation, which had more to do with the downward trend in oil prices, oil‐saving policies and greater international labor competition: May I remind you that we shouldn’t take too much credit for the price easing? I never thought we were totally at fault for the price increases that we suffered from OPEC and food; and I don’t think the fact that OPEC and food have calmed down has a great deal to do with monetary policy per se, except in the very long run. (Teeters, FOMC meeting, July 1981, page 46) The Volcker experiment was, however, a public‐relation success. Most FOMC members knew that reserve targeting was not possible; still, it allowed them to claim that they were not responsible for the high interest rates of the period: I do think that the monetary aggregates provided a very good political shelter for us to do the things we probably couldn’t have done otherwise. (Teeters, FOMC meeting, February 1983, page 26) I think the important argument, and really the reason why we went to this procedure, was basically a political one. We were afraid that we could not move the federal funds rate as much as we really felt we ought to, unless we obfuscated in some way: We’re not really moving the federal funds rate, we’re targeting reserves and the markets have driven the funds rate up. That may have had some validity at the time, and I had some sympathy for it. But as time goes on, I’ve become more and more concerned about a procedure that really involves trying to fool the public and the Congress and the markets, and at times fooling ourselves in the process. (Black, FOMC meeting, March 1988, page 12) Of course the high and volatile FFR was precisely the result of the change in monetary‐policy procedures. If needed, some FOMC members were willing to do the same thing in the future: Well, I have only a little to add to all of this. I think Tom Melzer is probably right: We’re going to need to shift the focus to some measure or measures of the money supply as we proceed here if we can, both for substantive reasons and also because that has some political advantages as well, as we go forward. (Stern, FOMC meeting, December 1989, page 50)
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Figure 5.1 Average and standard deviation of the FFR Source: Federal Reserve Board, NY Federal Reserve Bank
Q3: IS TARGETING THE FFR INFLATIONARY? With the failure of the Volcker experiment, the FOMC entered a period of operational uncertainty until the mid‐1990s. The Fed was back on a tight FFR target procedure (there was still a wide range until 1991 but the Fed mostly targeted the middle of the range) and this was deeply unsatisfactory to FOMC members. We’ve advanced from pragmatic monetarism to full‐blown eclecticism. (Corrigan, FOMC meeting, October 1985, page 33) No, I would say that we have a specific operational problem that we have to find a way of resolving. Just to be locked in on the federal funds rate is to me simplistic monetary policy: it doesn’t work. (Greenspan, FOMC meeting, October 1990, pages 55–56) In a world where we do not have monetary aggregates to guide us as to the thrust of monetary policy actions, we are kind of groping around just trying to characterize where the stance is. (Jordan, FOMC meeting, March 1994, page 49) The Fed was unwilling to disclose that it was targeting the FFR, and continued to announce targeted growth ranges for monetary aggregates even though it did not use them for policy purposes. [In response] to talk that says we can significantly influence this – or as the phraseology goes that if we lower rates, we will move M2 up into the range – I say “garbage.” Having said all of that, I then ask myself: ‘What should we be doing?’ Well, we have a statute out there. If we didn’t have the statute, I would argue that we ought to forget the whole thing. If it doesn’t have any policy purpose, why are 51
CHAPTER 5: FAQs ABOUT CENTRAL BANKING we doing it? By law [we have] to make such forecasts. And if we are to do so, I suggest that we do them in a context which does us the least harm, if I may put it that way. (Greenspan, FOMC meeting, February 1993, page 39) We do not, in fact, discuss monetary policy in terms of the Ms between Humphrey‐ Hawkins meetings. Don Kohn dutifully mentions them because he thinks he ought to, but that is not the way we think about monetary policy. (Rivlin, FOMC meeting, February 1998, page 91) To announce to the general public that the FOMC was targeting the FFR would be going against all the Monetarist principles (reserve targeting, money multiplier theory, quantity theory of money). Targeting an interest rate, and so having an elastic supply of reserves (horizontal supply at a given FFRT), seemed to indicate that the Fed was no longer willing to control inflation. FOMC members themselves believed that was the case: Many analysts, both inside and outside the Fed, argued that using the Federal funds rate as the operational target had encouraged repeated over‐shooting of the monetary objectives. (Meulendyke 1998 49) Talking about the FFR target became a taboo and “the Committee deliberately avoided explicit announced federal funds targets and explicit narrow ranges for movements in the funds rate” (Kohn, FOMC Transcripts, March 1991, page 1): I must say I’m still quite reluctant to cave in, if you will, on this question that we can do nothing but target the federal funds rate. (Greenspan, FOMC transcripts, March 1991, page 2) As a practical matter we are on a fed funds targeting regime now. We have chosen not to say that to the world. I think it’s bad public relations, basically, to say that that is what we are doing, and I think it’s right not to; but internally we all recognize that that’s what we are doing. (Melzer, FOMC transcripts, March 1991, page 4) We will see later why the entire Monetarist logic is flawed. Monetary policy is always about providing an elastic supply at a given interest rate. There is nothing intrinsically inflationary about this. Having an “elastic currency” usually just means supplying whatever quantity of reserves banks want, and usually banks do not want much. While all this was very well understood by many economists long before Volcker’s experiment (see for example Nicholas Kaldor),1 it took FOMC members until the mid‐1990s to get comfortable with FFR targeting.
Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED? Monetary policy is always about setting at least one interest rate. While today the Fed operates mostly through the fed funds market, it has other tools at its disposition to help influence interest rates. One is the (re)discount rate, the rate at which banks can obtain borrowed reserves (see Chapter 3). This interest rate is now higher than the FFR target but from the mid‐1960s until 2003 the discount rate was usually below the FFR target. The Fed decided to put the discount rate above the FFR target to put a ceiling on the FFR and so limit upward volatility in FFR (see Chapter 4). 52
CHAPTER 5: FAQs ABOUT CENTRAL BANKING Reserve requirement ratios can also help target the FFR. These ratios state how many total reserves banks must keep on their balance sheet as a proportion of the bank accounts they issued. While these ratios are often discussed in relation to the ability of banks to create checking accounts, their actual purpose is once again to help target the FFR. By raising reserve requirement ratios, the demand for reserves becomes more predictable given that a greater proportion of the reserves available must be held by banks. With a more stable demand for reserves comes less volatility in the FFR.
Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES? The link cannot be one where banks have excess reserves that they use to buy assets in the secondary market. Chapter 2 explains that banks cannot do this as a whole. They could buy from one another, but if they all have reserves they want to get rid of, this is not possible because no bank wants to sell assets for reserves. The link goes through the following channels: 1‐ The Fed buys large quantities of securities from banks which raises their prices and so lowers their yields. 2‐ As yields on these securities fall, economic units seek assets that provide higher yields. They will look for assets with large expected capital gains, especially so knowing that others are experiencing the same problems and are “searching for yield.” They will continue to buy these securities, which will raise their prices, until all rates of return are equalized once adjusted for risks. Financial companies have to do the second step because they try to reach the target rates of return that they promised to their stakeholders. Pensioners expect a substantial rate of return from their pension funds, wealthy individuals expect a substantial rate of return from hedge funds, mutual funds shareholders wants a substantial rate of return…and they all check every quarter if financial companies stay on course to meet the promised target. Long‐term Treasuries used to provide a safe and simple way to meet this promise; no longer so. Bill Gross (a well‐known portfolio manager who specializes in bond trading) brought the point forward very clearly. He hopes that the Fed will raise the FFR to make it easier to reach targeted rates of return. He notes2 that low FFR prevents savers from earning enough to pay for healthcare, retirement and other costs because yields on financial assets are so low compared to the expected 7% or 8%. If the Fed does not help by raising the FFR, financial‐market participants will take large risks on their asset side (speculative, high credit risk, and structured securities) and liability side (high leverage) to try to reach their targeted rate of return. There is a broad problem though. In an economy in which the growth of the standard of living is low, why should anyone expect that demanding 7‐8% be sustainable? Those can only be achieved through capital gains and leverage, and the combination of these two is highly toxic (see Chapter 9 and Chapter 14). Instead of the Fed raising its FFR, it should be the rentiers who should reduce their expectations of rates of return. An economy that grows at 2% per year cannot sustainably provide a real rate of return higher than 2%; even that is a stretch. Other means3 must be used to meet the challenge of an aging economy than increasing the financialization of the economy.
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Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY Normalization policy4 means the willingness of the Fed to do two things: 1‐to raise the FFR to a more normal level 2‐ to reduce the size of its balance sheet in order to return the proportion of excess reserves to pre‐crisis value. Chapter 4 shows how this would be done for the FFR. Regarding reserve balances, Chapter 3 shows that their dollar amount is determined as follows: L2 = Assets of the Fed – (L1 + L3 + L4 + L5) Most of L2 is now composed of excess reserves, which is unusual. A graphical representation of this balance‐sheet identity is Figure 5.2.
Figure 5.2 Balance sheet of the Fed and reserve balances Source: Board of Governors of the Federal Reserve System (Series H.4.1)
The implication of this balance‐sheet identity is that reserves balances will fall either when assets of the Fed decline given other liabilities, or when the other liabilities of the Fed rise given assets. Let us look at each case in turn. Given liabilities other than reserves balances, reserves will not go back down until the following happens to the securities held by the Fed: 1‐ Securities issued by non‐fed‐account holders mature (let us call them “private securities” to simplify) 2‐ The Fed decides to sell some securities to banks. If the Fed let Treasuries mature the account of the Treasury (L3), not reserve balances, is debited:
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CHAPTER 5: FAQs ABOUT CENTRAL BANKING Fed ΔAssets Treasuries: ‐$100
ΔLiabilities and Net Worth L3: ‐$100
Treasury ΔAssets L3: ‐$100
ΔLiabilities and Net Worth Treasuries: ‐$100
When private securities held by the Fed, currently agency‐guaranteed MBS,5 mature the following occurs: Fed ΔAssets Private securities: ‐$100
ΔLiabilities and Net Worth Reserve balances: ‐$100
Banks of issuer ΔAssets Reserve balances: ‐$100
ΔLiabilities and Net Worth Account of issuer: ‐$100
Issuer of private securities ΔAssets ΔLiabilities and Net Worth Account of issuer: ‐$100 Private securities: ‐$100 If all MBS held by the Fed matured at once, that would reduce reserve balances by almost $2 trillion (the Fed does not plan to sell most of the MBS it holds).6 Given assets, reserve balances will go down if banks need to make payments to other Fed account holders or if banks convert reserve balances into cash. For example, if the Treasury ran fiscal surpluses, reserve balances would fall as funds would move from L2 to L3. While the Fed may ask, and has asked, for the Treasury’s help in managing monetary policy (see Chapter 6), the Fed has mostly no control over what happens to liabilities that impact reserve balances. One may note to conclude that, besides changes in assets and liabilities, another way to reduce excess reserves without reducing the quantity of reserves is to raise reserve requirement ratios. As to when the reserves will be back to their usual level, nobody knows. The pace of decline will change as the economic environment change, which brings us to a final point. There is no need for the Fed to be proactive about normalizing its balance sheet because, with the change in monetary policy procedures that occurred in 2008, the Fed can target the overnight interbank rate.
Q7: IS THERE A ZERO LOWER BOUND? This question is so 2013! There is no lower bound. The discount rate is the most straightforward to grasp because the Board of Governor has perfect control over the discount rate and can set it wherever it wants whenever it wants. There is no operational constraint that prevents the Board from setting a discount rate at ‐1%, ‐10% or even ‐100%, it just needs to announce tomorrow that this is what it is and that is it.
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CHAPTER 5: FAQs ABOUT CENTRAL BANKING The federal funds rate is slightly more complicated but not that much. To set a negative fed fund rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero‐ coupon securities like T‐bills, the present value of a T‐bill is: P = FV/(1 + d)t P is the market price, FV is the face value, d is the discount factor, and t is time to maturity (let us set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T‐bills at $90 and bankers agree to buy back the next day at $95 (d = 5%). After the 2008, one can assume that d = 0%, that is, if bankers want reserves from the Fed, they sell T‐bills at $90 and promise to buy them back at $90 the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90. In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough of these kinds of operations, the federal funds rate will reach the ‐5% target. Remember that the Fed sets the price of reserves. It can set it wherever it wants: “It is the Fed’s way or the highway.” Which interest rate can be below zero? Any of them as long as the Fed is committed to doing so by buying enough of securities at a price consistent with the interest rate it wants to target. The interest rates used in the corridor framework (see Chapter 4) are under the total control of the Fed so they are easy to make negative. The Swedish central bank shows us how this is done under a corridor framework (Figure 5.4). The Swiss central bank shows us how it is done with a negative overnight interbank rate range (Figure 5.3).
Figure 5.3 Target overnight rate range and daily overnight rate, Swiss National Bank, percent Source: Swiss National Bank
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Figure 5.4 Corridor of the Sveriges Riksbank, percent Note: The “deposit rate” is the interest rate on reserve balances, the “lending rate” is the rate charged by the central bank for advances (the discount rate of the Fed), the “repo rate” is the rate at which the central bank performs open‐market operations (the targeted overnight rate). Of course, if a central bank has negative policy rates and is expected to continue to have negative rates for a while, this enters into portfolio strategies and pushes longer‐term rates into/toward negative territories (Figures 5.5 and 5.6). But, the European Central Bank is going further and is buying large quantities of long‐term government bonds. And financial‐market participants took notice 7 and bought government bonds in anticipation of the intervention of the ECB. Financial‐ market participants are so sure the ECB will buy a lot of securities that they are willing to buy at a premium (so yields to maturity are negative) (Figure 5.4). They will sell to the ECB who will be the one taking the loss by holding to maturity. For example, take a 1‐year zero‐coupon government security with a face value of $1000. Normally, this security will trade at a discount, that is, economic units will only buy it for less than $1000 because it does not pay any coupon. They will earn an income by keeping the security until the Treasury repays the $1000 at maturity. If the security is bought at $800 then the rate of return is $200/$800 = 25% (rate of return is what the earning you get for what you paid for it). Rates of return on Eurozone government 1‐year securities are now negative because securities sell at a premium. For example, if one has to pay $1200 on a 1‐year zero‐coupon security and gets $1000 at maturity, the rate of return is ‐$200/$1200 = ‐17%. Nobody will want to buy that unless one expects someone else to buy at, say, $1300 in upcoming days or months. The ECB is willing to do so and will take a loss of $300 (‐23% rate of return) when the securities mature, while financial market participants make a return of $100/$1200 = 8%.
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Figure 5.5 Yields on government bonds Source: The Economist
Figure 5.6 Yields on Swedish government securities, percent Source: Swedish Central Bank
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Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE POLICY? It depends on which rate is concerned. A simplified bank profit is: Profit of banks = (ROA*other assets + IOR*R) – FFR*fed funds debt ROA is the return on assets held by banks (say you have a $1000 mortgage with an interest rate of 5%, this 5% is an income for the bank equal to ROA*mortgage = 5%*$1000 = $50). IOR is interest on reserve balances and R is reserve balances. There are no other debts than those incurred from getting reserves in the fed funds market either from Fed or from other market participants than banks. Interest payments on interbank loans cancel out in the aggregate profit of banks, it is an income for one bank and an expense for another). ‐
Given everything else, negative FFR raises the profitability of banks because banks are paid to get an advance of reserves.
‐
Given everything else, negative IOR lowers the profitability of banks. This is especially significant today given how large reserve balances are.
Banks will react to these effects in several ways in order to preserve their profitability. To counter a negative IOR, banks may do three things: ‐
Ask their customers to pay a fee on their checking accounts (either a larger one or raise the minimum quantity of funds in an account below which a fee is paid)
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Raise the bank prime rate (i.e. interest rate paid by the most creditworthy economic units) or acquire riskier assets so as to raise ROA.
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Raise leverage on the funding of assets with positive ROA.
If the fee on bank accounts is too large, customers may ask for cash and close their accounts, but that is not really a problem for banks given that: 1‐ If the FFR is negative, banks can borrow all the reserves they need and be rewarded for it. Today they have plenty of reserves so this effect is limited, but it also means that meeting cash withdrawals is easy. 2‐ Banks work by granting advances and making electronic payments so some individuals must have deposits. In addition, nobody can access cash (Federal Reserve notes) if one does not have an account in the first place, and banks create these accounts by providing advances. Advances pay interest. The real problem is a negative IOR in the context of a large quantity of excess reserves. It acts like a tax and may incentivize banks to take more risks. This effect is all the more strong given that banks do not need to borrow in the fed funds market so a negative FFR has a limited ability to offset the negative impact of a negative IOR. In terms of negative bond rates, the impact is that bondholders make capital gains by selling to the central bank (see Q7). The central bank hopes that bondholders will use some of their capital gains to consume and so stimulate the economy. Given how unequal wealth distribution is, the ability of this channel to work seems doubtful. It is a form of trickle‐down economics.
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Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE INTEREST RATES AND QE? Here is the logic followed: 1‐ A negative policy rate in a time of deflation (or low/zero inflation) allows us to keep the real interest rate low (allows us to lower the real rate). Economic units pay attention to the real rate (interest rate less inflation) when they decide to go into debt. If policy rate goes negative that should incentivize economic units to go into debt. 2‐ By buying a lot of securities from banks, banks will have a lot of excess reserves and will be encouraged to provide credit. And there will be a demand for credit given step 1. 3‐ Now that QE provided banks with lots of excess reserves, banks are supposed “to lend” (see money multiplier theory in Chapter 10). By setting IOR negative, banks will have less incentive to cling on their reserves and instead will provide credit. Indeed, if they keep reserves a negative IOR would lead to losses (see Q8). 4‐ Beyond the positive impact of bank credit, negative policy rates and quantitative easing also help push down other rates, which promotes capital gains by securities holders and so consumption. There are several issues but the three main ones are: 1‐ The ability of banks to grant credit is unrelated to the quantity of excess reserves they have. Chapter 4 shows that banks cannot do much with reserve balances (see Chapter 10). Central banks can feed banks to tons of reserves and may even threaten banks’ profitability with negative IOR, but it is just like beating a dead horse; banks are stuck with reserves. 2‐ In a depressed and over‐indebted economy, incentivizing economic units to go into debt is the wrong way to proceed. 3‐ The form of trickle‐down economics that quantitative easing and negative yield rates represent has never worked. We need a bottom‐up approach8 that focuses on providing jobs, fighting poverty, and meeting the needs of the nation. Fiscal policy is the means to do so.
Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY? While the Fed is heavily involved in “fine‐tuning” the economy—i.e. making sure the economy is not too hot (inflation) nor too cold (unemployment) by moving the FFR target up and down—one may note that the Fed (and other central banks) was not created for that purpose. Central banks were created either to finance the crown/state, or to promote financial stability (both goals are actually intertwined as shown in Chapter 6). Some economists, like Hyman Minsky, think that fine‐tuning and promoting financial stability are incompatible goals. A central bank should focus on promoting financial stability through low and stable nominal interest rates, as well as proper regulation, supervision and enforcement. The Fed could also influence financial innovations by refusing to accept as collateral any financial instrument 60
CHAPTER 5: FAQs ABOUT CENTRAL BANKING that promotes “Ponzi finance” (see Chapter 14). Fine‐tuning the economy with interest rates implies raising interest rate during an expansion, which ultimately contributes to problems with servicing debts. Given that decisions to go into debt are not interest‐rate sensitive, raising rates just pushes economic units to go more into debt to pay existing debts. The hope is that income and capital gains will ultimately enable the full repayment of debts. More broadly, the link between FFR and the end goals of employment growth and inflation control is tenuous and subject to perverse linkages. For example: ‐
The link between interest rates and business investment is very weak, with investment by companies overwhelmingly dependent on expected net cash flows.
‐
Higher interest rate raises the cost of doing business and firms may pass that cost to their clients, resulting in inflation.
‐
Higher interest rate also raises the income of rentiers and so their consumption. If the economy has a large proportion of rentiers (pensioners, wealthy individuals, etc.) then raising rates may be inflationary.
‐
Higher interest rate raises the private‐debt burden and promotes financial instability.
‐
Interest‐rate volatility promotes financial innovations to remove the sensitivity of profit to interest‐rate swings.
‐
Increments in FFR are small and announced well in advance, giving plenty of time to economic units to adapt in order not to let their decisions be influenced by the cost of credit.
Instead of nudging incentives so that, maybe, the private sector will spend, some economists promote a more direct approach. In times of crisis, implement large scale fiscal spending to meet the needs of the nations (in the US, one of these needs would be infrastructure that is in really bad shape).9 At any time, involve the government in direct job creation by employing people in similar way it was done in the New Deal; a Job Guarantee program. In times of expansion, constantly check financial innovations and forbid financial practices related to Ponzi finance or at least remove any safety net for them. Finally, there have been some debates 10 also about how to set the FFR target. In the more mainstream literature, this issue boils down to what to include in the Taylor rule (a rule that determines what the optimal FFR target should be given a state of the economy) and how much weight to put on each element that influences the rule. In the non‐mainstream approach, the discussion is broader and includes discussions about the distributive and destabilizing impacts of monetary policy. Some authors want the central bank to target a specific interest rate to make rentiers’ income stable and related to the productivity gains of the economy. Others want to leave FFR permanently around zero and let other rates do the job of sorting credit risk, inflation risk, etc. A positive FFR just adds extra income to rentiers and does not reward any risk (see Q5 with Bill Gross). For your reading pleasure below are three extracts from some Federal Open Market Committee meetings that illustrate some of the previous points. First on the lack of interest‐rate sensitivity: In addition to the input that we bring to these meetings and the usual sources of our own research staff and directors, last Friday when Vice Chairman Schultz visited us in San Francisco we called in a special small group of bankers, businessmen, and 61
CHAPTER 5: FAQs ABOUT CENTRAL BANKING academicians for a very frank exchange of views. We sounded them out about their feelings on the economy and on Fed policy, and I must say, Fred, that I thought the reactions were quite candid and somewhat humiliating in a way. The bankers generally expressed the view that as yet there’s very little evidence that the high level of interest rates is having any significant total effect on cutting off credit demand. Now, one has to add to that the expressions we got from them in our usual go‐around with bankers and bank directors that these high rates are having a cutting effect on the so‐called middle market for business borrowers – the smaller firms – and for mortgage loans and some small farmers. That’s where the incidence of the high interest rate effect has been felt thus far in our part of the country. But as a general matter, even if the businessmen present were mostly from big concerns, they simply indicated that the higher rates per se are not having any effect at all on their capital projects. If a project is worthwhile, it‘s not going to get cut off by a one or two percentage point increase in the cost of funds. A minority expressed the view that this is leading to some greater caution on inventory policy, which is already being viewed as quite cautious. One major real estate developer present indicated that the higher rates are just built into their projects and aren’t having any dampening effect at all. (Balles, FOMC meeting, September 1979, page 27) Second on the cost impact of raising interest rates: Interest rates may be [low] after tax, or in real terms, but they are still contributing to cost and are creating, I think, some of the upward pressure on prices. (Teeters, FOMC meeting, May 1981, page 10) There is deterioration in the inflation rate stemming from interest costs and energy costs, and those are not trivial sources of deterioration. At the end of the day it doesn’t have to be labor costs that are causing the overall inflation deterioration. (Greenspan, FOMC meeting, November 2000, page 85)
Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION? Partly due to the culture of the United States, and partly due to strong economic interests against centralized institutions, the Federal Reserve System is an oddly organized public‐private partnership. Member banks do hold stocks issued by the System that provide a dividend payment but this dividend payment is not guaranteed, the stocks do not provide any voting rights, and they cannot be traded. For example, recently 11 Congress decided to divert some of the dividend payments to fund highway expenses. In addition, all leftover income of the System must be transferred to the Treasury. Note that this makes for an odd situation. The Fed holds Treasuries that pay interest, part of this interest income ends up going back to the Treasury: the Treasury pays itself interest! In addition, the Treasury tries to maximize its earnings from the Fed through cash management.12 Instead of looking at stock holdings and income payment, a more relevant analysis of the political economy of the Fed looks at its structure and who can make decisions regarding monetary policy and emergency operations. In terms of monetary policy, the influence of Wall Street is large, with strong representation on the Federal Open Market Committee via members with former ties to 62
CHAPTER 5: FAQs ABOUT CENTRAL BANKING major banks (in 2016 half the Fed presidents have former ties to two major banks: Goldman Sachs and Citibank). Financial sector members tend to be more hawkish and more concerned, if not obsessed, with price stability. This leads them to want to raise the FFR target early, leading to a level of employment lower than it would otherwise have been. They are also friendlier to the financial industry and more lenient in terms of regulations and in terms of response to a financial crisis. Finally, there is a risk of regulatory capture. If one combines this with the fact that economists at the Board are mostly pro‐market supply‐sided economists (economic growth is ultimately a supply‐side thing), financial regulation and enforcement do not make much sense and raising rates very early in anticipation of inflation makes sense. Many economists, however, doubt that markets are efficient and that demand has no role to play in the long run.
Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS) 1‐ “The Fed controls the money supply”: No, it does not, it sets an interest rate, what happens after that is up to firms and households and their desire for external funds (see Chapter 4). 2‐ “The Fed injects reserves which lowers the interest rate” or, worse offender, “The Fed injects money which lowers interest rate”. Under normal circumstances (that is, pre‐Great Recession, which is what most people have in mind when saying this), the Fed does not proactively inject reserves, it waits for banks to ask. And, the Fed’s monetary policy never injects money, i.e. never deals directly with the public (M1) (see Chapter 4). 3‐ “The Fed printed money during the financial crisis”: No, it just credited account by keystroking dollar amounts, no Federal Reserve notes were printed. More to the point, none of these funds entered the money supply, that is, funds held by the public. 4‐ “The Fed used taxpayers’ money during the financial crisis”: No, it just credited accounts of banks by keystroking dollar amounts (see Chapter 2). 5‐ “Banks use reserves to buy stocks and corporate bonds”: No banks cannot do that with reserves (see Chapter 2). 6‐ “The large inflow of reserves in banks did not lead to inflation because banks did not lend the reserves or based on reserves”: No, banks do not operate that way, bank credit and quantity of reserves are unrelated (see Chapter 10) 7‐ “Central banks lend reserves”: No, the Fed does not lend reserves because reserves are its liability (see Chapter 2). 8‐ “Fiscal deficits raise interest rates”: No, there was a hint about this in Chapter 3. More is coming in Chapter 6.
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Summary of Major Points 1‐ Setting an interest rate does not mean supplying an infinite quantity of reserves. It just means supplying what banks want. 2‐ The Volcker experiment aimed at following more closely the Monetarist principles of monetary‐ policy making. In practice, the Fed widened dramatically the target range for the FFR but it never completely let the FFR respond to market forces. 3‐ FOMC members did not understand that targeting the FFR was not inflationary until the middle of the 1990s. 4‐ Normalizing the balance sheets means returning the quantity of excess reserves back to its pre‐ Great Recession proportion in total reserves. This can be done by selling assets to banks or by letting some of the securities held by the Fed mature. 5‐ Normalizing the balance sheet of the Fed is not necessary given that the Fed has changed its procedures for setting the FFR. 6‐ The FFR and discount rate are policy variables completely under the control of the Fed. They can be set wherever the Fed wants, even in negative territory. 7‐ In order to set market rate into negative values, the Fed just has to complete enough purchases of securities at a premium. 8‐ By providing capital gains and by making it costly to hold reserves, a negative interest rate policy is supposed to promote economic activity. 9‐ Fine‐tuning the economy may be difficult and counterproductive because rising interest rates may promote financial fragility and may be inflationary. In addition, business investment is not very sensitive to changes in interest rates; the transparent and gradual monetary policy strategies used since the mid‐1990s have made spending decisions even less sensitive to interest‐rate hikes. Keywords Volcker experiment, premium, fine‐tuning, normalization, excess reserves, total reserves Review Questions Q1: How did the Volcker experiment lead to an increase in the volatility of the FFR? Did the Fed abandon completely interest‐rate targeting? Q2: FOMC members did not believe that setting an interest rate was a sustainable monetary policy practice; why not? Why were they wrong? Q3: How does QE impact the yields of securities? Why the link cannot be one in which banks buy securities with reserves? Q4: How can banks offset the adverse impact of negative interest rates on the profitability of banks? Q5: What are the two ways through which QE is supposed to boost economic activity? What are potential issues with this policy? Suggested readings For an analysis of FOMC meetings during the period 1979‐1999 see chapter 6 of Central Banking, Asset Prices, and Financial Fragility by Eric Tymoigne. Kaldor, N. (1982) The Scourge of Monetarism, Oxford: Oxford University Press.
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CHAPTER 5: FAQs ABOUT CENTRAL BANKING 1 A succinct profile of Nicholas Kaldor was written in the central bank of the Slovak Republic BIATEC, Volume XIV, 12/2006
http://www.nbs.sk/_img/Documents/BIATEC/BIA12_06/26_30.pdf See “Bill Gross: Americans are being "cooked alive" by the Fed's zero interest rates” by Chis Matthew at http://fortune.com/2015/09/23/bill‐gross‐federal‐reserve‐interest‐rates/ 3 See Wray, L.R. (2006) “Global Demographic Trends and Provisioning for the Future” Levy Economics Institute, Working Paper No. 468 at http://www.levyinstitute.org/pubs/wp_468.pdf 4 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf 5 See “About MBS/ABS” by the Securities Industry and Financial Markets Association at http://www.investinginbonds.com/learnmore.asp?catid=11&subcatid=56&id=134 6 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf 7 See “Euro Area's Negative‐Yielding Debt Tops $2 Trillion on Draghi” by Lucie Meakin at http://www.bloomberg.com/news/articles/2015‐11‐23/euro‐area‐s‐negative‐yielding‐debt‐tops‐2‐trillion‐on‐draghi 8 See Tcherneva, P.R. (2013) “Reorienting Fiscal Policy: A Critical Assessment of Fiscal Fine Tuning” Levy Economics Institute, Working Paper No. 772 at http://www.levyinstitute.org/pubs/wp_772.pdf 9 See the Infrastructure Report Card by the American Society of Civil Engineers at http://www.infrastructurereportcard.org/ 10 See Tymoigne, E. (2006) “Asset Prices, Financial Fragility, and Central Banking” Levy Economics Institute, Working Paper No. 468 http://www.levyinstitute.org/pubs/wp_456.pdf. See also 11 See “Fed Money Tapped in Highway Bill as Banks Get Dividend Break” by Cheyenne Hopkins at http://www.bloomberg.com/news/articles/2015‐12‐01/fed‐surplus‐tapped‐in‐highway‐bill‐as‐banks‐get‐dividend‐ break 12 Santoro, P.J. (2012) “The Evolution of Treasury Cash Management during the Financial Crisis,” Federal Reserve of New York Current Issues in Economics and Finance, 18 (3): 1‐8. 2
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CHAPTER 6:
After reading this Chapter you should be able to understand: How and why the central bank and Treasury must coordinate their fiscal and monetary operations How the Treasury helps the central bank implement monetary policy on a daily basis Why the Treasury is involved in the implementation of monetary policy Why the financing of the Treasury by the central bank is not optional and must always occur directly or indirectly How the central bank gets involved in financing the Treasury Why a monetarily sovereign government does not face any financial constraint What relevant questions a monetarily sovereign government must answer
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS This Chapter concludes the study of central banking matters included in this draft. The Chapter studies how the Fed is involved in fiscal operations and how the U.S. Treasury is involved in monetary‐policy operations. The extensive interaction between these two branches of the U.S. government is necessary for fiscal and monetary policies to work properly. Once again, the balance sheet of the Federal Reserve provides a simple starting point. The Treasury holds an account (called Treasury’ General Account, TGA) at the Fed, which is part of L3. To simplify, this Chapter assumes that the Fed still follows the monetary‐policy procedures that it followed prior to the 2008 crisis.
MONETARY POLICY AND THE U.S. TREASURY When Treasury spends, the Fed debits the TGA and credits reserve balances. Simultaneously, private bank credits the account of private economic units. Say the Treasury buys $100 worth of paper from a paper company. Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: +$100 TGA: ‐$100
Bank ΔAssets Reserve balances: +$100
ΔLiabilities and Net Worth Account of paper company: +$100
Paper company ΔAssets ΔLiabilities and Net Worth Paper: ‐$100 Account of paper company: +$100 Treasury ΔAssets TGA: ‐$100 Paper: +$100
ΔLiabilities and Net Worth
If Treasury receives $25 of income tax payments, the following happens: Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$25 TGA: +$25
Bank ΔAssets Reserve balances: ‐$25 67
ΔLiabilities and Net Worth Account of taxpayer: ‐$25
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Taxpayer ΔAssets Account of taxpayer: $25
ΔLiabilities and Net Worth Net worth: ‐$25
Treasury ΔAssets TGA: +$25
ΔLiabilities and Net Worth Net worth: +$25
Therefore, in case of a deficit (taxes less than expenses), there is a net injection of reserves. The consolidation of the two previous fiscal operations is: Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: +$75 TGA: ‐$75
If the Fed does not neutralize the impact of the fiscal deficit by removing the extra reserves, banks will dump everything in the Fed Funds market and the FFR rapidly falls toward 0% (see Chapter 4). As long as the Fed targets a positive FFR, it has to neutralize the impact of daily fiscal deficits (L3 falls)—that lower the FFR—and the impact of daily fiscal surpluses (L3 rises)—that raise the FFR. The Treasury understood the impact of its fiscal operations on money markets long before the Fed was created. In the current set up, the Treasury has helped the Fed to achieve its FFR target through two means: 1‐ Cash management: The Treasury collects proceeds from taxes and bonds issuances in thousands of private bank accounts called the “Treasury’s Tax and Loan accounts” (TT&Ls). Treasury moves funds between its TT&Ls and TGA to help monetary policy. 2‐ Public‐debt management: The Treasury changes the level of its outstanding Treasuries, or changes the structure of its Treasuries (proportion of short‐term vs. long‐term securities). Given that fluctuations in the TGA (L3 in Figure 2.1) influence reserve balances (L2 in Figure 2.1), until the Great Recession the Treasury limited these fluctuations by keeping the TGA around $5 billion (Figure 6.1). Treasury employees met every morning with Fed employees to discuss the expected net cash flow on TGA for the day and to decide on the quantity of funds to move in or out of TT&Ls to meet the $5 billion target. For example, say the TGA is currently at $5 and that this is the target of the Treasury. If the Treasury expects to spend $2, it would call $2 from its TT&Ls during the day. Cash flows of the TGA are very erratic throughout the day so they cannot be offset perfectly. Assume that spending occurs first (payment to a paper company): Bank ΔAssets Reserve balances: +$2
ΔLiabilities and Net Worth Account of company: +$2
Fed ΔAssets
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ΔLiabilities and Net Worth Reserve balances: +$2 TGA: ‐$2
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The injection of reserves is removed by calling funds from TT&Ls: Bank ΔAssets Reserve balances: ‐$2
ΔLiabilities and Net Worth TT&Ls: ‐$2
Fed ΔAssets
ΔLiabilities and Net Worth Reserve balances: ‐$2 TGA: +$2
So overall the net impact on reserve balances is zero and the balance sheet of the Fed is unchanged. The only change is on the liability side of private banks. Bank ΔAssets
ΔLiabilities and Net Worth Account of company: +$2 TT&Ls: ‐$2
Figure 6.1 TGA, weekly averages until 9/17/2008, billions of dollars Source: Board of Governors of the Federal Reserve System (H.4.1. series)
TREASURY’S INVOLVEMENT IN MONETARY POLICY DURING THE 2008 CRISIS Lehman’s collapse in September 2008 led to a large injection of reserves but this injection was partly contained by a rapid increase in other liabilities that peaked in value at $1.7 trillion on the week of November 5th 2008 (Figure 6.2). The cause of the increase is a massive cash and debt 69
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS management operation by the Treasury that started late September 2008. First, Treasury transferred tens of billions of dollars from its TT&Ls into the TGA, thereby breaking with its attempt to maintain TGA at $5 billion. Second, Treasury issued “Supplementary Financing Program” T‐bills (SFP bills), and immediately put the proceeds into a new Treasury’ account at the Fed called “Treasury’s Supplementary Financing Account” (TSFA) (Figure 6.3).
Figure 6.2 Balance sheet of the Federal Reserve, trillions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)
Why did the Treasury do this? To help drain reserves in order to maintain the FFR on target. The FFR target was positive until December 2008, so reserves had to be drained in order to maintain the FFR around the non‐zero target. Chapter 4 explains that the Fed had been neutralizing the impact of emergency programs on reserves since December 2007. It had been doing so by selling its holdings of Treasuries to banks and in six months the outstanding value of its holdings fell from $780 billion in January 2008 to $480 billion in June 2008. If the Fed had continued to neutralize emergency programs in that fashion, it would have run out of Treasuries very quickly with the panic of September 2008. It is all the more so that the Fed had started to lend some of its Treasuries, so the dollar amount of unencumbered Treasuries actually dropped to $250 billion. In order to avoid running out of Treasuries, the Fed asked the Treasury to help drain reserves via cash management (TT&Ls to TGA transfers) and debt management (issuance of SFP bills). The T‐ bills were issued at the request of the Fed for monetary‐policy purposes, that is, to help drain reserves. 1 The outstanding dollar amount of SFP bills peaked at almost $560 billion in late October/early November 2008. After that, the outstanding dollar amount went down quickly for reasons explained below. Combined with its cash management operations, Treasury removed up to slightly more than $600 billion worth of reserves. As the Discount Window was advancing reserves to banks in difficulty, the Treasury was simultaneously draining them (Figure 6.4).
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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS
Figure 6.3 Treasury’s accounts at the Fed, billions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)
Figure 6.4 Injection (+) and ejection (‐) of reserve balances, trillions of dollars Source: Federal Reserve (Series H.4.1) In its announcement of the Program, the Treasury misrepresented the purpose of SFP bills by stating that their purpose was to “provide cash for use in the Federal Reserve initiatives.”2 Of course this is incorrect because the Fed does not need cash from anybody, it creates cash. 71
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The Treasury rapidly reduced its help through the SFP program by agreeing to roll over only $200 billion of T‐bills. Treasury did so because its help was no longer as needed (FFR target was at zero), and because of the debt‐ceiling debate of the time that almost killed the program in early 2010.
OTHER EXAMPLES OF TREASURY’S INVOLVEMENT IN MONETARY POLICY The Treasury has used other debt and cash management techniques in the past in order to help monetary policy. For example, Treasury used to be able to have an intraday overdraft on its TGA; unlimited from 1914 to 1935 and up to $5 billion from 1942 until 1979 (Table 6.1).3 As such, at times, the TGA would carry a negative balance during the day and, by the end of the day, the TGA would be replenished by direct financing of the Fed. The Treasury issued “special certificate of indebtedness” to the Fed and in exchange the Fed credited the TGA. The Treasury used this overdraft authorization exclusively for monetary‐policy purposes. For example, before a major tax season: On occasion, the Treasury, in anticipation of heavy tax receipts during heavy tax months, will, under statutory authority, replenish balances at Federal Reserve Banks by borrowing directly from such banks through the issuance of special certificates of indebtedness, rather than withdrawing funds from Treasury tax and loan accounts. These funds are borrowed for only a few days and enable the Treasury temporarily to make disbursements in excess of its current receipts thus providing the banks with additional reserves in advance of a later unavoidable drain. (U.S. Treasury 1955, 282, italics added) This allowed the Treasury to replenish its TGA without having to drain its TT&Ls. The Treasury did this not because it was running out of money: At the time [Treasury’s administrators] have used the overdraft in the past, it has not been when they have had no balances with the banks. They have usually had very substantial balances with the banks. And they could have drawn on those balances to meet the overdraft. That, however, […] would be undesirable and unstabilizing to the money market to withdraw the [TT&Ls] for such a very short period of time. It would then build up unnecessary balances in the Reserve banks, and would create a deficiency of reserves in the banks throughout the country, and would compel them to sell securities or to borrow from the Federal Reserve banks (Eccles in U.S. House 1947, 7)) Throughout most of WWII, the Fed was targeting the entire yield curve (that is, all the interest rates on Treasuries) and Treasury helped through debt management (Figure 6.5). The strict targeting of T‐bond rate at 2.5% was relaxed a bit toward the end of the war, but Treasury and Fed still did not want the rate to deviate too much from 2.5%. After the war, fiscal surpluses removed T‐bonds from the market even though there was high demand for them. This situation raised their price and the yield on 10‐year T‐bonds declined steadily toward 2%. To bring back the T‐bond rate up toward 2.5%, more T‐bonds needed to be supplied. Unfortunately, the Fed did not hold enough T‐bonds so the Treasury supplied more:
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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS At any rate, the effect of a budget surplus at that time was terribly important in all of the monetary and debt management operations that went on. […] At that time, the Federal Reserve System owned practically no long‐term Government bonds and, therefore, in its open‐market operations was unable to supply the market with that type of investment. The Treasury Department, however, held large amounts of long‐term bonds in various investment accounts. After consultations and discussions, both at a staff level and at a policy level, between the Treasury and the Federal Reserve and in full agreement, the Treasury Department, through the open‐market committee of the Federal Reserve, sold large amounts of long‐term Government bonds so as to fill the demand and to prevent a further decline in the long‐term interest rate. During this period, the Treasury sold $1.5 billion of long‐ term bonds. However, the amount was not adequate to satisfy the demand nor to increase the market yield on such securities. Thereupon, the Treasury Department, after consultation with the Federal Reserve and with full agreement on the part of both, sold a nonmarketable 18‐year issue in the amount of $1 billion. The purpose of this sale was to mop up any remaining investment funds that were exerting upward pressure on the market. (Wiggins in U.S. Senate, 1952, p. 227, p. 237)) From a fiscal perspective this seems strange—a Treasury trying to raise the cost of its indebtedness and a Treasury issuing securities when running a fiscal surplus—but again all this was done for monetary‐policy purposes, and more broadly for what was considered the social purpose. 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942
(1) 30 14 15 14 46 20 17 18 18 8 4 19
(2) 1 1 1 1 1 1 1 1 1 1 1 6
(3) 156.5 184 182 246 251.5 316 314 218 219.5 32 9 422
1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962
(1) 48 9 2 2 4 30 29 15 2 -
(2) 28 7 2 1 2 9 20 13 2 -
(3) 1,302 484 220 180 320 811 1,172 424 207 -
1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982
(1) 3 7 8 21 9 1 10 1 16 4 N/A -
(2) 3 3 6 12 7 1 6 1 7 4 N/A -
(3) 169 153 596 1,102 610 38 485 131 1,042 2,500 2,600 -
Table 6.1 Direct financing of the Treasury by the Fed to close the TGA overdraft: Number of Days Used (1), Maximum Number of Days Used at any One Time (2), and Maximum Outstanding at any Time (Millions of Dollars) (3) Sources: U.S. House (1962), U.S. Treasury (1978), Board of Governors of the Federal Reserve System (1979)
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Figure 6.5 U.S. Interest rates in the 1930s, 1940s and 1950s, percent. Sources: NBER, Board of Governors of the Federal Reserve System Note: Grey area is represents U.S. official involvement in World War Two.
There have been other cash and debt management techniques used by the Treasury but those above should give you a sense that the Fed cannot do it alone given the way it operates in terms of monetary policy (it uses Treasuries so Treasury must supply enough securities), and given that Treasury has an account at the Fed (a fiscal surplus/deficit drains/injects reserves). In other countries the institutional details change, but some coordination between Treasury and central bank is needed for monetary‐policy operations to work properly.
FISCAL POLICY AND THE FED For a government that has monetary sovereignty, one that issues its own currency and securities only denominated in its unit of account, the central bank always helps one way or another to finance the budget of the Treasury. After all, central banks were created in part to help finance the state, that is, to make sure that the state has the financial means to fulfill its goals expressed in the annual budget. Once again, the following focuses on the United States. The most straightforward involvement of the Fed into fiscal operations was the availability of an overdraft on TGA until the late 1970s. As stated in the previous section, in practice this overdraft facility had been strictly used for monetary‐policy operations, but it could be used for fiscal purposes in case of “national emergency.” The $5 billion limit was, however, very limiting for that purpose and there were Congressional hearings in the 1960s that looked into the possibility of expanding that limit and making the overdraft line permanent (authorization of the overdraft had to be renewed by Congress every two years). This went nowhere because the use of the overdraft for fiscal purposes was seen as inflationary and unsound. The Treasury always justified the use of
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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS the overdraft as a brief and occasional means to finance its expenditures in order to avoid disruptions in the money market. Even though direct financing was discouraged and later forbidden, the Treasury uses Fed’s monetary instruments to spend. Thus, one way or another, the Treasury will get financed by the Fed because only the Fed supplies the funds that the Treasury uses. Indeed, while TT&Ls are used to receive bond and tax proceeds, they are just a tool that allows for smoothing out the impact of tax and bond proceeds on reserves. Ultimately, all the proceeds go to the TGA, which drains reserves. As a consequence the Fed has to ensure that banks have enough reserves to allow the Treasury to be able to make the transfer from TT&Ls to TGA. In addition, the Fed also has been heavily involved in treasury auctions4 to ensure that they go on smoothly. Chairman Eccles again provides an insightful insider’s view on the financing of the Treasury: [In past Congressional hearings] there was a feeling that […] Government [borrowing] directly from the Federal Reserve bank […] took off any restraint toward getting a balanced budget. Of course, in my opinion, that really had no relationship to budgetary deficits, for the reason that it is the Congress which decides on the deficits or the surpluses, and not the Treasury. If Congress appropriates more money than Congress levies taxes to pay, then, there is naturally a deficit, and the Treasury is obligated to borrow. The fact that they cannot go directly to the Federal Reserve bank to borrow does not mean that they cannot go indirectly to the Federal Reserve bank, for the very reason that there is no limit to the amount that the Federal Reserve System can buy in the market. […] Therefore, if the Treasury has to finance a heavy deficit, the Reserve System creates the condition in the money market to enable the borrowing to be done, so that, in effect, the Reserve System indirectly finances the Treasury through the money market, and that is how the interest rates were stabilized as they were during the war, and as they will have to continue to be in the future. So it is an illusion to think that to eliminate or to restrict the direct borrowing privilege reduces the amount of deficit financing. Or that the market controls the interest rate. Neither is true. (Eccles in U.S. House, 1947, 8) If the Treasury does not get the funds it needs to implement Congressional mandates, and if Congress passes a budget in deficit, then the democratic process will not be fulfilled (the budget cannot be implemented), and interest rates will rise. In terms of auctions of Treasuries, the Fed makes sure they are always successful; “bond vigilantes” have no influence. The Fed has done so in many different ways; one way was to buy whatever was leftover during an auction. The Fed had to do so, either because until the 1970s T‐bond auctions were not well established and so participation was not always as high as needed, or because the Fed was targeting the entire yield curve. Now today in pricing a new Treasury issue, the Federal [Reserve] is in the position of underwriter. During the period of the offering the Federal [Reserve] tries to see to it that the Treasury's issue is successful […] It stabilizes the market just the way any underwriter does. (Martin in U.S. Senate, 1952, p. 96) Another way has been to provide a dependable refinancing channel to the Treasury because the Fed is still allowed to participate in auctions to replace its maturing Treasuries. 75
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Finally, today the Fed participates indirectly in the financing of Treasury through the Primary Dealer System. During an auction, primary dealers must submit a reasonable bid and the Fed ensures that they have enough reserves at time of settlement by purchasing, or repoing, outstanding Treasuries. Prior to the Primary Dealer System, the Fed also ensured that banks had enough reserves to settle an auction. For example during World War Two (see Figure 6.6 for reserve data during that period): It was evident that all funds needed for financing the war which were not raised by taxation or by the sale of Government securities to nonbank investors would need to be raised by the sale of securities to the banking system. At first commercial banks were able to draw down excess reserves by several billion dollars, but later they had to be supplied with a considerable amount of additional reserve funds in order to purchase the necessary securities […] In general, further reserve funds were supplied by Federal Reserve purchases of short‐term Government securities. (Martin in U.S. Senate, 1952B, p. 288) Thus, one way or another the Fed will ensure that auctions never fail; and in the process it will be financing either directly or indirectly the Treasury.
Figure 6.6 Total reserves, Aug. 1917 to Dec. 1958, billions of dollars Sources: Banking and Monetary Statistics 1914‐1941, Banking and Monetary Statistics 1941‐ 1970.
A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES The Treasury and the central bank must work extensively together for fiscal and monetary policies to work properly. The central bank cannot be fully independent from the Treasury:
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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The history of central banking, as was brought out earlier by the chairman, is that central banking cannot get too far away from the policies of Government too long; and that while central banks historically have won battles against the Government, they have always lost the war. (Wiggins in U.S. Senate, 1952, p. 235) The central bank has independence of tools (interest‐rate setting) and goals (inflation, etc.) but must work Treasury operations into its daily activities. Similarly, the Treasury needs to work monetary‐policy considerations in its daily activities otherwise interest‐rate stability would not be maintained and inflationary pressures could more easily materialize.
TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION. It should be clear from the previous sections that ultimately all the funds that the Treasury uses come from the Fed. Indeed, while taxes and bond issuances debit the account of private economic units and credit TT&Ls, ultimately the Treasury needs funds in its account at the Fed (the TGA). And these funds cannot exist before reserves exist unless the Fed directly provides funds to the Treasury. Put in terms of T‐accounts, assumes that the TGA gets credited $100: Fed ΔAssets
ΔLiabilities and Net Worth TGA: +$100
There are only a few possible offsetting operation. One is that the Fed directly finances the Treasury: Fed ΔAssets Treasuries: +$100
ΔLiabilities and Net Worth TGA: +$100
Another is that other Fed accounts are drained as a results of tax settlement or the settlement of auctions of Treasuries: Fed ΔAssets
ΔLiabilities and Net Worth TGA: +$100 Other Fed accounts: ‐$100
In the latter case, the Fed previously had to provide those funds to the holders of these accounts, either by advancing funds to them or by buying something from them (see Chapter 4). The Fed is then indirectly financing the Treasury by working through intermediaries (primary dealers, banks, etc.). Pushing a bit further, it is quite clear that tax payments cannot be settled unless reserves are injected first in the banking system either by the Fed (through advances or purchases: assets go up, L2 goes up) or by the Treasury (via spending: L3 falls, L2 goes up). The same applies to proceeds from issuing Treasuries. Monetary financing of the Treasury is not optional, it occurs one way or another. Either the Fed buys Treasuries directly from the Treasury, or it buys them indirectly by first providing funds to primary dealers through some outright or temporary purchases of Treasuries.
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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Some economists following Modern Money Theory (MMT) have used these conclusions and noted that no analytical insight is gained from making a distinction between Treasury and central bank when dealing with a monetarily sovereign government. We might as well consolidate them into one economic unit, the government. Consolidation is actually not infrequent in economic analysis, but MMT pushes for consolidation based on a detailed analysis of the inner workings of Treasury and central bank relationships. It is a theoretical simplification that is grounded in a detailed institutional analysis. More importantly, MMT claims that consolidation has some implications for understanding the role of taxes and government‐bond issuances for a monetarily sovereign government. The balance sheets of Treasury and central bank look as follows (the word “currency” is used broadly to mean all forms of central bank monetary instruments: cash and reserve balances). Treasury Department Assets Liabilities and Net Worth A1T: Physical assets and financial claims on L1T: Treasuries held by central bank the non‐federal sectors L2T: Other liabilities plus net worth A2T: TGA+ FRNs held by Treasury Central bank Assets A1CB: Physical assets and financial claims on the non‐federal sectors A2CB: Treasuries
Liabilities and Net Worth L1CB: Monetary base L2CB: TGA + FRNs held by Treasury L3CB: Other liabilities and net worth
The government balance sheet is: Federal government Assets Liabilities and Net Worth A1: Physical assets and financial claims on L1: Monetary base the non‐federal sectors L3: Other liabilities held by the domestic non‐federal sectors and the rest of the world plus net worth Tax payments lead to: -
ΔL1 0: higher net worth of government (or ΔA1 0. Taxes do not fund the (consolidated) government, that is, there is no crediting of a government checking account, no accumulation of funds by government: taxes destroy government currency (ΔL1 0) must occur before taxing because tax payment is done by handing over to the government its currency (ΔL1 $10
2‐ Better return •
•
Return on Asset (ROA) -
No leverage: interest/bond = $10/$100 = 10%
-
10x leverage: net interest/bond = ($100 ‐ $9)/$1000 = 9.1%
Return on equity (ROE) -
No leverage: interest/equity = $10/$100 = 10% = ROA
-
10x leverage: net interest/equity = ($100 ‐ $9)/$100 = $91/$100 = 91%
By leveraging 10x, ROE is 10 times higher than ROA (9.1% vs 91%) simply because one could acquire ten times more assets.
WHAT ARE THE DISADVANTAGES OF LEVERAGE? INTEREST‐RATE RISK
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CHAPTER 7: LEVERAGE What if the interest rate on bank debt goes up to 12% in the previous example? -
No leverage: cash outflow = $0 => net cash flow = $10
-
10x leverage: cash outflow = $900 x .12 = $108 => net cash flow = ‐$8.
This risk is especially high if an economic unit went into debt on a short‐term basis for a long‐term portfolio strategy. Assume one plans to hold 10 bonds for 2 years but issued debt with a 6‐month term to maturity; then one needs to refinance (i.e. repay the debt and ask for credit again) three times. But there are more worries because economic units care much more about percentage gains (ROE) than nominal gains. In this case, ROE losses are also multiplied by the size of the leverage. -
No leverage: ROA = ROE = 10%
-
10x leverage: ROA = ‐$8/$1000 = ‐0.8%
-
10x leverage: ROE = ‐$8/$100 = ‐8%
HIGHER SENSITIVITY OF CAPITAL TO CREDIT AND MARKET RISKS The same percentage decline in the value of bonds (due to default or loss of market value) leads to much bigger decline in equity (Figure 7.4). -
No leverage: A 10% decline in the value of the bond wipes out only 10% of net worth
-
10x leverage: A 10% decline in the value of bonds wipes 100% of net worth
Chapter 9 shows that banks can only tolerate a limited decline in the value of their assets. Indeed, not only are they highly leveraged, but there are regulations governing the amount of capital they are required to have, as well.
Figure 7.4 Impact on capital of a 10% decline in the value of bonds under no leverage and 10x leverage
REFINANCING RISK AND MARGIN CALLS IMPACT ON MORTGAGE DEBT
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CHAPTER 7: LEVERAGE Say that in 2006 a household wants to buy a house that costs $100k and that the bank states that one must provide a 20% down‐payment. How much of the cost of the house is the bank willing to fund at the maximum? 0.8*100000 = $80000 Now, say that the value of the home goes down to $50000. Assuming the bank is still willing to provide up to 80% of the house value, the maximum the bank will provide is: .8*50000 = $40000 For the same house, the bank is willing to provide less of an advance. Table 7.1 shows three different contract structures with actual numbers when a household agrees to issue an $80k mortgage note: Year Case Structure
Debt Service
2006 A A 30‐year fully amortized with a fixed rate of 10% $8,424.69 for 30 years
2006 2016 B C An 30‐year IO with a 30‐year 5% fixed‐rate 10% fixed rate, starts to fully amortized amortize after 10 years First 10 Years: $8000 $5153.49 for 30‐years Last 20 years: $9264.21
Table 7.1 Mortgage notes with different terms
In the U.S. the traditional mortgage is a fixed‐rate fully amortized (i.e. for which principal is repaid bit by bit every month) mortgage (case A). During the 2000s housing boom, a lot of prime and subprime households choose to issue interest‐only mortgages (IOs) (case B). With an IO, a mortgagor can choose to pay only the interest due for a certain time period (say 10 years), and after that the principal must be repaid bit by bit. This means that for a period of time, case B is cheaper than case A. The proportion of IO issued by non‐prime households in a given year went from virtually 0% to 30% of mortgages issued by non‐prime households. As the Fed started to raise interest rate in 2004, the proportion of pay‐option mortgages issued by non‐prime households grew (Figure 7.5). Pay‐option mortgages allow debtors to pay only part of the interest due. The selling point offered by mortgage brokers was that IO are cheaper to service for 10 years and that, while it is true that one might not be able to make that additional $1264 payment that will come in 10 years, there is no need to worry because refinancing at better terms is always possible given that home prices always go up. Come 2016 and the household can cannot make the additional $1264 payment. What can be done? Let us refinance by issuing an $80000 fixed‐rate mortgage with better terms (option C) and by using the funds to repay the $80000 due on the IO mortgage. So the household goes to a bank with the intention to get a credit of $80000. Unfortunately, the bank states it can only provide $40000, i.e. it refuses to refinance unless the household can come up with $40000. Why? Because the home value is now $50000. In times of crisis, the refinancing problem induced by the decline in the value of houses is actually reinforced by the fact that the loan‐to‐value ratio declines. So instead of granting an advance of up
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CHAPTER 7: LEVERAGE to 80% of the home value, now a bank will do only 60%, which means that the household can only get $30000 from the bank.
Figure 7.5 Share of exotic mortgages in non‐prime mortgage originations, percent. Source: Federal Deposit Insurance Corporation (FDIC Outlook, Summer 2006).
IMPACT ON SECURITY‐BASED DEBT: MARGIN CALL RISK A broker allows an economic unit to have outstanding bonds with a nominal value 10 times as large as the value of equity. What if suddenly: -
The value of bonds declines. Net worth declines so leverage is much higher than 10 and the broker demands additional collateral (and so net worth in the balance sheet) to restore a 10x leverage.
-
The broker increases the margin requirement (loan‐to‐value ratio declines), that is, decides to lower the allowed leverage from 10 to 5. This is equivalent to saying that now in order to be able to get external funds to buy $1000 worth of bonds one must put down $200 instead of $100.
EMBEDDED LEVERAGE Leverage comes in many forms and may not be directly observable in the balance sheet. In fact, financial institutions try to hide leverage as much as possible to circumvent regulation, and, in the worst cases, to confuse potential clients who are attracted by the high promised ROE. A form of leverage that gained attention during the recent crisis is embedded leverage—or leverage on leverage. Figure 7.6 presents a “simple” case of embedded leverage.
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Households Houses
Subprime Mortgages
SPE1 Subprime Mortgages
High‐rate MBSs
SPE 2 Low‐rate MBS
High CDOs
rate
Mezzanine CDOs (14%) Equity (very thin or none)
Low‐rate MBSs (5%)
Low‐rate CDOs (10%)
SPE 3 Mezzanine CDOs
Senior‐AAA CDO2s (60 %)
Other CDO2 (40%)
Figure 7.6 Financial layering or embedded leverage. The following is going on in this picture: 1‐ A bunch of households with poor creditworthiness issued mortgages to a bank to finance 100% of their houses ($100k house is financed by $100k mortgage) (balance sheet A) 2‐ The bank did not want to keep the mortgages on its balance sheet so the bank created an SPE1 (special purpose entity 1) that purchased the mortgages. To finance the purchase, SPE1 issued bonds collateralized by the mortgages (mortgage‐backed securities, MBS) of two different ratings, low and high, with low representing 5% of the issuance. The debt service received from subprime mortgages is used to service the MBSs (balance sheet B) 3‐ Nobody wanted to buy the low‐rate MBS so the bank created SPE2 to purchase them. SPE2 issued bonds backed by MBSs (collateralized debt obligations, CDOs). The debt service from low‐rate MBSs is used to service CDOs (balance sheet C) 4‐ Nobody wanted to buy the mezzanine CDOs that represent 14% of all the CDOs issued by SPE2. The bank created yet another SPE that bought the mezzanine CDOs by issuing bonds backed by them (CDO squared). AAA CDO2s are bought by pension funds, others are bought by hedge funds and others. The debt service from the mezzanine CDOs provides the cash flow necessary to service the CDO2s (Balance sheet D) Taken in isolation, i.e. looking at SPE3 alone, AAA CDO2s seem very safe because the value of mezzanine CDOs must fall by 40% before the principal on the AAA CDO2s starts to be impacted (other CDO2s act as equity for AAA CDO2s). A pension fund that looks only at that deal does not even blink; AAA CDO2s provide higher yield than AAA corporate bonds: Buy! Buy! Buy! Of course, the higher yield was achieved by the embedded leverage. Say that households start to default, what is the default rate that makes AAA‐CDO2 worthless?
90
-
A 5% loss on the mortgages makes low‐rate MBS worthless (they are the first to take the loss in this SPE structure), which makes SPE2 insolvent and so all CDOs worthless.
-
CDO2 become worthless much faster. If the mezzanine CDOs are worthless then CDO2 are worthless. Mezzanine CDOs are worthless after a 1.2% decline in the value of subprime mortgages (5%*24%)! Suddenly those AAA CDO2 do not seem that safe anymore, especially so knowing that delinquency rates on subprime mortgages are way north of 1.2%. However, one needs to look at the entire chain of securitization to understand that. Most buyers of AAA CDO2 did not do that (they usually could not do that given the information available) and only looked at the high return of AAA CDO2 relative to AAA corporate bonds, together with the 40% buffer against loss provided by other CDO2.
CHAPTER 7: LEVERAGE There is a way to estimate what the leverage is in this type of transaction.1 Financial institutions created many SPEs that bought from each other.2
BALANCE‐SHEET LEVERAGE, SOME DATA The Financial Accounts of the United States provide simple measures of balance‐sheet leverage that are easy to get for the private non‐financial sector because actual balance sheets are provided. We are not so lucky for the financial sector for which data about total assets is not available. One can get an idea of the leverage used by financial institutions by using the ratio (liabilities + equity)/equity, knowing that in theory the sum of liabilities and equity ought to be equal to total assets. In practice the sum of liabilities and equity is not very reliable and gives leverage levels that sometimes are much too high. Figure 7.8 only presents preliminary data that seems to pass the smell test. Chapter 8 presents official leverage data in the banking sector. Figures 7.7 and 7.8 give a broad idea of the relative leverage across sectors and of the trend in leverage. Clearly, the non‐financial sector is less leveraged than the financial sector with households being the least leveraged of all sectors. Overall, leverage in the non‐financial sector grew relatively smoothly until the Great Recession, especially so for households. Leverage in the financial sector is much more volatile.
Figure 7.7 Balance‐sheet leverage in the nonfinancial private sectors, assets/net worth Source: Board of Governors of the Federal Reserve System (Series Z.1)
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Figure 7.8 Balance‐sheet leverage in the financial sector, (liabilities+equity)/equity Source: Board of Governors of the Federal Reserve System (Series Z.1)
THE FINANCIALIZATION OF THE ECONOMY The financial industry is in the business of dealing with leverage. Its business is about incentivizing other economic unit to go into debt (that is what most of its assets are: claims on others) and the financial sector itself uses a lot of leverage to boost the profitability of its business. Banks grant credit, pension funds rely on financial claims to pay pensions, etc. For every creditor there is a corresponding debtor and so for every financial asset there is a corresponding financial liability: “financialization” also means “debtization” of the economy. The financialization of the economy means that the financial sector has become much more important to the daily operations of the economic system than it used to be. The private nonfinancial sectors have become more dependent on the smooth functioning of the financial sector in order to maintain the liquidity and solvency of their balance sheets, and to improve or maintain their economic welfare. Households have become more reliant on financial assets to obtain an income (interest, dividends and capital gains) and have increased their use of debt to fund education, healthcare, housing, transportation, leisure, and, more broadly, to maintain and grow their standard of living. Nonfinancial businesses also have recorded a very rapid increase in financial assets in their portfolio and a growing use of leverage. Some of them, like Ford or GE (until recently), have a financial branch that provides more cash balances than their core nonfinancial activity (Figures 7.11) and about half of their cash flows. The counterpart of these trends has been a growing share of outstanding financial assets held by private finance (Figure 7.9). From the late 1960s, the share of financial assets held directly by households dropped significantly from about 55 percent to about 35 percent. Instead, a growing share of assets has been held by private financial institutions, which went from 92
CHAPTER 7: LEVERAGE 25 percent in the late 1940s to 40 percent right before the crisis. The rest of the world recorded most of the rest of the gains from 2 percent to 10 percent of U.S. financial assets. The share of national income going to the financial industry has also grown quite significantly after WWII (Figure 7.10). A first wave occurred in the 1950s and a second one in the 1980s and 1990s. Today, about 18% of national income goes to the financial sector, something not seen since the 1920s.
Figure 7.9 Distribution of U.S. financial assets among the different macroeconomic sectors. Source: Board of Governors of the Federal Reserve System (Series Z.1)
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Figure 7.10 Proportion of national income earned by the financial sector. Sources: BEA, Historical statistics of the United States
Figure 7.11 Percent of cash balance coming from financial activities Source: SEC (10K statements) 94
CHAPTER 7: LEVERAGE
Summary of Major Points 1‐ To leverage is the act of going into debt 2‐ This debt can be on the balance sheet or can be hidden off‐balance sheet 3‐ Leverage helps to boost the return on equity by multiplying gains but it can also multiply losses. 4‐ The use of leverage has increased throughout non‐financial economic sectors, while leverage is usually higher in the financial industry. The financial industry uses a lot of off‐balance‐sheet leverage. 5‐ The financial sector has played an ever increasing role in the economic life of the non‐financial sector by providing an increasing share of national income and by providing advances to maintain existing standards of living. Keywords Financialization, debtization, leverage, embedded leverage, return on asset, return on equity, interest‐rate risk, refinancing risk, margin call risk, interest‐only mortgage, pay‐option mortgage Review Questions Q1: Why may a decline in home prices create a problem for refinancing a mortgage? Q2: If the leverage is 3X, what does it mean? Q3: If the leverage is 3X, what would happen to net worth following a 5% decrease in the value of assets? What would happen to ROE given ROA? Q4: Why does the financialization of the economy implies the debtization of the economy? Suggested readings Chapter 1 of Guns, Traders and Money by Satyajit Das relates personal recollections surrounding leverage is a very clear and funny way and present how leverage can be built outside the balance sheet. For a more technical view of leverage and its relation to regulation, the Basel III leverage ratio framework provides an example of a regulatory framework for different forms of leverage: http://www.bis.org/publ/bcbs270.pdf 1 Check page 26 of Riddiough, T.J. (2010) “Can Securitization Work? Economic, Structural and Policy Considerations.” At https://www.fdic.gov/bank/analytical/cfr/mortgage_future_house_finance/papers/Riddiough.PDF 2 In 2010, Propublica made a nice visual made with actual data in “Interactive: CDOs’ Interlocking Ownership,” by Jeff Larson and Karen Weise at https://www.propublica.org/special/interactive‐cdos‐interlocking‐ownership#cdo/
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CHAPTER 8: After reading this Chapter you should be able to understand: What banks do How banks make a profit What the risks of the banking business are How the banking industry has changed over the past four decades
CHAPTER 8: THE PRIVATE BANKING BUSINESS The US financial system is extremely complicated and this preliminary text shades light only on some corners of that system by focusing on the banking sector. Since the beginning of this text, Chapters have emphasized the importance of balance sheets to get a solid understanding of the mechanics at play in the financial sector. This Chapter continues that trend.
THE BALANCE SHEET OF A BANK Figure 8.1 depicts the balance sheet of a commercial bank. Promissory notes issued by others include any kind of agreement between the bank and an entity that promised to pay some monetary amount(s). That entity can be a domestic or foreign, household (mortgage note or any other customer notes), company (business credit, corporate securities), and government (Treasuries, municipals). Promissory notes may or may not have a market in which they can be traded. If they have a market they are called “securities”, if they do not they are called “loans and leases” (Chapter 2 and Chapter 10 explain that the word “loan” is really inappropriate). Chapter 3 studied in details reserves, which are themselves a promissory note as explained in Chapter 15, but are singled out for analytical purposes. Non‐financial assets include real estate, computers, goodwill etc. Assets Reserve balances and vault cash Promissory notes issued by others (aka “loans and leases,” “securities”) Non‐financial assets
Liabilities and Net Worth Promissory notes issued by the bank (aka “accounts,” “CDs,” etc.) Net worth/Equity/Capital
Figure 8.1. Balance sheet of a typical commercial bank
Promissory notes issued by the bank include checking accounts, savings accounts and other transaction accounts. They also include other liabilities such as certificates of deposits (CDs), bonds and other securities issued by the bank. One may choose to include shares here or in net worth; for our purposes, it is not that important. As usual, net worth is the residual item and its main role, as explained in Chapter 2, is to protect the creditors of the bank, i.e. those who hold the promissory notes issued by the bank (you and I for the accounts, CD holders, etc.). Figures 8.2 and 8.3 show how the composition of financial assets and liabilities of US banks has changed since 1945 (quantity of non‐financial assets is not available). After WWII, banks were stuffed with Treasuries and reserves that represented about 75% of their assets. A switch occurred progressively toward privately‐issued notes and municipals as banks turned their business activity toward supporting the growth of the economy instead of the war effort. Today, percentage‐wise, Treasuries and reserves are marginal items in the assets of banks. Bank accounts (“deposits”) are still the main liability of commercial banks but the structure of accounts changed with checking accounts representing about 10% of liabilities in 2010 versus 75% after WWII. Time and savings accounts have grown in proportion, and they represented about 55% of the liabilities of banks in 2010. Figure 8.2 also clearly shows the rise of the federal funds market from the 1960s (see Chapter 4). Figure 8.2 does not show interbank lending debt given that it is the balance sheet of the banking sector. Indeed, if bank X owes to bank Y, when they are put together in one balance sheet the consolidation removes debt owed to each other. Federal funds and repurchase agreements (RPs) are liabilities with other participants of the federal funds market. 97
CHAPTER 8: THE PRIVATE BANKING BUSINESS Figure 8.3 shows how the predominance of “private depository institutions” (commercial banks and thrifts) in the financial sector has changed through time. From 1980 until 2000, the share of financial assets held by banks fell dramatically from 50% of all financial held by the financial industry to about 20%; this has been a stable proportion since 2000. Instead, money managers (mutual funds, pension funds, etc.) have gained in importance as did financial institutions related to securitization that together held about 55% of the financial assets held by the financial industry in 2015. Money lenders (pay‐day loans, etc.) have also recorded an increase in the proportion of financial assets they hold since the 1970s.
Figure 8.1 Financial assets of US‐chartered commercial banks Source: Board of Governors of the Federal Reserve System (series Z.1) Note: Other securities includes corporate and foreign bonds, mutual funds shares, corporate shares, and open‐market papers.
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CHAPTER 8: THE PRIVATE BANKING BUSINESS
Figure 8.2 Financial liabilities and corporate shares of US‐chartered commercial bank Source: Board of Governors of the Federal Reserve System (series Z.1) Note: Others include net taxes payables, corporate bonds, open‐market papers, net interbank transactions, and miscellaneous liabilities.
Figure 8.3 Allocation of financial assets within the financial sector Source: Board of Governors of the Federal Reserve System (series Z.1) 99
CHAPTER 8: THE PRIVATE BANKING BUSINESS
WHAT DO BANKS DO? The previous balance sheet hints that banks are involved in many crucial activities including: ‐
Credit services: Swapping promissory notes to allow liquidity, creditworthiness, and maturity transformation
‐
Payment services: Transferring funds between bank accounts
‐
Retail portfolio services: Providing income‐earning opportunities for small entities with excess monetary balances and providing cash at will.
A central aspect of the balance sheet of banks is that the promissory notes issued by banks have a shorter term to maturity than the promissory notes on their asset side. Banks are involved in maturity transformation. They accept promissory notes from their customers for which the principal will not be repaid for a long time. In exchange, they give their customers some promissory notes that are due relatively quickly. Checking accounts are due at the demand of their bearers and CDs come due at most in a few years, whereas the principal on mortgage notes will be fully repaid in decades. A central implication of maturity transformation is that banks have an inherent need for a stable refinancing source because they must fund long‐term positions in assets with short‐term liabilities. To limit the refinancing risk (that was exemplified with households in Chapter 7) that comes with this balance‐sheet structure, a central bank that provides stable low‐cost refinancing channels is crucial. Some of the promissory notes that banks issue have another other interesting property for potential clients. Chapter 15 explains that their financial characteristics are such that they ought to trade at par if they do not carry any credit risk and if the financial structure is properly set up. Today, transfers between bank accounts are done at par, conversions into Federal Reserve note are done at par, and in case of default FDIC guarantees the funds in bank accounts, and the interbank payment system works smoothly. The main takeaway is that banks provide to their customers a reliable means of payments that is widely accepted. By contrast, the promissory notes issued by clients are not widely accepted so making payments with them is difficult, if not impossible.
WHAT MAKES A BANK PROFITABLE? Like any other for‐profit business, a bank operates to meet its profitability target while being constantly on the look‐out to maintain its liquidity and solvency. At least, that is the hope. When banks are run by fraudsters or are focused on short‐term results, concerns about liquidity and solvency go out of the window.1 The profit of a bank depends on the following components: Profit of a bank = Net capital gains + Net interest income + Other income – Other expenses than interest payments Net capital gains is the difference between capital gains and capital losses. This net change can be positive (net capital gain) or negative (net capital loss). Net interest income (aka net interest margin) is the difference between interest earned on bank assets and interest paid on bank liabilities. Other income include fees and other charges imposed on customers. Net interest income 100
CHAPTER 8: THE PRIVATE BANKING BUSINESS is the biggest source of income for banks but its proportion in bank income has declined since the early 1980s for reasons explained in the last section. In 2014, net interest income represented about 60% of the income earned by banks compared to 80% from about the mid‐1940s to the early 1980s (Figure 8.4). Net interest income is the lowest proportion of profit for the largest banks.
Figure 8.4 Sources of income of FDIC‐insured banks. Source: FDIC Annual Financial Data
Banks, however, are not interested in monetary profit per se. Instead, a key measure of profitability is the return on equity (ROE), the ratio of monetary profit over net worth. Chapter 7 explains that this ratio can be decomposed into the return on assets (ROA) and leverage (Figure 8.5). ROE and ROA averaged 9.7% and 0.84% respectively from 1984 to 2014. The ROA of the largest banks is more volatile and has been relatively higher since the late 1990s (Figure 8.6). The larger the bank, the higher the leverage (Figure 8.7), but balance‐sheet leverage has mostly fallen over time and Tier‐1 leverage has converged to 9 for all banks, 11 for the biggest banks, 8 for the smallest. Banks have a ROE target (among other targets) in mind to which bonuses of employees are related (if a bank reaches or passes the target, employees can expect a good bonus). Bank employees have two means whereby to reach the target if ROE is falling away from it: raise ROA and/or increase leverage. Raising ROA means charging a higher interest rate on customers’ notes (higher mortgage rate, higher consumer credit rate, etc.), charging more fees, buying higher‐yield securities, trading securities more aggressively to make bigger capital gains, and/or reducing expenses. Given expenses, all this means taking more credit risk and market risk, because raising ROA implies catering to less creditworthy economic units or being involved in more volatile trading strategies. Raising leverage means increasing the size of liabilities relative to net worth. Chapter 7 explores the concept of leverage more carefully in terms of its advantages and risks. Chapter 9 explains that banks are limited at any point in time in their ability to leverage by regulation, but they always “innovate” over time to bypass regulations. 101
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Figure 8.5 ROA, ROE, leverage of all FDIC‐insured institutions Source: FDIC Graph Book
Figure 8.6 Annual return on assets Source: FDIC Aggregate Time Series Data Note: Banks with over $10 billion in assets represent about 10% of the FDIC‐insured banks (595 institutions). Most FDIC‐insured banks (62% or 3800 institutions) are between $100 and $1 billion. 102
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Figure 8.7 Tier‐1 leverage (inverse of tier‐1 leverage capital ratio) Source: FDIC Aggregate Time Series Data Note: Tier‐1 capital is a component of capital.
RISKS ON THE BANK BALANCE SHEET The profitability of a bank critically depends on the following:
•
•
The ROA which depends on:
–
Creditworthiness of the issuers of promissory notes (credit risk): households, businesses, and government may not be able to service their promissory note, which means that a bank does not receive its expected income and instead records a loss.
–
Actual and expected market value of securities (market risk): capital gain and losses are recorded on a daily basis for some assets.
The cost of funding the banking business (refinancing risks induced by interest‐rate risk, maturity mismatch risk): cost of acquiring reserves and cost of holding accounts (i.e. giving incentive to account holders not to withdraw their funds in order to avoid having to borrow reserves or to sell interest‐earning assets to get reserves). If the Fed raises FFR quickly, banks that have fixed‐rate long‐term assets see their net interest income dwindle quickly.
Creditworthiness, capital gains and losses, and bank‐funding costs are influenced by the state of the economy, expected interest rates, future monetary and fiscal policies and many other factors. For example, if it is expected that economic activity will slowdown, then one may expect that layoffs will rise and so that some debtors will have problems servicing their debts. Chapter 4 explains how expected monetary policy impacts current asset prices and refinancing cost.
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CHAPTER 8: THE PRIVATE BANKING BUSINESS This means that, to run a banking business properly, a banker must form expectations about a wide range of factors. Of course, these expectations usually turn out to be incorrect. When expectations are under‐optimistic, bankers are pleasantly surprised and may double‐down on the risks they take. When expectations are over‐optimistic, things can turn sour very quickly if credit analysis was not done properly, if capital, liquidity, and loss‐reserve buffers are inadequate, or if fraud has been prevalent. Figure 8.8 shows the impact of credit and market risks. The value of promissory notes falls as economic units default or the value of securities falls. This impacts net worth and so the ability to meet the capital requirements presented in Chapter 9 (in the example a 15% loss on promissory notes leads to a decline in the capital ratio from 20% to 5%). If a bank is unable to meet its capital requirements, regulators may demand that the bank be closed. Figure 8.9 shows the value of non‐tradable promissory notes that were past due by at least 30 days relative to the value of tier‐1 capital and loan‐loss reserves. Loan‐loss reserves are not the same thing as bank reserves, they are extra capital that banks keep to buffer against expected losses on the non‐tradable promissory notes of their clients. In general, the larger the banks the worst the performance, that is, the larger the bank, the higher the proportion of past due loans. This can be explained by looking at Figure 8.6. Major banks (those with assets worth at least $1 billion) have increased their ROA to maintain their ROE. Raising the ROA means acquiring more risky assets, that is, assets that have a higher likelihood of defaulting.
Figure 8.8 Impact of default and/or capital losses
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Figure 8.9 Noncurrent loans & leases as a percent of tier‐1 capital plus loan‐loss reserves Source: FDIC Aggregate Time Series Data
BANKING ON THE FUTURE A study of the profitability of banks clearly shows that this business is all about “banking on the future.” There is a myriad of future economic events that influences the assets and liabilities of banks and so how profitable, solvent and liquid banks are. In terms of assets, the role of banks is to judge and validate (or not) the expectations that are brought to the table by their clients. As the saying goes in the banking industry, “I’ve never seen a pro forma I didn’t like.” Economic units that want to go into debt with a bank always present a very favorable view of their project and future economic prospects. The role of bankers ought to be to tame that vision of the future into a more realistic view, in the sense that the view conforms more closely to past economic trends and past history of probable success. Bankers are supposed to do this by requesting documents that provide evidence that an economic unit will be able to fulfill the requirement of the promissory note (usually pay interest and principal due on time), and by requesting some guarantees in terms of covenants (e.g., ability to check how a business is run or ability to influence business management if needed) and collateral (ability to seize assets held by the economic unit in case of default). Bankers are then supposed to check this information against a given set of standards that defines what a creditworthy economic unit is. Such standards include among others: ‐
The debt‐service to income ratio: what is a sustainable amount of interest and principal payment relative to the income earned? 20%, 30%, 40%?
‐
The value of monetary balances relative to the value of debt: what is a sustainable amount of liquid savings that an economic unit should have relative to an amount of debt? 10%, 50%, 60%?
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The loan‐to‐value ratio: What is the maximum amount of credit a customer can ask relative to the value of a collateral? Is it ok to have a mortgage that represents 50% of the house value, 80%, 100%?
In practice, given that the future is uncertain and given the elastic nature of the standards used, assessing creditworthiness is not always easy. In addition, banking is a competitive sector so assessing creditworthiness is influenced, not only by the need to check carefully an economic unit’s ability to pay, but also by the need to maintain and grow market shares. If a TV maker has sold all the black‐and‐white TVs that could be sold, the next step is not to close shop or to rely only on repairs and replacements. The next step is to invent color‐TVs, flat‐screen TVs, 3D‐TVs, etc. so that consumers have an incentive to ditch their old TVs and buy new ones. The same dynamics are at play in banking. Maintaining market share may require banks to “innovate”: ‐
By pushing existing and new clients into new “low cost” products. A typical example of that was the mid‐2000s, when clients were incentivized to go into interest‐only mortgages, pay‐ option mortgages, cash‐out refinance mortgages, home‐equity advances.
‐
By incentivizing existing clients to go further into debt or to refinance. A typical example of that is the 2001 refinancing wave of prime mortgagors when they refinance into fixed‐rate mortgages with lower rates.
‐
By loosening credit standards when the pool of what is deemed a creditworthy client is shrinking and new business opportunities must be sought to maintain ROE. After the 2001 refinancing wave among prime households, banks turned toward non‐prime households for new business opportunities.
Thus, over time, credit standards may loosen. When previously one had to have a debt‐service to income ratio of at most 30% to be considered creditworthy, now banks are ok with 40%. The mortgage boom of the mid‐2000s broke all standards of creditworthiness, with bankers willing to provide high‐interest‐rate mortgages to customers with no proof of income, job or assets (the infamous “NINJA loans”) in an amount that represented over 100% of the value of a house. Even prisoners could get a mortgage.2 The only way to make that type of mortgage profitable was to resell the house at a price high enough to cover the repayment of all the principal and interest due. This implies finding another person willing to go into debt to buy the house at this higher price. A typical Ponzi game was at play. Some bank managers thought that “the whole system was based on raping the public” and refused to lower their credit standards; but, this came at the cost of accepting a massive loss of market share.3 Most bankers, especially on Wall Street, cannot accept such a decline; in fact they cannot even accept stable market shares, as Mr. Blankfein noted: It should be clear that self‐regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self‐interest in preserving and expending our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak. (Blankfein 2009) Wall‐street financial institutions are growth‐oriented businesses and so must find ways to constantly expand their business. The loosening of credit standards will occur all the faster given that the banking structure is such that it rewards bankers based on the volume of promissory notes
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CHAPTER 8: THE PRIVATE BANKING BUSINESS accepted instead of the quality of promissory notes. As explained below, the banking industry has moved in that direction since the 1980s at least. This pressure to loosen credit standards has been illustrated neatly quite a few times. For example Wojnilower noted in 1977: In the 1960s, commercial bank clients frequently inquired how far they could prudently go in breaching traditional standards of liquidity and capitalization that were clearly obsolescent. My advice was always the same—to stick with the majority. Anyone out front risked drawing the lightning of the Federal Reserve or other regulatory retribution. Anyone who lagged behind would lose their market share. But those in the middle had safety in numbers; they could not all be punished, for fear of the repercussion of the economy as a whole. […] And if the problem grew too big for the Federal Reserve and the banking system were swamped, well then the world would be at an end anyhow and even the most cautious of banks would likely be dragged down with the rest. (Wojnilower 1977, 235‐236) John Maynard Keynes noted more than eighty years ago while talking about financial‐market participants: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”4
EVOLUTION OF BANKING SINCE THE 1980s The promotion of competition and short‐run rewards, together with the lack of regulatory enforcement (see Chapter 9) and a monetary policy focused on fine‐tuning the economy (see Chapter 4), have pushed banks to move away from a business model that promotes careful underwriting and toward market‐share growth. Figure 8.4 gives a hint of that trend. This banking system is more unstable because it promotes an increase in the size of leverage (indebtedness is bigger) and a decline in the quality of leverage (more dangerous financial products, fewer guarantees, less verification). Within banks, there are two important desks, the loan‐officer desk (whose task is to judge the quality of the projects proposed by potential clients and to tame optimism) and the position‐making desk (whose task is to finance and to refinance the asset positions taken by the bank). In the originate‐and‐hold banking model, the point of a bank is to establish long‐term relationships with clients based on trust and recurring credit agreements, and to make a profit based on the net interest margin. A bank carefully checks the 3Cs of credit analysis: cash flow, collateral, and character. Think of George Bailey in It’s a Wonderful Life as the stereotypical banker of this type of banking model: he knows his neighborhood well and does business there, he knows most of his clients personally, he keeps his clients’ promissory notes in the bank vault, he makes a profit by waiting patiently for debts to be serviced; if a client has a problem they sit down and try to work it out given that George’s success depends on his client’s success. This form of banking always exists at any point in time (that is what banking is after all), but it thrived after the Great Depression when competition in the financial industry was reduced and the central bank kept its refinancing cost stable and low. With increased competition from other financial institutions and changes in the monetary policy practices of the Fed, this banking model became less viable as the interest‐rate risk became too great. Chapter 5 shows that the Volcker 107
CHAPTER 8: THE PRIVATE BANKING BUSINESS experiment led to a very large increase in the level and volatility of the federal funds rate. This occurred at a time when banks had a lot of fixed‐rate long‐term assets on their balance sheet (think mortgages) so their net interest margin shrank. This is all the more so given that rising short‐term rate pushed banks to raise the rate on their savings accounts. Regulation Q (a Fed regulation regarding the maximum interest rate that savings account and certificates of deposit could carry) limited banks’ ability to do so, and so lots of economic units removed funds from their savings accounts and put them into more lucrative, but still liquid, financial instruments. Regulation Q was relaxed as FFR rose and was ultimately abandoned. Banks pushed for—and obtained—a deregulation of their business to allow them to diversify the assets they could buy and to allow them to provide more attractive rates on their liabilities. This ultimately led to the savings and loan (S&L) crisis when savings and loan institutions (banks that specialized in holding mortgage notes) were hit by massive credit risk. From the early 1980s, they had taken positions in more risky assets to offset the higher cost of their liabilities induced by the Volker experiment, and widespread fraud by top bank managers followed deregulation. 5 Other banks were not immune from the crisis and also recorded large defaults (Figure 8.9). The S&L crisis marks the end of the originate‐and‐hold banking model.
Figure 8.10 Trading revenues from cash and derivative positions Source: OCC Quarterly Report on Bank Derivatives Activities Note: Data discontinued for all banks as of Q2 2014 Note: The number and composition of “Top Banks” vary through time. Currently there are four top banks: JP Morgan Chase, Bank of America, Citibank, and Goldman Sachs. This model has now been replaced by an originate‐and‐distribute banking model. Profit‐making activities have been shifted toward the position‐making desk. While net interest margin is still a significant source of profit for banks, its importance has diminished substantially (Figure 8.4). Banks no longer look for a long‐term individualized relationship with recurring borrowers; the relation is impersonal and judged in minutes through a credit‐scoring method. Promissory notes of customers 108
CHAPTER 8: THE PRIVATE BANKING BUSINESS are packaged and sold to special purpose entities that fund the purchase by issuing bonds (mortgage‐backed securities, collateralized debt obligations, etc.). Banks make money from the fees that come from passing the debt service to the SPEs, and have been more involved in trading activities, especially top banks that currently get between 6% and 9% of their gross revenue from trading (Figure 8.10). Summary of Major Points 1‐ The main assets of commercial banks are mortgages, consumer credit and other promissory notes of economic units resulting in advances provided to the private sector. 2‐ The main liabilities of commercial banks are deposits of all sorts, with small time‐deposits (certificates of deposits) and savings accounts representing the majority of the liabilities. 3‐ Over the past 30 years, the importance of commercial banks and other depository institutions has declined, with a greater share of financial assets held within the financial industry going to money managers and issuers of securitized products. 4‐ The business of banking involves settling payments between private non‐bank economic units, providing opportunities for small savers to access higher earning financial assets, supplying the currency to the non‐bank sectors, and helping economic units to finance economic and speculative activities. 5‐ While the majority of the income of banks comes from interest receipts, the share of that income has declined by 20 percentage points since 1980. 6‐ The size of leverage in the banking industry has declined. Major banks (those with over $1 billion in assets) take more risks on their liability side (more leverage) and asset side (reliance on riskier financial assets that provide higher ROA). 7‐ The business of banking is influenced by all sorts of internal and external factors that influence the value of their assets, default risk, and the interest rate they pay on their liabilities. On one side, banks try to anticipate adverse changes in these factors to protect their balance sheet, but on the other side each bank also will tend to ignore those factors, or to discount them, if anticipating them decreases its current market share. 8‐ Banking is about anticipating the future while also keeping up with the competition to avoid losing market shares. As such, credit standards are elastic and tend to loosen over a period of economic prosperity and to sharply tighten during a recession. 9‐ Banks have moved away from a business structure that involves acquiring non‐tradable promissory notes and keeping them until they mature. Much more emphasis is put on trading securities. Keywords Bank profit, promissory note, loan and lease, security, certificate of deposit, mortgage, credit service, payment services, retail portfolio services, credit standards, maturity transformation, net interest income, net capital gain, return on equity, return on assets, leverage, loan‐to‐value ratio, debt service, originate and hold model, originate and distribute model
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Review Questions Q1: What is the impact of a decline in the value of bank assets on the net worth of banks? Why is that a problem for banks? Q2: Why do banks exist? Q3: If interest rates on the liabilities of banks go up, what happens to their profit? Q4: In order to provide an advance of funds, what does a bank do? Why does it need to do that? Q5: Why does the profitability of a bank depend on the ability of its customers to fulfill their promissory notes? Q6: Have banks become more or less dependent on the ability of their customer to service their debts? Q7: Do big banks take more or less risk than small banks? How so? Q8: Why is it important for a bank to loosen its credit standards at about the same pace as its competitors? What happens if it is more conservative than others? Less conservative then others? Suggested readings For a succinct view of the evolution of banking since the 1960s and a bullish view of its recent development, read “Banking” a 2004 speech by Chairman Greenspan: http://www.federalreserve.gov/BOARDDOCS/Speeches/2004/20041005/default.htm Hyman, H.P (1984) “Banking and industry between the two wars: The United States,” Journal of European Economic History, 13 (Special Issue): 235‐272. 1 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press. 2 See Part 4 of Klein, A. and Goldfarb, Z.A. (2008) “The bubble,” The Washington Post, June 15, 16, 17 at http://www.washingtonpost.com/wp‐dyn/content/article/2008/06/14/AR2008061401479_4.html 3 See Schwartz, N.D. (2007) “Can the Mortgage Crisis Swallow a Town?” The New York Times, September 2 at http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html 4 In Chapter 12 of the General Theory. Available at https://www.marxists.org/reference/subject/economics/keynes/general‐theory/ch12.htm 5 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press.
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CHAPTER 9: After reading this Chapter you should be able to understand: Why banks need to be regulated and supervised How banks are regulated and supervised What has led to a decline in the ability and willingness to regulate banks and to enforce existing regulations Why economists may have different views about the more relevant way to perform bank regulation
CHAPTER 9: BANKING REGULATION It may surprise you to know that the banking sector is one of the most regulated industries in the United States, with each bank having to file regulatory documents with several agencies. These regulations determine how banks should and should not operate their business in terms of many aspects; from disclosure of information to potential customers, to means of determining creditworthiness of a potential client, to the quantity of reserves to hold, to management issues, among others. For example the National Association of Mortgage Brokers noted in 2006 Mortgage brokers are governed by a host of federal laws and regulations. For example, mortgage brokers must comply with: the Real Estate Settlement Procedures Act (RESPA), the Truth in Lending Act (TILA), the Home Ownership and Equity Protection Act (HOEPA), the Fair Credit Reporting Act (FCRA), the Equal Credit Opportunity Act (ECOA), the Gramm‐Leach‐Bliley Act (GLBA), and the Federal Trade Commission Act (FTC Act), as well as fair lending and fair housing laws. Many of these statutes, coupled with their implementing regulations, provide substantive protection to borrowers who seek mortgage financing. These laws impose disclosure requirements on brokers, define high‐cost loans, and contain anti‐discrimination provisions. Additionally, mortgage brokers are under the oversight of the Department of Housing and Urban Development (HUD) and the Federal Trade Commission (FTC); and to the extent their promulgated laws apply to mortgage brokers, the Federal Reserve Board, the Internal Revenue Service, and the Department of Labor. Let us focus on four examples of regulation.
EXAMPLES OF BANK REGULATIONS RESERVE REQUIREMENT RATIOS The reserve requirement ratio (RRR) dictates the quantity of total reserves banks must have in proportion to the accounts they issued (see Chapter 3). Table 9.1 shows what the ratios look like today in the US. If a bank issued less than $15.2 million of transaction accounts (checking accounts and others) it does not have to have any reserves, 3% between 15.2 to $110.2 million worth of outstanding transaction accounts, and 10% beyond that. Some countries do not have any reserve requirements.
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Liability Type
Requirement % of liabilities
Effective date
$0 to $15.2 million2
0
1‐21‐16
More than $15.2 million to $110.2 million3
3
1‐21‐16
More than $110.2 million
10
1‐21‐16
Nonpersonal time deposits
0
12‐27‐90
Eurocurrency liabilities
0
12‐27‐90
Net transaction accounts 1
Table 9.1 Reserve requirement ratios for the United States. Source: Board of Governors of the Federal Reserve System
CAPITAL ADEQUACY RATIOS Say that a bank has the following balance sheet: the value of assets is $100, bank accounts are $90 and net worth is $10. The net worth acts has a buffer for account holders against losses on assets, i.e. as long as, the value of assets falls by 10% or less, the bank can fully repay all account holders by liquidating its assets (assuming, of course, that at time of liquidation markets are well behaved and allow quick liquidation at low cost). Regulators want to make sure that banks have enough capital to protect their creditors against a substantial decline in the value of bank assets. This is all the more so given that the government may guarantee that customers will get the funds in their bank accounts even if a bank goes bankrupt. Since 1988, with the Basel Accords, central banks have tried to make capital regulation more uniform across the world. Table 9.2 shows the current capital adequacy ratios (CAR) for FDIC‐ insured banks. We will focus on the total risk‐based CAR (Total RBC ratio column). In the US, a bank should have at least 8% of capital, preferably at least 10%, relative to its risk‐weighted assets. This means that the maximum weighted balance‐sheet leverage ought to be 12.5 (A/E = 1/0.08) and preferably 10.
Table 9.2 Capital adequacy ratios. Source: FDIC Capital Regulation Manual.
Assets are weighed according to the risk that their nominal value falls. Assume that a bank has the following balance sheet (Figure 9.1):
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Assets Mortgage notes = $40 (100%) Municipal bonds = $30 (80%) U.S. Treasuries = $30 (0%) Reserves = $10 (0%)
Liabilities and Net Worth Bank accounts = $104 Capital = $6
Figure 9.1 Bank balance sheet with weights
The ratio capital/assets is $6/$110 = 5.45%, which is below the 8% minimum CAR. However, assets weigh more heavily if they have a higher chance of generating losses. Mortgage notes are illiquid and contain credit risk so they are attached a 100% weight, municipals contain credit risk but are somewhat liquid so they have a weight of 80%, U.S. Treasuries contain no credit risk and trade in the most liquid financial market in the world so they are attached no weight. Same with reserves. So the actual capital ratio is $6/($40 + $24) = 9.38%, not ideal but adequate. Basel Accords have evolved over time as central banks have tried to account for changes in the financial industry and for drawbacks of the previous versions of the Accords (the Accords are in their third version). As one may expect, the way to set the weights and proper value of assets can get very complicated. The last section will explain why one may doubt that this type of regulation will be successful.
CAMELS RATING Beside the well‐known RRR and CAR, regulators such as the FDIC also calculate a CAMELS rating for each bank: –
C: Capital adequacy
–
A: Asset quality
–
M: Management quality
–
E: Earnings level and quality
–
L: Liquidity
–
S: Sensitivity to market risk (change in the nominal value of securities)
CAMELS rating goes from 1 (strong business) to 5 (highly troubled). A rating of 4 or higher leads regulators to check carefully a bank and if necessary to issue a cease and desist order In a cease and desist order, a bank must stop immediately its dangerous activities (risky credit, improper management, too low capital ratio, etc.) and must find means to restore its soundness permanently (as measured by the CAMELS rating). Restoring permanent soundness (i.e., desisting from dangerous activities) may imply significant changes in management and business strategies, and may involve finding reliable sources of funding, and other relevant restructuring operations. The board of a troubled bank is given a limited amount of time (e.g., 60 days) to comply with the demands of its regulator. If the board cannot comply, the bank is closed and the regulator uses the least costly procedure to take care of the problem bank: liquidation or facilitation of acquisition by another bank.
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UNDERWRITING REQUIREMENTS One would think that banks carefully check the creditworthiness of a customer before they accept her promissory note. They would ask for proof of income and verify with the Internal Revenue Services (nobody inflates his income on an income‐tax statement), carefully determine the value of available collateral, and judge ability to pay based on the overall debt service that would come due. After all, this is what banks are supposed to do; their job is precisely to judge ability to pay and to tame expectations. As noted in Chapter 8, during the housing boom all this went out of the window, banks manufactured creditworthiness by inflating it on credit application (sometimes raising the income stated on a mortgage application without the knowledge of the applicant), they did not bother to check with the IRS even though it can be done easily (they did not do so for the obvious reason that they lied on the application), they maintained a black list of house appraisers who were honest and would not provide an inflated valuation of a house, they qualified households on the basis of interest payments calculated from a very low interest rate (aka teaser rate) that would prevail only for a few months. It is as if your mechanic did everything to wreck the engine of your car. So it turned out regulations had to be put in place to tell bankers what they are supposed to do! This is included in Title 14 of the Dodd‐Frank act. It forces mortgagees to determine the capacity to pay of mortgagors on the basis of other means than the expected refinancing sources and expected equity in the house, as well as to verify income and to qualify individuals based on the full debt service: A determination under this subsection of a consumer’s ability to repay a residential mortgage loan shall include consideration of the consumer’s credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt‐to‐income ratio or the residual income the consumer will have after paying non‐mortgage debt and mortgage‐related obligations, employment status, and other financial resources other than the consumer’s equity in the dwelling or real property that secures repayment of the loan. A creditor shall determine the ability of the consumer to repay using a payment schedule that fully amortizes the loan over the term of the loan. (Dodd‐Frank Act, 768) While Title 14 is limited to residential mortgages (commercial mortgages were a big problem during the S&L crisis and other promissory notes should also follow the same underwriting methods), this Title is a great contribution to financial stability…if enforced. The need for such a regulation suggests how much the banking industry has changed for the worse.
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT? This is, at least, a three‐part answer: 1‐ there was some deregulation that has promoted competition and concentration, 2‐ the willingness and ability to enforce the law has diminished, 3‐ regulatory arbitrage and regulatory apathy.
DEREGULATION, COMPETITION AND CONCENTRATION 115
CHAPTER 9: BANKING REGULATION The Great Depression put in place financial regulations that compartmentalized the financial industry. Banks were forbidden to perform some activities related to financial markets, they were limited in the types of assets they could hold, and they had access to a low cost and stable refinancing source via the central bank. This led to a very stable banking system with very few and limited problems. Table 9.3 shows the gross saving of depository institutions grew at a slower but steadier pace compared to the post‐1970s period. The number of failures and assistances was also dramatically smaller—around 4 failures and assistances per year versus 113 from the 1980s—and represented only 2.8 percent of all failures and assistances that occurred between 1945 and 2010. Taking a broader historical perspective, Figure 9.2 shows that the stability of the banking from 1940 to 1980 also stands out. Gross Saving, Average Growth Rate 1945‐1971 1982‐2010 Gross Saving, Std. Deviation 1945‐1971 1982‐2010 Insured Bank Failures and Assistances 1945‐1971 1982‐2010
U.S. Depository Institutions 8.2% 24.0%
Credit Unions
Commercial Banks
15.1% 14.1%
9.1% 11.7%
15.1% 225.8%
20.1% 31.2%
16.4% 26.1%
Number (% of total)
Yearly Average
100 (2.8%) 3266 (93.5%)
3.7 112.6
Table 9.3 Gross saving and failures of FDIC‐insured depository institutions. Sources: Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation. Note: Gross saving is defined as undistributed profit plus consumption of fixed capital Chapter 8 notes that the enthusiasm of banks for the originate‐and‐hold model declined sharply in the 1980s. They pushed for a deregulation of their industry to be able to offer higher interest rate on their liabilities and to widen the type of assets they could hold (1980 Depository Institution Deregulation and Monetary Control Act, 1982 Garn St. Germain Act). Then, banks lobbied to deregulate branching restrictions (1994 Riegle‐Neal Interstate Banking and Branching Efficiency Act), to be able to participate in broader financial activities (1999 Financial Modernization Act), and to limit regulation in the derivative markets (2000 Commodity Futures Modernization Act). Today, the U.S. banking industry is highly concentrated (Figure 9.3) and a few large financial holding companies dominate the industry. 80% of the assets of the banking industry are concentrated in the 595 largest banks that account for about 10% of FDIC‐insured banks. Among these, the top 5/7 banks hold almost all the derivative contracts held by banks. Table 9.4 shows the recent data about derivative holding concentration among FDIC‐insured institutions; the seven biggest institutions hold 97% of derivate contracts held by FDIC‐insured institutions, worth almost $170 trillion notionally. The high concentration of the industry means that if one of the banks fails, it may have a major impact on the financial system. Banks may become “too big to fail,” and so must be saved even though they are not economically viable. This may promote moral hazard and increase financial instability over time.
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Figure 9.2 Annual number of bank suspensions (1892‐1941) and bank failures (1934‐2015) Sources: FDIC (Bank failures) and Monetary and Banking Statistics 1914‐1941 (Bank suspensions) Note: Bank suspensions include banks that closed temporarily or permanently on account of financial difficulty; excludes times of special bank holiday. Bank failures refer to banks that closed permanently.
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Figure 9.3 Concentration of the banking industry Source: FDIC Graph Book Note: Largest FDIC Insured Bank have over $10 Billion of Assets (595 institutions in 2016 or 10% of the industry)
Report Date
Derivative Contracts (Trillions)
Percent of Total Derivative Contracts
Number of Banks
Spot Foreign Exchange Contracts (Billions)
Size Grouping
December 31, 2015
$169.3
97%
7
$928.0
7 Largest Participants
December 31, 2015
$4.7
3%
1,400
$105.5
All Other Participants
Table 9.4. Concentration of derivatives notional amounts Source: FDIC Graph Book
DEENFORCEMENT AND DESUPERVISION Overall, there was a deregulatory trend but the fact remains that this industry is still heavily regulated. However, for a set of regulations to work properly it has to be enforced. With the return of free‐market thinking as a dominant framework of thought in the 1970s, enforcement took a toll. Free‐market thinkers who do not believe in government intervention were put in charge of major regulatory bodies; individuals such as Alan Greenspan at the Fed, Robert Rubin at the Treasury, and Christopher Cox at the SEC. These are individuals who believe in the self‐cleansing and self‐ stabilizing properties of market.1 As such, according to them, there is no need to do anything to prevent fraud and dangerous financial practices, or to make sure that banks do not get involved in 118
CHAPTER 9: BANKING REGULATION predatory business practices. Markets take care of it, after all, as the thought goes, a business is judged by its clients so if the clients do not like what a business does, the business will close. Thus, in recent years, regulators like the Federal Reserve deliberately loosely implemented existing regulations or chose “to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies”.2 In addition, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) blocked efforts of federal regulators, and states like Georgia and North Carolina were prohibited by OCC and the OTS from investigating local subsidiaries of nationally chartered banks. Chairman Bair at the FDIC worked with Federal Reserve Governor Gramlich to raise concerns about predatory mortgage practices starting in 2001 but their effort did not lead anywhere. Chairman Born at the Commodity Futures and Trade Commission (CFTC) raised concerned about derivatives and wanted to make them more transparent but was shut down by Congress.3 In 1994, a Government Accountability Office (GAO) report strongly criticized the existing derivatives legislation. It noted that “no comprehensive industry or federal regulatory requirements existed to ensure that U.S. OTC derivatives dealers followed good risk‐management practices” and that “regulatory gaps and weaknesses that presently exist must be addressed, especially considering the rapid growth in derivatives activity”.4 None of the recommendations was implemented and instead large cuts were made by Congress to the budget of the GAO. These cuts were estimated to reduce the staff of the GAO by 850 persons (20 percent of its employees). Other regulators also suffered large cuts to their staff. The FDIC staff was cut drastically and constantly from 20,000 employees in the early 1990s to 5,000 employees right before the Great Recession (Figure 9.4). This occurred at the same time as the financial industry became more concentrated and more complex. In addition, the cut in staff was much more rapid than the decline in the number of FDIC insured institutions to be supervised, thereby increasing the burden of supervision on each employee. This double trend of increasing complexity and increasing burden on supervisors drastically decreased their capacity to perform effective supervision and regulations. The SEC, under Christopher Cox (who, like Alan Greenspan, is a follower of Ayn Rand’s economic thinking), also decreased its staff and, by 2009, the Securities and Exchange Commission had 400 people to examine 11000 investment advisers, which led it to contract with private auditors and other external reviewers. In addition, the SEC did not develop the necessary tools it needed to perform effective regulation.
REGULATORY ARBITRAGE Beyond deregulation, desupervision and deenforcement, banks themselves have always found means to bypass partly some of the regulations that they have found too constraining. An example of that are capital regulations that banks have bypassed partly through securitization. Securitization allows banks to remove highly‐weighted assets (that is carrying high risks) from their balance sheet without compromising their profitability. Regulatory arbitrage is a common response of banks to new regulations. To counter it, regulation needs to be flexible and broad enough, and regulators need to act quickly; both requirements are lacking with regulators today focused on limiting intervention to avoid hurting bank profits and competitiveness with foreign institutions. In addition, a bank can choose its main regulator, and a bank can change its regulator if it thinks another one will be more lenient. This “regulator shopping” is all the more prevalent given that regulators
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CHAPTER 9: BANKING REGULATION compete to get the most banks under their wings because regulators are funded partly through the fees they charge for supervision.
Figure 9.4 Number of employees at the Federal Deposit Insurance Corporation. Source: FDIC.
THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS The way the banking system is regulated heavily depends on regulators’ understanding of what causes banking crises. There are two broad views regarding the origins of banking crises and financial crises more generally; one states that crises are random events in an otherwise self‐ stabilizing economic system based on market principles, another states that bank crises are the result of the inner working of markets.
LAISSEZ FAIRE, LAISSEZ PASSER: CRISES AS RANDOM EVENTS Greenspan summed up neatly the first view when he characterized the 2008 financial crisis as a “once‐in‐a‐century credit tsunami.” Crises are equivalent to weather calamities that affect the return on assets (see Chapter 7). These adverse random shocks are amplified by individual imperfections (think of any deviation from the cold rational homo economicus) and market imperfections (lack of information, etc.). Market imperfections can themselves contribute to the growing risk of financial crises if they contribute to the mispricing of securities, which leads rational agents to take too much risk on their assets and liabilities given the price signal. Thus, according to this view, the recent crisis is the product of mispriced assets (like CDOs) that led to the issuance of too many of them (see discussion about embedded leverage in Chapter 7), and of a “black‐swan”
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CHAPTER 9: BANKING REGULATION event, that is, an unusually large negative shock. One might call this view the “shit‐happens” view of financial crises. In this type of view, there is no point in trying to promote a regulatory framework that proactively helps prevent crises and limit their strength—in the same way no one can proactively prevent the occurrence and reduce the strength of tsunamis. Market mechanisms weed out problems by themselves because, with enough disclosure, financial‐market participants will not engage in fraudulent practices, and unsustainable business will be closed down. Anything that promotes market mechanisms is praised and that includes the recent innovations in derivatives and securitization. Policy makers such as Alan Greenspan and academics such as Philip Das made statements in the mid 2000 that illustrate well this position: Development of financial products, such as asset‐backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk… These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter‐century ago. (Greenspan 2004, 2005) Financial risks, particularly credit risks, are no longer borne by banks. They are increasingly moved off balance sheets. Assets are converted into tradable securities, which in turn eliminates credit risks. (Das 2006) Given that markets usually get it right, instead of having regulations that constrain market mechanisms, regulation should focus on limiting the destructive impact of financial crises on economic activity and improving disclosure of information and market mechanisms. Following the tsunami analogy, the goal is to build high enough seawalls so that protection is available against most tsunamis. If there is a “once‐in‐a‐century” tsunami…well…too bad…at least we tried! In terms of banking regulation, the goal is to put in place large enough liquidity and capital buffers in the balance sheets of banks. The Basel accords are an example of such regulatory view: Given the scope and speed with which the recent and previous crises have been transmitted around the globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks. (Basel 2010a: 2) With enough capital, banks will be able to protect their creditors against most declines in the value of their assets. With enough liquid assets, the value of assets will decline less than it would have otherwise. At the same time, having too much capital and liquidity puts downward pressures on the ROE that banks can earn because leverage declines and ROA is lowered (the more liquid an asset, the lower the ROA). The point, therefore, becomes to find the optimal level of capital and liquidity. The move toward risk management is the ultimate expression of this belief. It uses complex mathematical algorithms to determine what the appropriate level of buffers is given existing risks on‐ and off‐balance sheets. The goal has been to refine the measurement of different risks as well as the methods used to calculate the appropriate level of each buffer. The government has a limited role to play in determining appropriate buffers, especially for “sophisticated” financial institutions. The government also has not much to say about the way banks should be managed, the proper underwriting procedures, and the types of assets that banks should be allow to hold. Bankers know best.
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SAVE CAPITALISM CONTRADICTIONS
FROM
ITSELF:
CRISES
AS
INTERNAL
Another view of financial crises argues that they are the normal result of profit‐seeking operations of banks, and that the way the banking system is structured greatly dampens or amplifies the destabilizing effect of profit‐seeking operations. While an unstable banking system can be attributed in part to greed and irrational or “bad” people, the most important contributor is the way the banking system is set up. The more of a role is given to market mechanisms, the more unstable the financial system will be. The issue is not one of mispricing, lack of disclosure, black swan, massive tsunami, or imperfections. Tsunamis are created by the very practices of banks when trying to make a buck and, if banks are left alone, their practices will lead to a “once‐in‐a‐century tsunami.” Put differently, financial crises are not the results of “bad luck” because nature threw a tantrum; banks make their own luck. As such, one may also doubt that capital regulation and other buffer‐requirement approach will do much to prevent financial crises. 5 They are too passive regulations. As explained in Chapter 8, over a period of stability, banks are incentivized to change their underwriting practices by lowering credit standards and/or deemphasizing income as the main means of servicing debts. Some of this loosening is welcomed when banks have tightened credit standards so much that economic growth cannot proceed well. This tends to happen after financial crises, when bankers become too careful. 6 However, credit standards are elastic and, when profitability is threatened, loosening credit standards is the easy road, especially during a period of economic stability when economic news is good. Periods of economic stability feed the models used by bankers with information that suggests that leverage is safe and risk‐taking is warranted. Beyond banks, other financial institutions such as pension funds have an incentive to buy CDOs and other risky financial assets (even a non‐investment grade securities) in order to maintain the targeted ROE they promised their pensioners; this is so especially when interest rates are very low. More broadly, corporate businesses have some profitability target to meet that is largely invariant to the growth of their assets, thereby pushing them to innovate and to use leverage to reach that target. Again, a very rational response to profitability pressures defined by a target ROE. As such, risk‐management tools may provide information that suggests that it is safer not to engage in certain activities, but this information will be ignored if it threatens market shares and profitability: To some extent […] all risk management tools are unable to model/present the most severe forms of financial shocks in a fashion that is credible to senior management […].To the extent that users of stress tests consider these assumptions to be unrealistic, too onerous, […] incorporating unlikely correlations or having similar issues which detract from their credibility, the stress tests can be dismissed by the target audience and its informational content thereby lost. (Counterparty Risk Management Policy Group III 2008: 70, 84) This is so especially in an environment where it is difficult to reach the target ROE and the search for yield is intensive. Chapter 8 illustrates how the banking system (and financial system as a whole) is driven by competitive pressures and the need to stick with the majority to avoid losing market shares. As such, financial institutions will engage in unsustainable financial practices if that means keeping profitability up. Given that profit is the only relevant metric to judge a business, market 122
CHAPTER 9: BANKING REGULATION mechanisms will not weed out unsustainable practices if they sustain profit. As these accumulate, the economic system becomes more fragile and ultimately collapses under a debt‐deflation (see Chapter 14). The point is that the weeding out of bad apples that market proponents argue occurs to prevent crises does not happen. The problem comes from too much focus on profit as the key metrics of health for a business. From the bank managers’ standpoint, if the business is profitable, it means they do what customers want and so are fulfilling a need (never mind that this may involve “raping the public” as shown in Chapter 8). Regulators see profit as a key measure of health because profit grows capital (see Chapter 1) and so improves buffers against crises. However, from a financial stability perspective, a key issue is not merely if profit is generated but how that profit is generated. If this second question is ignored, the weeding out mechanism used by markets is the crisis itself, and that ends up destroying the entire economy and wiping out any buffer available. So much for a smooth self‐stabilizing mechanism. Given that credit standards are elastic concepts, one may wonder if there is a means to know what a sustainable credit practice is and how to use that for regulatory purpose. Fortunately yes. Hyman P. Minsky provides us with a useful categorization of underwriting practices in terms of Hedge, Speculative and Ponzi finance. Chapter 14 studies this categorization more carefully. The main point is that if debt is underwritten on the basis of income (income‐based credit), it is much less likely to lead to financial instability. If, instead, banks grant advances by qualifying clients on the basis of the expected rise in the value of a collateral or other assets (asset‐based credit), then the economic system is prone to financial instability. The recent housing boom with its dangerous mortgage practices, presented in Chapter 8, is an example of such unsustainable underwriting practices. The problem is not merely one of knowing if a customer will be able to service his debt (the main concern of banks), but also how a customer will service his debt: servicing debt with income is sustainable, debt servicing by liquidating assets is not. It is not sustainable because while an individual may be able to do it by relying on a bonanza (asset prices went up as expected and can be liquidated easily), for the system as a whole it is impossible to liquidate assets. Markets rely on a balance of buyers and sellers and if a significant proportion of debtors rely on a strategy that involves selling assets to service debts, asset prices will plunge when liquidation occurs. A Ponzi strategy is sustainable only for so long, given that the number of participants (and indebtedness) must exponentially grow to keep the strategy going. With the H/S/P categorization in mind, the point is to discourage, and if necessary, forbid any economic growth process that is not based on sound financial practices (income‐based credit), even if everybody is profiting from the continuation of this process in the short term, and even if the financial community ends up considering those practices acceptable and a normal way to do business. In order to do so, the financial practices of economic agents should be checked carefully and growing signs of asset‐based credit should be tackled immediately, even if there is no bubble, no rising default rate, rising wealth and profit. This policy agenda is, of course, much broader and more ambitious than the previous one, but its relevance has been demonstrated many times. For example, prior to the savings and loan crisis, several in‐field supervisors wanted to shut down some thrifts that were recording large profits, because they were suspected of being involved in Ponzi finance sustained by massive frauds. However, there were strong pressures from their bosses and politicians not to close these thrifts
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CHAPTER 9: BANKING REGULATION because their profitability made them models for the industry. 7 Those thrifts were allowed to continue to operate but ended up costing hundreds of billions of dollars when they failed. Similarly, during the housing boom of the mid‐2000s, households’ wealth grew very rapidly, financial companies registered record‐high profits, and homeownership also reached a record high, but all these gains were wiped out once the economy collapsed. Homeownership is back to its level prior to the housing boom, and is still falling (Figure 9.5).
Figure 9.5 Homeownership rate in the U.S. (Percent). Source: U.S. Census Bureau
Steps should have been taken since at least 2003 to prevent the unsustainable growth of homeownership and dangerous business practices. This should have been done by forbidding no‐ doc mortgages, by limiting access to pay‐option mortgages to households with enough cash buffer and income, by not allowing financial institutions to create Ponzi‐generating financial innovations, and by regulating closely all new financial activities. Instead, in 2004, Greenspan praised the dynamic mortgage market and argued that rising mortgage debt among U.S. households was not a problem because households’ wealth was rising thanks to rapidly rising home prices; precisely what asset‐based credit is all about.8 Finally, asset‐based credit is impossible to buffer properly in an economically profitable way and so should not be allowed at least by banks. An alternative is to remove any government backing from economic activities that rely on, or promote, asset‐based credit, which implies isolating the payment system from those activities. In the end, CDOs and other financial innovations were problematic not because they were mispriced (although they surely were), but because they were encouraging financial practices that are unsustainable even if priced correctly. Asset‐based credit always fails because there is ultimately no income to meet the debt service and assets must be liquidated in distress. Financial‐ market participants are always willing to pay for something if that means more profit (even more so when bonuses are based on short‐term profitability), and they will get a better idea of what to 124
CHAPTER 9: BANKING REGULATION pay with more information. But profit‐seeking activity is different from financial‐crisis avoidance activity. In fact, these two activities usually are complete opposite activities and the latter is never on the radar of any particular firm (“if we fail, we fail together, nobody gets blamed; let me focus on my profit” is the thought as Wojnilower illustrates in Chapter 8). Summary of Major Points 1‐ Banks are heavily regulated because they are at the core of the payment system. If they fail en masse, the economy freezes because other economic units cannot get paid, cannot make payments, and cannot obtain currency. 2‐ Banks must have a certain proportion of capital relative to the weighted value of their assets. This is supposed to allow banks to be able to sustain large unexpected adverse shocks on their assets, while still being able to pay their creditors 3‐ Banks must have a certain proportion of reserves relative to the outstanding value of the bank accounts that they have issued. This is supposed to allow them to meet unexpected large demand for cash by customers. 4‐ If banks do not comply with regulations, regulators may issue a cease and desist order and give a limited amount of time for a bank to comply. After that time, the bank is either sold to another bank or its assets are liquidated to pay the creditors. 5‐ The banking industry has become highly concentrated and highly dependent on derivatives and capital gains to maintain its profitability. This is the results of a period of deregulation, desupervision and deenforcemnt that have allowed major banks to broaden their activities. 6‐ Some economists believe that markets self‐regulate and that, at most, banks only need to be protected against the most probably shocks that may adversely impact their balance sheet. This can be done by passive regulation such as capital regulation. Other economists believe that banks make their own luck, that is, that financial crises are the product on the loosening of credit standards during period of economic prosperity. As such, regulation of the banking business must be more thorough, flexible and proactive, and must focus on the type of assets acquired by, and underwriting methods used by banks. Keywords Reserve requirement, capital requirement, CAMELS rating, efficient markets, financial instability hypothesis, risk management techniques, underwriting requirements Review Questions Q1: What is the role of capital regulation? Underwriting regulation? Q2: What does a CAMELS rating measure and how does it do it? Q3: What has happened to the banking industry over the past 30 to 40 years and why? Q4: What can be done in terms of regulation if one believes that financial crises are random events, aka black‐swan events? Q5: What type of regulation should be put in place if one believes that financial crises are the result of the way banks conduct their business? Q6: How can an increase in the concentration of the banking industry, together with deregulation and lack of enforcement, promote the occurrence of financial crises?
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Suggested readings For a relative easy read with a compelling narrative about saving & loan white collar crimes and the fight of some regulators to stop them read The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry by William K. Black. More advanced readings: Cargill, T.F. and Garcia, G.G. (1982) Financial Deregulation and Monetary Control: Historical Perspective and Impact of the 1980 Act. Stanford: Hoover Institution Press. Campbell, C. and Minsky, H.P. (1987) “How to Get Off the Back of a Tiger or, Do Initial Conditions Constrain Deposit Insurance Reform?” In Federal Reserve Bank of Chicago (ed.) Proceedings of a Conference on Bank Structure and Competition, 252‐266. Chicago: Federal Reserve Bank of Chicago. Minsky, H.P. (1975) “Suggestions for a cash flow‐oriented bank examination,” in Federal Reserve Bank of Chicago (ed.) Proceedings of a Conference on Bank Structure and Competition, 150‐184, Chicago: Federal Reserve Bank of Chicago. Knutsen, S. and Lie, E. (2002) “Financial fragility, growth strategies and banking failures: The major Norwegian banks and the banking crisis, 1987‐92.” Business History, 44 (2): 88‐111. 1 When the full blown crisis occurred in the September 2008, Greenspan and others conceded that they went too far in believing in the efficiency of markets—it was the time for a public mea culpa. Donald Kohn, former Vice Chairman of the Federal Reserve, stated: “I placed too much confidence in the ability of the private market participants to police themselves” (Kohn in House of Commons 2011: Ev3). A humble Greenspan was asked to testify to Congress and created some stir by stating: I made a mistake in presuming that the self‐interest of organizations, specifically banks and others, were such is [sic] that they were best capable of protecting their own shareholders and their equity in the firms. (Greenspan in U.S. House of Representatives 2008b: 34) Similar remarks were made in the United Kingdom by Adair Turner, chair of the U.K. Financial Services Authority (FSA): In the past, in the years running up to the crisis, it was the strong mindset of the FSA—shared with securities and prudential regulators and central banks across the world, it was almost part of our DNA—that we assumed that financial innovation was always beneficial, that more trading and more liquidity creation was always valuable, that ever more complex products were by definition beneficial because they completed more markets, allowing a more precise matching of instruments to investor demand for liquidity, risk and return combinations. And that mindset did affect our approach—and the approach of the whole world regulatory community—to the setting of capital requirements on trading activity; it affected our willingness to demand risk reduction in the CDS market; and it influenced the degree to which we could even consider short‐selling bans in conditions of exceptional market volatility.[…] [Stepping out of that mindset] poses for regulators the challenge of complexity, because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever perfect and self‐equilibrating markets, ever rational human behaviors. (Turner 2009) 2 Appelbaum, B. (2009) “Fed held back as evidence mounted on subprime loan abuses,” The Washington Post, September 27 at http://www.washingtonpost.com/wp‐dyn/content/article/2009/09/26/AR2009092602706.html 3 Watch “The Warning” by PBS Frontline at http://www.pbs.org/video/1302794657/ 4 Government Accountability Office (1994) Financial Derivatives: Actions Needed to Protect the Financial System, Report No. GAO/GGD‐94‐133, May, at http://www.gao.gov/assets/160/154342.pdf 5 http://www.levyinstitute.org/conferences/minsky2015/minsky2015_tymoigne.pdf 6 In 2014, Chairman Bernanke could not refinance his mortgage http://www.bloomberg.com/news/articles/2014‐10‐ 03/why‐even‐ben‐bernanke‐cant‐refinance‐his‐mortgage‐chart 7 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press. 8 “The mortgage market and consumer debt,” remarks by at America’s Community Bankers Annual Convention, Washington, D.C., October 19, 2004. http://www.federalreserve.gov/boardDocs/speeches/2004/20041019/default.htm
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CHAPTER 10: After reading this Chapter you should be able to understand: What banks do before providing credit How banks create their monetary instruments How banks destroy their monetary instruments How banks make a profit What the limits to the monetary creation process by banks are
CHAPTER 10: MONETARY CREATION BY BANKS The last three Chapters have explained how the operations of banks are constrained by profitability and regulatory constraints, and how banks operate to try to bypass these constraints. It is now time to go into the details of how banks provide credit and payment services to the rest of the economy.
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES Bank A just opened for business and its balance sheet looks like this: Bank A Assets Building: $200
Liabilities and Net Worth Net worth: $200
Now comes household #1 who wants to buy a house worth $100 from household #2. #1 sits down with a banker (a.k.a. loan officer) who asks a few questions regarding annual income, available assets, monetary balances, the down‐payment #1 is willing to make, among others. The banker asks for documentation that corroborates the answers provided by #1. The banker also shows #1 what financing options are available; that is, the banker shows #1 what type of mortgage note household #1 has to issue to be accepted by bank A. Figure 10.1 is taken from an actual website. ‐
For 100% financing (no down‐payment by household), the bank is prepared to provide up to $330,000 and it will only accept a 30‐year 5.125% fixed‐rate mortgage note. The bank will not accept a 20‐year mortgage note, or a 3.875% note for 100% financing.
‐
For up to 97% financing (household provides at least a 3% down‐payment), the types of mortgage note that a household can issue to the bank widen. The bank is willing to accept a 30‐year 3.875% fixed‐rate note, or a 15‐year 3.125% fixed‐rate note, among others. The maximum face value of the note that the bank will accept is $417,000 unless the household is able to provide a 20% down‐payment.
#1 picks one of the options and fills up a credit application that is attached to all the documentation provided by #1. The credit application is then sent to the credit department for further analysis (check the 3Cs of Chapter 8) and either approved or not. All this is similar to bond issuances by corporations, except that mortgage notes do not have an active market in which they can be traded. In the case of a bond, a corporation may issue a bond with terms that are different than what market participants want. The bond will trade at a discount or a premium in that case. If Ford issues a 10‐year 5% corporate bond but the market yield is currently 6% (i.e. market participants want a 6% rate of return), market participants will only buy the bond from Ford at a discount. To simplify, assume a bond with a $1000 face value and a 5% coupon rate (every year the bond pays $50 of interest income), then to get a 6% yield someone should pay $833 (50/833=6%); a 17% discount. Unfortunately for #1, there is no active market for its promissory notes, so if #1 does not issue a mortgage note with the terms required by A, its note will trade at 100% discount; A will not buy it (#1 could always check what another bank would offer). That is the disadvantage of non‐tradable promissory notes over securities; the issuer is completely bound by what potential bearers require in terms of the characteristics of the promissory note (interest rate, term to maturity, etc.). 128
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Figure 10.1 Example of types of mortgage note a bank will accept
Figure 10.2 shows what a mortgage note looks like. It is a legal document that formalizes a promise made by a household to a bank. The household issued a 30‐year fully‐amortized fixed‐rate 7.5% note to a bank called “Shelter Mortgage Co.,” which means that, over 30 years, the household promises to pay an annual interest representing 7.5% of the outstanding note value and to repay some of the principal every month. That comes down to a monthly payment of $1896.27. The mortgage note is accompanied by a mortgage deed (and many other documents). The deed is a legal document that establishes the right of the bank to seize the house if the household does not fulfill the terms of the mortgage note.
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Figure 10.2 A mortgage note
Going back to our household #1 that wants to buy a $100 house, suppose that bank A agrees to acquire from #1 a 30‐year 5% mortgage note with a $100 face value. How does A pay for it? Bank A issues its own promissory note, called “bank account,” to #1. Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200 Or, in terms of t‐account, we have the following first step: 130
Liabilities and Net Worth Bank account of #1: $100 Net Worth: $200
CHAPTER 10: MONETARY CREATION BY BANKS Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100
ΔLiabilities and Net Worth Bank account of #1: +$100
#1 then pays #2 and, for the moment, let us assume #2 opens an account at A (we will see what happens below when #2 has an account at a different bank): Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200
Liabilities and Net Worth Bank account of #1: $0 Bank account of #2: $100 Net Worth: $200
Or in terms of t‐accounts, we have the following when the payment occurs: Bank A ΔAssets
ΔLiabilities and Net Worth Bank account of #1: ‐$100 Bank account of #2: +$100
Household #1 ΔAssets House: +$100 Bank account at A: ‐$100
ΔLiabilities and Net Worth
Household #2 ΔAssets House: ‐$100 Bank account at A: +$100
ΔLiabilities and Net Worth
While the above shows the logic of what goes on when a bank provides credit services, the bank also provides payment services. This means that, in practice, the accounting is simpler because A makes the payment on behalf of #1, it does not let #1 touch any funds. Instead, A directly credits the account of #2 so the first step is actually: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100
ΔLiabilities and Net Worth Bank account of #2: +$100
And the final balance sheet is (#1 does not need to have a bank account for the payment to go through, A just credits the account of #2 by typing “100” on the computer) Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200
Liabilities and Net Worth Bank account of #2: $100 Net worth: $200
The promissory note of the bank called “bank account” is one type of monetary instrument as explained in Chapter 15. 131
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WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? POINT 1: THE BANK IS NOT LENDING ANYTHING IT HAS: WHEN PROVIDING CREDIT SERVICES, THE BANK SWAPS PROMISSORY NOTES WITH ITS CLIENTS The accounting of the previous section is commonly referred to as “bank lending,” i.e. the A is said to lend $100 to #1. As stated in Chapter 2, when studying central banking, “lending” means giving up temporarily an asset, “I lend you my pen for a minute.” This is clearly not what is going on. Banks are not in the business of allowing customers to temporarily use some of the banks’ assets: that is a loan shark business. The bank is not lending anything it owns. Lending would mean this: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100 Reserves: ‐$100
ΔLiabilities and Net Worth
Household#1 is borrowing cash from the bank. But what happened is this: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100
ΔLiabilities and Net Worth Bank account of #1: +$100
One may ask: Is there not an indirect lending of reserves though? After #1 gets its account credited, it could withdraw reserves and make a cash payment to #2. #1 would then have to get reserves back to A. The answer is no for two reasons: ‐
We have just seen that in practice the bank makes the payment for #1. That payment does not need to result into any reserve drainage (it did not above).
‐
As shown below, #1 does not have to give back reserves to A to repay its debt, and #1 rarely, if ever, does so in practice.
So not only is #1 not borrowing reserves from A, but also #1 is not giving back reserves to A. There is no lending or borrowing of reserves going on between A and #1, either directly or indirectly. What a bank does do is to swap promissory notes with economic units and to make payments for them. Reserves may enter the picture at the time of the provision of payment services, never at the time of the provision of credit services.
POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE CREDIT SERVICES While it may need reserves to provide payment services (that is to transfer funds to #2), A does not need any reserves to provide credit services to #1. All it does with household #1 is to exchange promissory notes:
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CHAPTER 10: MONETARY CREATION BY BANKS ‐
The household makes the following promise: pay 5% interest on the outstanding mortgage value for 30 years and repay some of the principal every month.
‐
The bank makes the following two promises: o
To convert bank accounts into Federal Reserve notes at the will of the account holders
o
To accept its own promissory note when #1 services the mortgage.
All these are promises and none of the issuers has to have what is needed to fulfill the promise right away when he issues his promissory notes. That is the point of finance; it is about banking on the future (see Chapter 8). Think of a pizza shop that issues coupons for a free pizza. The shop does not have to make pizzas first before it issues the coupons; it will make pizzas only if people show up with coupons. Converting the coupons into pizzas is costly for the shop and so affects its profitability, but the issuance of coupons is not constrained by the current availability to pizzas. The shop is just making a promise and anybody can make any kind of promise. The hard parts are, first, to convince someone of the genuineness of this promise and, second, to fulfill the promise once it has been accepted by someone. In the same way, a bank does not have to have any Federal Reserve notes now to be able to issue a bank account that promises Federal Reserve notes on demand. A bank will need reserves only if account holders request cash or make payments to someone who has an account at another bank. The Fed will provide reserves on demand, i.e. at the will of solvent banks, so banks never worry about being unable to get reserves (see Chapter 4). Reserves will never run out. What banks do need to worry about is the cost of acquiring reserves. In normal times, this cost is predictable and relatively stable but the Volcker experiment shows that a central bank may make reserves prohibitively expensive.
POINT 3: THE BANK IS NOT USING “OTHER PEOPLE’S MONEY”: IT IS NOT A FINANCIAL INTERMEDIARY BETWEEN SAVERS AND INVESTORS This is a development of the first and second point. A view of banking, from which the word “lending” probably comes from, is that banks are intermediaries between savers and investors. Some people come to deposit cash and then banks lend the cash. It is quite clear that a bank is not lending any funds that some deposited (nobody deposited anything in our example). And, worse offender, a bank is certainly not using others’ bank accounts to grant credit. Assume that household #3 comes to bank A to get a $100 credit, A never does this: Bank A ΔAssets
ΔLiabilities and Net Worth Bank account of #2: ‐$100 Bank account of #3: +$100
That is, it does not take the funds of #2 and give them to #3. This t‐account would be a payment from #2 to #3, not a credit by bank A. To provide a credit is exactly what credit means, it is about crediting accounts. The crediting is done by typing a number on the computer. Once this number is entered, the bank is liable to the account holder for the two reasons presented above. 133
CHAPTER 10: MONETARY CREATION BY BANKS Banks do not wait for depositors before they engage in the provision of credit services. Say household #3 comes to open an account by depositing $50 worth of Federal Reserve notes. The following occurs: Bank A ΔAssets Reserves: +$50
ΔLiabilities and Net Worth Bank account of #3: +$50
This deposit does not enhance the ability to provide credit services because A is not in the business of lending reserves to non‐bank economic units. The ability of the bank to acquire non‐bank private promissory notes is unrelated to the quantity of reserves on its balance sheet because a bank pays for them by issuing its own promissory notes. There is one case where a bank does need reserves to acquire a promissory note: if a bank buys the note from an institution with a Federal Reserve account. For example: ‐
If a bank participates in an auction of Treasuries, the Treasury only accepts federal funds in payment. In the past, the Treasury sometimes allowed banks to pay for the Treasuries by crediting the TT&Ls (another cash management method used for monetary‐policy purpose beyond the ones presented in Chapter 6), but it no longer does since 1989.
‐
if it buys promissory notes from another bank
In the first case, the balance sheet changes as follows (says the bank buys $10 worth of Treasuries from the Treasury) Bank A ΔAssets Reserves: ‐$10 Treasuries: +$10
ΔLiabilities and Net Worth
And on the balance sheet of the Fed the following occurs Fed ΔAssets
ΔLiabilities and Net Worth Reserve: ‐$10 TGA: +$10
And the Treasury: Treasury ΔAssets TGA: +$10
ΔLiabilities and Net Worth Treasuries: +$10
Chapter 6 showed that the Fed always ensures that banks have enough reserves to make the auction successful. The supply of Federal Reserve notes by savers is irrelevant for the success of auctions of Treasuries.
POINT 4: THE BANK’S PROMISSORY NOTE IS IN HIGH DEMAND Why did #1 enter in an agreement with A? Because nobody else would accept #1’s promissory note and a large number of economic units accepts A’s promissory note (if someone does not, A offers
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CHAPTER 10: MONETARY CREATION BY BANKS conversion into cash that most accept in payments). Chapter 15 explains why bank monetary instruments are widely accepted. If #2 had been willing to accept #1’s promissory note then none of the previous agreement would have been needed. The problems with #1’s promissory note are two fold: ‐
There is a credit risk: #2 is not sure that it will get paid the interest due and that it will be able to make payments to #1 by giving back to #1 its promissory note. If #2 knew that it would become heavily indebted ($100 is a lot in our example) to #1 in the future, then assuming that #1 is creditworthy, #2 may be willing to accept #1’s promissory note for the payment of the house. Later #2 could use #1’s promissory note to pay debts owed to #1.
‐
There is a liquidity risk: the promissory note only comes due in 30 years so household #1 does not have to take it back before that time (though it could because mortgage notes usually allow accelerated repayment of principal). In the meantime, #2 is stuck with this promissory note that nobody else will accept.
Bank A’s promissory note is due at any time the bearer wants (it converts into cash on demand and it can be used to pay the bank at any time) and the creditworthiness of a bank is strong. This is all the more so given that the government guarantees that A’s promissory note can always be converted into Federal Reserve notes at par, and that the (nominal) value of A’s promissory note will not fall even if A goes bankrupt. All this makes the A’s promissory note free of credit risk and perfectly liquid.
HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION Banks are dealers of promissory notes: banks take non‐bank non‐federal promissory notes and in exchange give their own promissory note. Banks make a profit by taking back their own promissory notes. At the beginning of the second month, #1 starts to honor its promise made to A by servicing the mortgage note. The monthly principal due is 27 cents ($100/(30*12), assuming linear repayment of principal) and the first interest payment is 41 cents (the annual interest rate is 5% so on a monthly basis the rate is 0.407% = (1.05)1/12 – 1) making the total debt service for the first month $0.68. How does #1 pay this? There are two ways this amount can be paid; one is by giving $0.68 in cash to the bank. Another more common solution is to follow up on the promise embedded in the bank’s promissory note: Bank A promised to take back its promissory note as means of payment of debts owed to Bank A. Thus, another means to pay the mortgage is to debit $0.68 from the account of #1. Let us assume that #1 has an account at A, that account first needs to be credited: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200 How can household #1 get funds credited to its account?
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Liabilities and Net Worth Bank account of #1: $0 Bank account of #2: $100 Net worth: $200
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o
Case 1: #1 receives a $1 payment from the federal government either by selling something to the government or by receiving a transfer payment. The balance sheet of the bank would look like this (Chapter 6 shows that transactions with the federal government lead to reserve crediting and debiting)
Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserves: $1 Building: $200 o
Liabilities and Net Worth Bank account of #1: $1 Bank account of #2: $100 Net worth: $200
Case 2: #1 works for business α that produces widgets. Business α just started. It has not sold anything yet but must purchase raw materials and pay #1 (the only employee) to be able to produce widgets. In order to do that, α asked for a $10 operating line of credit from A (an operating line of credit is an off‐balance sheet item unless it is used). When α pays #1 the following happens:
Bank A Assets 30‐year 5% mortgage note of #1: $100 Credit line payable by α : $1 Building: $200
Liabilities and Net Worth Bank account of #1: $1 Bank account of #2: $100 Net worth: $200
Business α has gone into debt by $1 to be able to pay the monthly wage of household #1. Note how similar case 2 is to the first section: business gets credit, banks makes payment, business does not touch any funds. o
Case 3: #1 receives a $1 from #2. Why? I will let you decide.
One may note that any payment made to #1 that does not come from the government (or an institution that has a federal reserve account) (case 1), or from funds that got created previously by #1 going into debt (case 3), requires that someone other than #1 goes into debt toward a bank (Case 2). Otherwise #1 cannot get access to the payment services offered by A. Let assume that case 2 prevailed so now #1 has enough funds to pay A the first monthly service of $0.68. How is that recorded? It is exactly the same procedure as debt‐service payments by banks to the central bank. Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200
Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Net worth: $200.41
Or in terms of t‐accounts: Bank A ΔAssets 30‐year 5% mortgage note of #1: ‐$0.27
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ΔLiabilities and Net Worth Bank account of #1: ‐$0.68 Net worth: +$0.41
CHAPTER 10: MONETARY CREATION BY BANKS Again, as in the case of a central bank presented in Chapter 2, the bank is not gaining any cash flow from the transaction. Its profit does not increase the quantity of reserves on the asset side. What profit does is to raise the net worth of the bank. As noted in the first Chapter, profit is just an addition to net worth, the monetary gain that profit represents may not translate into any cash flow gains. What the servicing of debts owed to banks does is to destroy bank monetary instruments, that is, bank liabilities. While there is no cash flow gain for A, profit is extremely important for the viability of its business. Indeed, the bank needs to meet its capital ratio and making a profit improves net worth. In addition, capital is extremely important to allow any bank to further develop its credit service because it can now create more promissory notes, given that it has more capital to protect its creditors. Let us look at how the capital position of A evolved through time (to simplify the unweighted capital ratio is calculated): 1‐ After it opened: Bank A Assets Building: $200
Liabilities and Net Worth Net worth: $200
Capital ratio = net worth/assets = $200/$200 = 100% 2‐ After it granted credit to #1: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200
Liabilities and Net Worth Bank account of #2: $100 Net worth: $200
Capital ratio = $200/$300 = 66.7% 3‐ After it granted credit to α and made the payment to #1: Bank A Assets Liabilities and Net Worth Bank account of #1: $1 30‐year 5% mortgage note of #1: $100 Bank account of #2: $100 Credit line payable by α : $1 Net worth: $200 Building: $200 Capital ratio = $200/$301 = 66.4% 4‐ After it received the mortgage service payment from #1: Bank A Assets Liabilities and Net Worth Bank account of #1: $0.32 30‐year 5% mortgage note of #1: $99.73 Bank account of #2: $100 Credit line payable by α : $1 Net worth: $200.41 Building: $200 Capital ratio = $200.41/$300.73 = 66.64% Until A receives the mortgage service payment, its capital position worsens as A grants more credit. Profit allows a bank to restore its capital position and to further pursue the provision of credit services. It also allows a bank to pay its own employees without further lowering its capital position. 137
CHAPTER 10: MONETARY CREATION BY BANKS So if A has one employee (household #3) who receives a monthly salary of 20 cents, then the following is recorded: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200
Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Net worth: $200.21
Bank A pays #3 by typing a number on the computer. The capital ratio is 66.57%, still better than the 66.4% that prevailed after A granted credit to α.
INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES Reserves are conspicuously absent from the previous discussions but banks do need reserves as explained in Chapter 3. Reserves enter the picture with payment services (interbank payments), retail portfolio services (withdrawals and deposits), the law (reserve requirements) and federal government operations (taxes, government spending, and auctions of Treasuries), as well as transactions with other Fed account holders (we will leave that aside). Let us go back to the point where #1 pays #2 and now let us say that #2 has an account at bank B instead of bank A. In that case, A instructs B to credit the account of #2 on behalf of A and A acknowledges it is indebted to B: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200
Liabilities and Net Worth Debt to bank B: $100 Net worth: $200
Bank B Assets Promissory note: $170 Debt of bank A: $100 Building: $80
Liabilities and Net Worth Bank account of #2: $100 Other bank accounts: $50 Net worth: $200
Interbank debts are settled with reserves but there is a small problem: bank A does not have any reserves! How could A get them right now? There are several possibilities: 1‐ Selling non‐strategic tradable assets to another bank or the Fed, say Treasuries: bank A does not have any (the building is a strategic assets because A cannot operate without it, the mortgage note of #1 is not tradable). 2‐ Getting reserves in the interbank market: borrow from a fed funds market participant with excess funds (see Chapter 4). 3‐ Getting reserves from the Fed: swap promissory note with Fed via the Discount Window 138
CHAPTER 10: MONETARY CREATION BY BANKS 4‐ Recording an overnight overdraft on its reserve balance. Over time there will be other means for A to get reserves because: 5‐ Other banks will ask A to make payments on their behalf to economic units with accounts at A. 6‐ Some economic units will come to deposit Federal Reserve notes at A 7‐ The government will make payments to economic units with accounts at bank A (see case 1 above). But right now bank A does not have the reserves so it needs to use sources 1 through 4. Recording an overnight overdraft is the costliest solution because it requires the payment of very high penalties.1 Going at the window is possible but, in normal times, there is a large stigma in the US and it is costly. Borrowing reserves in the federal funds market is usually the preferred means to get reserves. Assume that, first, Bank A uses the overdraft facility to pay Bank B: Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserves: ‐$100 Building: $200
Liabilities and Net Worth Net worth: $200
As long as the balance is negative only during the day, bank A does not have to pay any interest on it. Before the end of the day, bank A borrows reserves in the interbank market from bank C: Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserve: $0 Building: $200
Liabilities and Net Worth Debt to bank C: $100 Net worth: $200
This debt is due the next morning and, at the end of the next day, bank A will need to borrow again from bank C or another bank until it receives enough reserves from sources 5, 6, or 7. While it borrows from other banks, it must pay the interest rate that prevails on the interbank market, which, to simplify, is the Federal Funds rate target. Say bank A has to borrow every night for a month, then its profit for the first month, assuming a FFR of 2%, is: Profit = Interest received – interest paid = 0.41%*100 – 0.083%*100 = $0.327 As long as the FFR stays below the interest rate on the mortgage note, the bank is profitable. It is not as profitable as it would have been had it not borrowed reserves, but it is profitable. Beyond the need to make interbank payments, in some countries banks are also required to meet some reserve requirements. Bank A has the following balance sheet if we continue from the last balance sheet of the previous section: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200 139
Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Net worth: $200.21
CHAPTER 10: MONETARY CREATION BY BANKS The outstanding value of bank accounts is $104.93 so A now needs to get $10.49 of reserves on its balance sheet if the reserve requirement ratio is 10%. Again the sources of reserves are 1 through 7 but if A needs them right away only sources 1‐3 are available for reserve requirement purpose (A cannot have an overdraft in that case). The accounting implications and profit implications are the same as just presented. For example if it borrows from bank B: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Reserve: $10.49 Building: $200
Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Debt to bank B: $10.49 Net worth: $200.21
Beyond reserves needed for interbank debt settlements and reserve requirements, Chapter 6 also looks at the need to get reserves to settle auctions of Treasuries and to pay taxes. In all these cases (and the case of withdrawals of cash by account holders), the central bank always accommodates the needs of the banking system to ensure that the payment system works properly (economic units get paid and debts are settled), to ensure that banks follow the law (only the Fed can provide the reserves that banks need to meet reserve requirements), and to ensure that non‐ bank economic units can get the cash they need (see Chapter 4). Banks are never constrained by the quantity of reserves available, as long as a central bank merely targets an interest rate. While the quantity of reserves does not constrain bank A in any way, the Fed does set a price on the supply of reserves and this price impacts the profitability of bank A. As such, banks try to find the cheapest sources of reserves, which usually means attracting and keeping depositors. Banks also try to economize on reserve needs by net clearing interbank debts before settling them, among other means. Finally, banks do not try to hold more reserves than what they need. As shown in Chapter 3, in normal times, most reserves are held because banks are required to do so. Demand for excess reserves is very small and virtually zero. As shown in Chapter 4, banks have almost no incentive to keep excess reserves because they can get any quantity of reserves they want at any time, because they cannot do much with reserves, and because keeping excess reserves lowers ROA. Banks do not proactively try to get reserves ahead of credit activities and, if credit activity slows, they slow their demand for reserves and may want to avoid attracting new depositors to avoiding building excess reserves. They may keep a slight quantity of excess reserves to avoid having to record an overnight overdraft.
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? Say that a bank really wants to increase aggressively its market share; this will tend to draw the attention of regulators for several reasons: 1‐ In order to grow fast, the best strategy is to provide credit to economic units that other banks do not want to qualify; for short non‐prime economic units. This can be done by loosening credit standards faster than other banks and/or, as shown in Chapter 8, by 140
CHAPTER 10: MONETARY CREATION BY BANKS offering to accept promissory notes with initial low monthly payments but upcoming large payment shocks (hopefully refinancing will be possible down the road). Both cases lead to a higher chance of default and so a higher probability of loss of net worth for a bank. The decline in the quality of assets may attract the attention of regulators. 2‐ The proportion of liquid assets relative to illiquid assets declines faster than its peers. 3‐ Its interbank debt will balloon rapidly as payments made on behalf of the bank grow quickly, which pushes down its profitability and so its ability to build its capital base. 4‐ The quality of its earnings declines. If a bank grants a lot of pay‐option mortgages to non‐ prime economic units, these units will usually only pay part of the interest due. However, accrual accounting allows a bank to record the whole debt service due as received and to record “phantom profits.” This may again attract the attention of regulators if accrual interest income grows out of proportion (accrual accounting is not a problem per se and is a convenient means to smooth business operations if used properly). Basically, if a bank grows faster than the rest of the industry, its CAMELS rating tends to increase relative to others and its interbank debt becomes unsustainable. Ultimately regulators will issue a cease and desist order. Note that if a bank grows fast by providing credit to non‐prime clients at a premium interest rate, then, given interbank debt, its short‐run profitability rises as leverage and ROA rise. However, such a bank will then experience massive losses in the near future that will lower rapidly profit and capital. As such, there are two limits to the monetary creation process induced by the swapping of promissory notes: ‐
The credit standards: if A considers that #1 does not meet the 3Cs of credit analysis, A will not accept #1 promissory note and so will not credit #1’s bank account (or #2’s).
‐
Regulation, but not through reserve requirements given that the Fed will provide all the reserves needed to fulfill the requirements, but, rather, through regulatory elements that impact CAMELS rating, that constrain the loosening of credit standards, and that limit the types of assets banks can hold (see Chapter 9).
MOVING IN STEP As noted in Chapter 8, there is safety in numbers. As long as banks grow in step, that is, as long as they create bank accounts at about the same speed (and so acquire assets at the about same speed), they may not attract the attention of regulators: 1‐ Interbank debt for a bank will not balloon out of control: requests to make payments on a bank’s behalf are offset by requests to make payments of behalf of others banks. 2‐ Leverage may rise, at least until debt servicing starts, and liquidity may fall but all this occurs at the industry level so no bank is singled out. As long as underwriting is done properly, ultimately, banks will make a profit and capital will be gained and so leverage will decline overtime. However, as explained in a Chapter 8, things may get out of hand if most banks aggressively pursue growth in market shares and search for yield.
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LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS Finance is not a scarce resource as long as the government is monetarily sovereign. Banks and the central bank can create an unlimited quantity of monetary instruments whenever they want. While they can create an unlimited quantity of monetary instruments, they will not do so for the following reasons:
-
For the central bank: under normal circumstances (see Chapter 4), the main limit to the reserve creation process is the need to maintain the overnight interbank rate positive, which basically implies that the central bank must supply whatever banks demand; no more, no less.
-
For banks: core limits to the monetary creation process are profitability and regulatory concerns.
I will finish this Chapter with Figure 10.4, which illustrates the points made above. The supply of credit is slightly upward sloping and then becomes vertical as banks ration credit given a set of credit standards. The supply slopes upward to reflect the fact that, at a point in time, as credit grows, the creditworthiness of the remaining pool of acceptable economic units falls. A given set of credit standards defines what a minimum level of creditworthiness is and anybody below that level will not be granted credit (hence the vertical supply of credit). The demand for credit is downward sloping but not very elastic. As explained in Chapter 5, demand for credit by businesses is very insensitive to interest‐rate conditions.
Figure 10.4 The market for bank credit
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL INTERMEDIATION.
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CHAPTER 10: MONETARY CREATION BY BANKS A now discredited view of monetary creation by banks argues that banks actively seek excess reserves to be able to provide credit. The logic goes as follows with a 10% reserve requirement ratio: 1‐ The central bank injects excess reserves by buying $100 worth Treasuries from bank A 2‐ Reserves do not earn any interest, so Bank A provides a credit of $100 to household #1 who makes a $100 payment to households #2 at bank B. Bank B now has $100 of extra bank account on its liability side and $100 of extra reserves on its asset side. Bank B has $90 of excess reserves. It grants a credit of $90 to household #3 who pays $90 to household #4 at bank C. Bank C has now $90 of extra reserves and has issued $90 of extra bank account so excess reserves is $81, upon which Bank C provides $81 credit to household #5, etc. This continues until there are no excess reserves left in the banking system. 3‐ The sum of bank accounts created is $100 by bank A, $90 by bank B, $81 by bank C, $72.9 by bank D, etc., which amounts to $1000: With $100 of excess reserves banks could create $1000 of bank accounts. 4‐ Conclusion: bank credit is constrained by the quantity of excess reserves and the reserve requirement ratio. Both can be used by the central bank to target the money supply and ultimately inflation. There are several issues with this view of how banks provide credit and so create monetary instruments: -
Step 1 never happens under normal monetary policy set up (see Chapter 4): any unwanted excess reserves are drained out of the banking system to prevent a fall of FFR to zero. Chapter 3 notes that banks have very little need for reserves. The Volker experiment (see Chapter 5) tried to move toward reserve targeting with the goal of targeting money supply, but this was a failure.
-
It is just not how banks operate (step 2): Banks are profit‐seeking institutions; they do not wait for reserves to grant credit. They grant credit first and look for reserves afterwards, in the same way a pizza shop prints coupons first and then make the pizzas as needed. Flooding banks with reserves just reduces their ROA; it acts like a tax.
-
Banks cannot force economic units to go into debt. Bank credit is demand‐driven so even if banks have a lot of reserves that does not improve their ability to provide credit. Bank A had to wait for #1 to show up before anything could happen. And while bank A could have tried to entice #1 to come to the bank for financing, ultimately it is #1 who decides to take a credit.
-
Milton Friedman himself recognized the problem with this approach: “Given the monetary policy of supporting a nearly fixed pattern of rates on government securities [during WWII], the Federal Reserve System had no effective control over the quantity of high‐powered money. It had to create whatever quantity was necessary to keep rates at that level. Though it is convenient to describe the process as running from an increase in high‐powered money to an increase in the stock of money through deposit‐currency and deposit‐reserve ratio, the chain of influence in fact ran in the opposite direction—from the increase in the stock of money consistent with the specified pattern of rates and other economic conditions to the increment in high‐powered money required to produce that increase.” (Friedman and Schwartz 1963, 566). There are two main problems with his view:
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He seems to view the WWII experience as a special case instead of the general case: a central bank always targets interest rates, at least the overnight interbank rate and at least within a band (see Chapter 4).
-
His theoretical position is untenable: if causality is known with certainty to be reversed (money supply to reserves instead of reserves to money supply), then one cannot proceed as if the opposite were true because “it is convenient.”
Another view of banking is that banks lend “other people’s money.” People save and deposit cash in the bank, and the bank proceeds to lend the cash deposited. The Chapter touched on this above but here are the problems: •
Banks do not lend the savings of households: banks do not temporarily take Paul’s funds and given them to Pierre.
•
Banks do not lend reserves to non‐banks: they do not look if Paul deposited enough cash before granting credit to Pierre.
•
Banks are not in the business of lending anything they have: Pierre does not temporarily take cash from the bank, and, usually, does not give back cash to a bank when he services his debt.
•
Savers can deposit cash, but savers are not the source of cash, cash comes from the Fed. And the Fed creates cash at the demand of banks so saving does not constraint credit.
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Summary of Major Points 1‐ Banks are not money lenders because their monetary instruments are their liability not their assets. One cannot lend one’s own debt. 2‐ Banks are promissory note dealers. They take non‐bank promissory notes and in exchange give their own promissory notes. Contrary to most non‐bank promissory notes, bank promissory notes are widely accepted and perfectly liquid. 3‐ If customers’ default on their promissory notes, the value of the assets of banks falls and they do not earn a profit, so banks are very interested in making sure that customers are creditworthy. 4‐ Monetary creation by banks merely involves accounting entries. These accounting entries make banks liable because their promissory notes are convertible in cash and can be used to paid debts owed to banks. 5‐ The money supply does not fall from the sky; it involves a simultaneous debt creation. Banks promise to pay customers, customers promise to pay banks. Banks accept their customers’ promissory note because banks think that their customers are involved in activities that are profitable. As such, monetary creation moves in sync with the needs of the economic system; these needs may or may not be related to production and the purchase of goods and services. 6‐ Banks are not bound by the quantity of reserves when they create monetary instruments. Their monetary instruments are just promises to obtain reserves at the demand of the bearers. Banks do not have to what they promise to deliver when they create monetary instruments. In addition, the central bank provides reserves at the demand of solvent banks, so solvent banks never have to worry about not getting the reserves they need when needed (at a price). 7‐ Monetary creation by banks is limited by regulatory and profitability concerns. They have to comply with capital requirements and asset quality requirements, among others, and promissory notes that have a poor creditworthiness negatively impact their profitability. 8‐ The money multiplier theory and the financial intermediary theory of banks are no longer seen as valid by most of the academic community. Keywords Credit standards, promissory notes, overdraft, capital ratio, credit service, payment service, retail portfolio services, net worth, interbank debt, withdrawals, reserves, money multiplier, credit line, credit receivable/payable Review Questions Q1: When banks provide credit what is the accounting side of this operation? Q2: If a customer comes to ask for a bank credit what will the bank do? Why? Q3: When customers service their promissory notes what happens to the quantity of reserves held by banks? Q4: What do banks do with the cash that some customers deposit? Q5: Why is bank credit not limited by the quantity of reserves? Why are savers irrelevant for credit operations? Q6: How does profit help to meet capital requirement? And why is that allowing banks to continue to keep their business going? Q7: What are the problems with the money multiplier theory at each stage of the argument? What about the financial intermediation theory of banking? 145
CHAPTER 10: MONETARY CREATION BY BANKS
Suggested readings For an oldie but goodie video that explains correctly how banks grant advances watch https://www.youtube.com/watch?v=OJMJ24U0Jp4#t=136 Following the failure of reserves injection to boost bank credit (or inflation), the Bank of England published a paper that explains correctly banking operations and rejects other theories: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prerel easemoneycreation.pdf More advanced reading: Carpenter, S. and Demiralp S. (2012) “Money, reserves, and the transmission of monetary policy: Does the money multiplier exist?” Journal of Macroeconomics 34 (1): 59‐75. Dow, S.C. (2006) “Endogenous money: Structuralist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 35‐51, Northampton: Edward Elgar. Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge: Cambridge University Press. Keister, J. and McAndrews, J. (2009) “Why are banks holding so many excess reserves?” Federal Reserve Bank of New York Current Issues in Economics and Finance 15 (8): 1‐10: www.newyorkfed.org/research/current_issues/ci15‐8.pdf Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 17‐34, Northampton: Edward Elgar. Wray, L. R. (1990) Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot: Edward Elgar. Wray, L. R. (2007) “Endogenous money: http://www.levyinstitute.org/pubs/wp_512.pdf
Structuralist
and
Horizontalist”
1 Federal Reserve’s policy on Overnight Overdrafts at http://www.federalreserve.gov/paymentsystems/oo_policy.htm
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After reading this Chapter you should be able to understand: Why economists disagree about how the financial system contributes to economic prosperity How the financial system can benefit, or be detrimental to, economic prosperity How different views about how money supply is created lead to different understandings of how money supply can contribute to economic prosperity What the role of monetary incentives is in influencing economic outcomes
CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM The previous Chapter concludes the study of banking operations. The next step is to incorporate them into the analysis of macroeconomic issues and this Chapter begins the discussion of such topics by focusing on economic growth. Money is the life‐blood of capitalist enterprise and finance is about money now for money later. As such, a well‐developed financial system is essential for economic activity in a capitalist economy. The broader the range of promissory notes that can be issued, the more accommodative the financial system is to the demands of the productive system. Households cannot fund the purchase of a house with a credit card and there is no point in buying groceries with a 30‐year mortgage. While all this may seem obvious, economists have been divided about the relevance of finance for economic activity. This divide ultimately rests on different premises on how to do economics, which John Maynard Keynes characterized as Real Exchange Economy versus Monetary Production Economy. Before I go further, a word of caution. Economists and national income accounts use the word “investment” in a specific way. Investment means adding to the quantity of real assets, i.e. growing productive capacities. One cannot invest in shares, bonds, and other financial assets but merely in machines and raw materials (knowledge is also an area emphasized by economists). Portfolio choice, which is usually what people have in mind when talking about (financial) investment, is not the same thing as (physical) investment.
THE REAL EXCHANGE ECONOMY MONEY SUPPLY IS A VEIL Until at least the 1980s, most economists believed that finance is neutral, 1 i.e. irrelevant for economic activity. The study of exchange within a barter economy with small independent producers—think of farmers with their own plot of land—is regarded as a satisfactory proxy to understand the basics of capitalism: Despite the important role of enterprises and of money in our actual economy, and despite the numerous and complex problems they raise, the central characteristic of the market technique of achieving co‐ordination is fully displayed in the simple exchange economy that contains neither enterprises nor money. (Friedman 1962, 13) The point is to understand how market exchange helps economic units to manage the prevailing natural scarcity of resources by allocating resources according to given sets of initial allocations, preferences and techniques of production. Once this is understood, money supply can be added to the analysis but it does not substantially change anything. It merely smooths exchange, is not sought after for itself, and so does not influence allocation, production, and distribution. Capitalism is equivalent to a barter economy with money. In addition, monetary instruments are conceptualized as commodities used as medium of exchange. As such, a willingness to hoard monetary instruments and to reduce spending on other things is merely changing the structure of demand for goods and services; it does not change its level. As a consequence, the level of economic activity is not impacted by monetary incentives and the willingness to hoard monetary instruments.
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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM Put in terms of the financial industry, one may think of financial markets and banks as institutions used by economic units to borrow and lend current production; finance is a market for intertemporal output: It may be supposed in theory that the entrepreneur borrows these consumption goods from the capitalists in kind, and then pays them out in kind in the shape of wages and rents. At the end of the period of production he repays the loan out of his own product, either directly or after exchanging it for other commodities. […] If this procedure were adopted by all entrepreneurs who work with borrowed capital, competition would bring about a certain rate of interest that would have to be paid to the capitalists in the form of some commodity or other. […] Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. (Wicksell 1898, 103‐104) Assume a barter economy in which the only product is potatoes and in which workers and other income earners are paid in potatoes. Some economic units may have too many potatoes for current consumption, so they save potatoes. Potato savers can go into a market in which they lend their potatoes to economic units who plant potatoes—the potato investors. The following year, there will be more potatoes than what was planted, as each potato is a seed that can be used to produce more potatoes, the marginal product of potatoes. This marginal product is at the foundation of the interest rate earned by the potato savers; their reward is more potatoes in the future, which means that interest and principal servicing creates an automatic demand for output (as did payment of wages). Monetary considerations can be added to this story, but they do not add anything to the understanding of what goes on in the financial industry. Money supply and other financial claims are just claims on production, that is, the money supply is a mere medium of exchange. Monetary considerations are irrelevant and “the objectives of agents that determine their actions and plans do not depend on any nominal magnitudes. Agents care only about ‘real’ things, such as goods […] leisure and effort” (Hahn 1982, 34). As such, economic units strive to get involved in the most productive economic activities in order to produce as much as possible in relation to their preferences. Markets are there to help them discover the most productive economic activities in the most efficient way. This way of thinking goes back at least to 19th century Austrian economists such as von Böhm‐Bawerk and Menger. In many current macroeconomic models, this reasoning is simplified even further by getting rid of any market and assuming a farmer who is both a saver and an investor (as well as producer/consumer and employer/employee). He saves potatoes today to plant them. The amount he saves (and so invests) depends on the reward received to be next year. The reward is the marginal product of potatoes.
FINANCE AND THE ECONOMY This understanding of finance is grafted to a specific theory of economic growth. Economic growth is driven by “supply factors”, i.e. the growth rate of inputs: physical capital (“machines”) and labor. Finance helps economic growth because the ability to invest (that is, to grow physical capital: Kt = Kt‐1 + It‐1) depends on the ability to save and the point of finance is to allocate saving—saving drives investment. 149
CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM Going back to the potato economy, in order to have more potatoes next year, one needs to save more today. Say that if one plants a potato at year 0 one gets two potatoes at year 1. To get three potatoes at year 2, one must not consume one and half potatoes at year 1. Of course, saving is painful because one gets fewer potatoes to eat, so saving must be rewarded (one more potato next year). The question becomes: is the reward worth the pain? The graphical way to represent all this is the loanable funds market (Figure 11.1).
Figure 11.1 The loanable funds market
Economic units meet in a market to borrow and lend current output, “potatoes.” The higher the interest rate provided to reward saving, the more saving there is, i.e. the more economic units reduce their current consumption and supply potatoes to economic units who invest. The interest rate needs to rise because each additional unit of saving is increasingly painful. The interest rate is of course a physical reward, a real interest rate, more potatoes in the future. Savers/lenders are not interested in monetary earnings so their credit standards are set in real terms. The opposite goes on with the planters of potatoes/borrowers. The incentive to invest decreases as the reward to pay out increases. The reason for that is found in the production process. As more potatoes are planted, the nutritive quality of a given quantity of soil declines and so each additional potato seed will produce fewer potatoes. As such, investors can afford to pay a smaller reward for each additional potato that is invested. In technical terms, the marginal product of capital falls as more capital is used in the production process given other inputs. The government may come in the market to borrow real resources too: The government's fundamental objective is to borrow a given amount of real resources, not a given amount of money. (Friedman 1952, 690) This leads to the well‐known “crowding out” effect (Figure 11.2). As government enters the loanable funds market, the real interest rate rises and private investment declines. Assume a market without a government that is at equilibrium (Figure 11.1). As the government comes to borrow potatoes (Figure 11.2), it competes with the private sector for the current quantity of saved potatoes. As in any other “well‐behaved” market, a higher demand for something increases the
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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM price of that thing. This is the market to borrow potatoes, so the real interest rate (i/P) will rise until the market finds a new equilibrium. A higher interest rate reduces the incentive to invest.
ΔI I) and “deficit” (if S 0. If the opposite is true, the sector is a net debtor (aka “net borrower”) during the period. Finally, this identity is sometimes rewritten as: DPB + GB + FB ≡ 0 With DPB the domestic private balance, FB the foreign balance (the opposite of the domestic current account balance), GB the government balance, and “balance” being measured either through the capital accounts (net saving) or through the financial accounts (net financial accumulation). Finally one may note that given that NW – RA ≡ FA – FL, then: (S – I) ≡ Δ(FA – FL) The operations on goods and services are mirrored by financial operations. Thus, a deficit, or net dissaving, is mirrored by a net financial disaccumulation; to spend more than what is earned one must sell assets or go into debt. Similarly, a surplus, or net saving, is mirrored by a net financial accumulation for the sector.
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CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY No theory, behavioral equations and statements of causal relations, was used above to explain the accounting identities (a bit of this is done below to examine the business cycle). The identities simply state that a net injection of funds by a sector must be accumulated in another sector. Every dollar must come from somewhere and must go somewhere.
SOME IMPORTANT IMPLICATIONS They are many implications but the main one is that one must not study a sector in isolation. Anything that a sector does has an impact on other sectors. When a forecast about the budgetary trend of the government is made, the forecaster must recognize the implications for other sectors to see if the forecast is realistic. This is usually not done. For example, the Congressional Budget Office in the early 2000s expected the federal government’s surplus to continue to grow but neglected to look at the implication in terms of the domestic private sector.1 A continuously rising government surplus implies continuously rising domestic private deficit given the foreign balance, which is not sustainable. Only the federal government of a monetarily sovereign government can sustain permanent deficits (see Chapter 6). There are many other implications and uses of this framework such as macroeconomic theory, the madness of fiscal austerity, among others. 2
POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES THAT SOMEONE GOES INTO DEBT. Let us start with an economy in which nothing has been produced or acquired yet. ADP FADP = 0 RADP = 0
LDP AG LG FLDP = 0 FAG = 0 FLG = 0 NWDP = 0 RAG = 0 NWG = 0
AF LF FAF = 0 FLF = 0 RAF = 0 NWF = 0
Say that someone in the economy wants to build a house that costs $10 to build. In order for domestic production to start, workers must be paid, raw material must be purchased (those had to be produced first by the way). If a private business is in charge of doing all this, it must obtain funds and Chapter 10 explains how this is done. The balance sheet of the domestic private sector would look like this once the house is built: ADP RADP = 10
LDP NWDP = 10
Consolidation eliminates the debt owed by the homebuilder to a bank, as well as wages and raw material payments, because they are all internal to the sector. Once produced, if the house is acquired by a domestic household for $11, the following is recorded at the macro level: ADP RADP = 11
LDP NWDP = 11
Again all this hides quite a few underlying financial transactions: 1‐ Households got a mortgage and paid the homebuilder who made a $1 profit
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CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY 2‐ Firm repaid its $10 debt with interest 3‐ House was transferred from firms’ balance sheet to household’s balance sheet. The next period the process would start all over again. This time the firm may have some savings from the previous period to finance part of the production. If, instead, the government buys the house, it must first fund the purchase by using a promissory note (FLG): ADP FADP = 11
LDP NWDP = 11
AG RAG = 11
LG FLG = 11
Spending by the government has allowed the domestic private sector to acquire a financial claim. It is a claim on the government. If a foreign economic unit buys the house and the housebuilder requires payment in US dollars, there are several ways the payment can be done but all of them involve the foreign sector going into debt in dollars. For example: ‐
The foreigner may ask for a bank advance in US dollars at a domestic bank
‐
The foreigner may write a check in a foreign currency (say euros) but when the domestic bank of the housebuilder receives the check, it will send the check back to the foreign bank of the buyer to request a dollar payment. The foreign bank will need to borrow US dollars to settle its debt with the domestic bank.
Once the house is sold, the firm makes a $1 profit that it uses to pay interest, dividend and taxes. What is left over is retained earnings, the saving of the firm. Households will also save some funds. But none of that can occur unless someone goes into debt to start production. And for savings to be bigger, debt must increase.
POINT 2: NOT ALL SECTORS CAN RECORD A SURPLUS AT THE SAME TIME It is quite straightforward to notice that not all sectors can be net creditors at the same time. At least one sector must be a net debtor if another sector is a net creditor because for every creditor there must be a debtor. Most of the time, the domestic private sector is in surplus and the government sector is in deficit (Figure 13.3, Figures 13.4). From 2000 to 2010, New Zealand was a particularly odd case where the private sector was in deficit while government and foreign sectors were in surplus. To simplify, let us assume that NFAF = 0, therefore: NFADP ≡ ‐ NFAG That is, in a closed economy, for the private domestic sector (households and private companies) to be able to record a surplus (NFADP > 0), the government must run a fiscal deficit (NFAG 0: Non‐government sector net saves what it desires. In that case it must be true that GB 0). In a growing economy, automatic stabilizers lower the deficit of the government, which is what the government wants. But, if the government is dissatisfied with the pace of return toward a surplus, it may implement austerity policies that raise taxes (T) and/or lower spending (G) (“the country must live within its means”), which compounds the effect of automatic stabilizers. Thus ∆GB > 0 and so ∆NGB 0) more funds than what refluxes to the government (ΔFLG 0) than the quantity of principal repaid by the non‐ government sectors (ΔFAG 0 => PgG > FV => coins disappear from circulation (melted into ingots or exported as commodities)
Lack of a proper interbank payment system: in that case interbank debts are difficult to clear and settle. This creates all sorts of problems going from delays in processing payments, to loss of purchasing power because some bank monetary instruments trade at a discount relative to other bank monetary instruments, to full blown financial crises because payments cannot be processed and so creditors do not receive what they are owed and in turn cannot pay their own creditors.
CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS
Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE? Legal tender laws state that, in court settlements, creditors must accept whatever is defined as legal tender in payments of what is owed to them. If they do not accept it, they cannot sue their debtors for unpaid dues. This does not mean that a legal tender cannot be refused during petty transactions. The current legal tenders in the United States are Federal Reserve notes, but plenty of shops and government offices refuse cash payments. Something that is legal tender is not necessarily a monetary instrument. In the past, commodities have been included in the legal tender laws, thereby, compelling creditors to accept payments in kind. Chapter 17 develops the case of tobacco leafs in the United States, which came about because of a shortage of monetary instruments. Something that has a fixed price is also not necessarily a monetary instrument. It may just be a commodity managed by an economic unit via the use of a buffer stock; the economic units accumulates large inventories of the commodity to offset downward pressures of its price, and sells off its inventories to offset upward pressures of its price.
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED? Public opinion about what is or what is not a monetary instrument does not matter and popular belief by itself cannot turn something into a monetary instrument. To use an analogy, one can use a shoe to hammer nails but it does not make the shoe a hammer. The fact that everybody thinks that shoes are hammers does not turn shoes into hammers. If everybody is delusional enough to believe the contrary, there will be many more work‐related accidents and productivity will drop because shoes are not built properly to hammer nails. In a similar fashion, if everybody wants to believe that gold nuggets, tobacco leafs, or grains of salt are monetary instruments, the payment system will not work smoothly and economic activity will suffer. As explained in Q2, some monetary instruments are used merely as collectible items. Some persons may also use monetary instruments as ornaments and for other non‐economic uses. These other uses do not demonetize a monetary instrument. That can only happen if a monetary instrument seizes to be a promise and that is up to the issuer to decide.
Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? Yes, as long as one does not counterfeit existing monetary instruments, one can do so.7 One should then have a monopoly over the issuance of such an instrument. Good luck getting it accepted!
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Summary of Major Points 1‐ A commodity cannot be a monetary instrument by itself, it needs additional financial characteristics fitted onto it. 2‐ In order to detect a monetary instrument one must study the financial characteristics of what is said to be a financial instrument. The fact that something is a legal tender, a medium of exchange, or circulates at a stable price does not tell us much about the monetary nature of that thing. 3‐ A proper monetary analysis involves dissecting the financial characteristics of a monetary instrument and determining if the means are available to make these financial characteristics a reality. In doing so, one must study the reflux mechanism and the issuer’s ability to fulfill the promises made in a financial instrument. 4‐ A monetary instrument is accepted by bearers for the same reasons that a stock or a bond is accepted by bearers: they trust the issuer’s ability to fulfill the promise embedded in the financial instruments. While on a daily basis bearers trade stock, bonds, cash and other monetary instruments without thinking about how creditworthy the issuer is, if the latter announces a default that has an immediate impact on the fair price. 5‐ Gold coins are not monetary instruments because they are made of gold. Gold is just a collateral embedded in the coin. 6‐ Inflation and deflation do not reflect a change in credit risk for the issuer of monetary instruments. Keywords fair price, face value, legal tender laws, debasement, crying down/up the coinage, term to maturity, collateral, free coinage, full‐bodied coin, redeeming clause, convertible, redeemable, Review Questions Q1: Explain why bitcoins and pretend‐play notes are not monetary instruments? Q2: Why may a legal tender not be a monetary instrument? Q3: If the issuer of a monetary instrument defaults, what happens to the fair price of that instrument? What does it mean for day to day transactions of that instrument? Q4: Who determines that something is a monetary instrument? Q5: Why is a gold nugget not a monetary instrument? Q6: What was the problem with free coinage? Full‐bodied coins? The absence of a redeeming clause? 1
See section on salt currency at the Encyclopedia of Money blog: http://encyclopedia‐of‐ money.blogspot.com/2011/10/salt‐currency.html 2 Kiyotaki, N. and Moore, J. (1997) “Credit Cycles,” Journal of Political Economy 105 (2): 211‐248. 3 See http://www.theguardian.com/money/2016/may/14/zimbabwe‐trillion‐dollar‐note‐hyerinflation‐investment 4 Listen to “Penny Hoarders Hope For The Day The Penny Dies” by Zoe Chase at http://www.npr.org/2014/05/21/314607045/penny‐hoarders‐hope‐for‐the‐day‐the‐penny‐dies 5 See Ilana E. Strauss’s “The Myth of the Barter Economy” http://www.theatlantic.com/business/archive/2016/02/barter‐ society‐myth/471051/ 6 See Eric Tymoigne’s “Fair price of bitzoing is zero” at http://neweconomicperspectives.org/2013/12/fair‐price‐bitcoin‐ zero.html
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CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS 7 For example of pround counterfeiters who take their art very seriously, see “'Counterfeiting is an art': Peruvian gang of
master fabricators churns out $100 bills” at http://www.theguardian.com/world/2016/mar/31/counterfeiting‐peruvian‐ gang‐fabricating‐fake‐100‐bills
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CHAPTER 17: After reading this Chapter you should be able to understand: What some of the problems have been in setting up a monetary system How a functional approach to monetary systems can mislead an inquirer into the existence of a monetary instrument. Why medieval times were dark times for monetary systems
CHAPTER 17: HISTORY OF MONETARY SYSTEMS The goal of this chapter does not to present a complete history of monetary systems but rather to illustrate the points and framework presented in the two previous chapters. The goal of this chapter is to show how to study the history of monetary system by taking a few examples. The financial mechanics at play are emphasized and linked to the socio‐politico‐economic context.
MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM Massachusetts Bay colonies responded to the lack of currency by issuing bills of credit that “shall be accordingly accepted by the treasurer and receivers subordinate to him, in all publick payments, and for any stock at any time in the treasury” (Davis 1900, 10). The government spent by issuing the bills and levied a tax to allow bearers to redeem them. Initially, trust in the bill was low because of the political and financial risks: When the government first offered these bills to creditors in place of coin, they were received with distrust. […] their circulating value was at first impaired from twenty to thirty per cent. […] Many people being afraid that the government would in half a year be so overturned as to convert their bills of credit altogether into waste paper, […]. When, however, the complete recognition of the bills was effected by the new government and it was realized that no effort was being made to circulate more of them than was required to meet the immediate necessities of the situation, and further, that no attempt was made to postpone the period when they should be called in, they were accepted with confidence by the entire community […] [and] they continued to circulate at par. (Davis 1900, 10, 15, 18, 20) The population was unsure that the government would be willing or able to fulfill the promise to take back the bills at any times at par in tax payment. This lack of trust was compounded by the fact that, while the promise stipulated that bills could be returned at any time, in practice the tax levied to redeem the bills was initially implemented only once a year. Thus, when bills were issued initially, d was positive and bearers’ expectations about the term to maturity (E(N)) compounded the discount applied to the bills. 1
The government asked for the help of Boston merchants who agreed to take the bills at a small discount in payments from the government. Ultimately, the bills circulated at par as the government retired the bills as expected in a timely fashion. However, as explained in Chapter 15, tying the issuance of bills of credits to a specific tax created a dilemma. The private sector wanted to accumulate the bills but taxes prevent the accumulation of the desired dollar amount of bills. At the same time, taxes were at the foundation of the monetary system so they needed to be implemented as expected. Ultimately, the provincial government was unsure about how to proceed. One drastic method was to breach the promised term to maturity by postponing the implementation of the tax levy for several years. This was an effective default relative to the terms of the bills and a sure means to decrease the confidence in the bills and so their fair value (ibid., 108); “this fact alone would have caused them to depreciate, even if the amount then in circulation had been properly proportioned to the needs of the community” (Ibid., 236
CHAPTER 17: HISTORY OF MONETARY SYSTEMS 20). The discount rate became positive again which lowered the purchasing power of bills given output prices. Later on, the provincial government found a more appropriate solution to the dilemma by broadening the types of dues that could be paid with the bills. From this example, one can learn several useful lessons. First, trust in the issuer of a monetary instrument requires some work to be earned but is central for the ability of that instrument to circulate at par. Second, if the reflux mechanisms in place are inconsistent with the promise made, there will be problems to fulfill the promise made. Colonial governments promised redemption at the will of bearers but payments owed to the government were only implemented occasionally and narrowly. Third, once one has made a promise, one had better keep up with it; otherwise, bearers lose confidence quite quickly.
MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL The most complex historical case regarding the fair value of monetary instruments concerns the medieval coins made of precious metal. There are three broad problems in this case. One relates to the face value of the coins, another relates to the intrinsic/bullion value of the coins (i.e., the market value of the precious‐metal content), and a third one relates to the interaction between the first two problems. Up until recently, the face value was not stamped so it “was carried out by royal proclamation in all the public squares, fairs, and markets, at the instigation of the ordinary provincial judges: bailiffs, seneschals, and lieutenants” (Boyer‐Xambeu et al. 1994, 47). This announcement declared at what nominal value the King would take each of his specific coins in payments due to him, thereby establishing their face value. Frequent changes in face value led to confusion among bearers, especially so given that the spread of information was slow and inadequate. Coins made of precious metals were a way to partly deal with the uncertainty surrounding the face value of coins. Coins with high precious metal content would be demanded from sovereigns that could not be trusted, either because they cried down too much, or refused some of their coins in payments too often, or were weak politically. The higher the content of precious metal relative to the face value, the more limited the capacity of Kings to cry down the coinage because coins would disappear if the face value fell below the market value of the precious‐metal content. Coins would be melted (or exported as bullions) to extract the precious metal, because more units of a unit of account could be obtained per coin by selling the precious metal instead of handing over coins to the King. Finally, others (e.g., mercenaries) demanded payments in such a form because they did not expect to be debtors to the King or to meet someone in debt to the King, or to meet someone who would expect to make transactions with someone else indebted to the King. While the issuance of such coins was warranted given the poor political and financial stability of the time, they created several issues related to their intrinsic value and its impact on the fair value. If circumstances in the precious metal market pushed the value of the precious metal higher than the prevailing face value, mint masters and money changers would melt or illegally debase (e.g., clipping and sweating) the coinage even if the creditworthiness of a King was excellent. In theory, illegal debasements would occur until the intrinsic value was brought back to the face value but it became such a habit that it continued even when the value differential was nil. Expectations about future increases in the price of the precious metal (or future crying down) also encouraged illegal 237
CHAPTER 17: HISTORY OF MONETARY SYSTEMS debasements, even if no profit could be made right now. Fraud was further encouraged by the imperfect production methods. Coins with the same denomination and date of issuance had different weight and fineness even under the best circumstances. Coins also had uneven edges that made clipping difficult to notice, if done moderately. Fraud was problematic because it disturbed the uniformity and order that Kings wanted to establish to give confidence in their coinage; the stamp was a certificate of authenticity of the weight and fineness of the collateral embedded in coins. The King’s reputation was at stake. If allowed to go on, the country would be left with a coinage of an insufficient quantity and quality to promote smooth economic operations, and clumsy and deformed coinage encouraged forgery. In order to prevent this from happening, Kings actively fought any fraudulent alteration of the intrinsic value of coins. They did so through several means. One was to punish severely fraudsters: The coins were rude and clumsy and forgery was easy, and the laws show how common it was in spite of penalties of death, or the loss of the right hand. Every local borough could have its local mint and the moneyers were often guilty of issuing coins of debased metal or short weight to make an extra profit. […] [Henry I] decided that something must be done and he ordered a round‐up of all the moneyers in 1125. A chronicle records that almost all were found guilty of fraud and had their right hands struck off. (Quigguin 1965, 57‐58) Another means was to weigh the coins that were brought to pay dues, and to refuse in payments all coins that had a lower weight than at issuance. Finally, two other ways were either to debase (decrease the quantity of previous metal to decrease the intrinsic value) or to cry up the coinage (increase the face value): debasements were only necessary alterations in the quantity of silver in the coins, in order to keep pace with the rise in the price of silver bullion in the market; […] It has always been necessary to regulate the quantity of metal in the coins, because, if too much was put in, they would immediately be withdrawn from circulation and sold for bullion, […]; if too little was put, they might be imitated. (Smith 1832, 34) In this case, debasement was not a means to increase the financing capacity of the King. It was a legitimate means to preserve the stability of a monetary system in which the value of precious metal played a role as collateral. However, debasement was a limited solution to offset the rising price of precious metals because the risk of forgery grew with further debasement. Debasement also negatively impacted the King’s creditworthiness even though he may have had nothing to do with the problem and was trying to promote a stable monetary system. Crying up the coins was not constrained by the risk of forgery, but it created another problem, as potential inflationary pressures emerged when the money supply was raised unilaterally overnight in nominal terms. Price pressures in the precious metal markets could creep into the market for goods and services, and, once again, the King would be blamed. Finally, frequent crying up created further confusion among the public about the face value of coins; thereby, it reinforced distrust and demands for coins with a high content of precious metal. If one combines changes in face value, changes in intrinsic value, as well as their interactions, the determination of the fair value of medieval coins becomes complicated. On the one hand, abusing crying down led to two types of speculation; one regarding the occurrence of a future crying down; another concerning the face value of the coins relative to the intrinsic value. On the other hand,
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CHAPTER 17: HISTORY OF MONETARY SYSTEMS developments in the precious metal markets affected expectations about future debasements or crying up of coins. What can we learn from this part of monetary history? First, an issuer should have some control over when a collateral can be seized by bearers. If the collateral is embedded in the monetary instruments, a rise in the value of the collateral above face value may lead bearers to seize it even if the issuer has not defaulted. Second, if a monetary instrument is made from precious metal, the intrinsic value of the coins should be lower than the face value by a margin large enough to accommodate significant increases in the market value of the precious metal. Third, anchoring the expectations of bearers about the face value is important for a well‐functioning monetary system.
TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS The case of Virginia and other U.S. colonies in the 17th and 18th centuries is usually put forward to make the case that tobacco leaf was a monetary instrument: Tobacco was an accepted medium of exchange in the southern colonies. Quit rents and fines were payable in tobacco. Individuals missing church were fined a pound of tobacco. In 1618, the governor of Virginia issued an order that directed that “all goods should be sold at an advance of twenty‐five percent, and tobacco taken in payment at three shillings per pound, and not more or less, on the penalty of three years of servitude to the Colony.” […] Virginia was using “tobacco notes” as a substitute for currency by 1713. These notes originated after tobacco farmers in Virginia began taking their tobacco crops to warehouses for weighing, testing, and storage […]. The inspectors at the rolling houses were allowed to issue notes or receipts that represented the amount of tobacco being held in storage for the planter. These notes were renewable and could be used in lieu of tobacco for payment of debts. […]Fines in Virginia were payable in tobacco. For example, a master caught harboring a slave that he did not own was subject to a fine of 150 pounds of tobacco. The Maryland Tobacco Inspection Act of 1747 was modeled after the Virginia statute. The Maryland statute required tobacco to be inspected and certified before export in order to stop trash from being put in the tobacco. […] Inspection notes were given for the tobacco that was inspected. Those notes were passed as money in Maryland. The use of warehouse receipts for tobacco and other commodities would spread to Kentucky as settlers began to cultivate that region. (Markham 2002, 44‐45) Hence, tobacco leafs served as media of exchange and so, following the narrow functional approach, were a monetary instrument. However, what the preceding description actually shows is that the colonies of Virginia and Maryland were at the center of a trading system of tobacco which was central to the economy of these states. By accepting tax payments, or any other dues, in tobacco at a relatively high fixed price, governments could influence tobacco output, could centralize output collection and redistribution, and make it easier for farmers—who usually did not have enough monetary instruments because of their scarcity—to pay their taxes. This, however, does not qualify payments in tobacco leafs as a monetary payment, but rather as a payment in kind at a price that was administered. Like in feudal times, taxes could be paid in kind. 239
CHAPTER 17: HISTORY OF MONETARY SYSTEMS However, the previous quote gives us some clues about the monetary system that existed. First, whereas tobacco was not a financial instrument, tobacco notes were a financial instrument of the government warehouses worth a certain number of pounds and collateralized by the value of the weight of tobacco that each note represented. Thus, tobacco notes may have become monetary instruments; nothing clear is said about that. Second, the provision of credit through bookkeeping was a common way to avoid the problems of barter: One method for financing private transactions in the colonies was through records of account kept by tradesmen and planters. Credits and debits were transferred among other merchants and traders. This was a form of “bookkeeping barter” in which goods were exchanged for other goods, and excess credits were carried on account. The barter economy that prevailed in the colonies required “voluminous record‐keeping … to carry over old accounts for many years.” This practice would continue through the eighteenth century […]. (Ibid., 46) The bookkeeping system was actually more complicated because credits on an account were sometimes transferable at par. Thus, a monetary system based initially on a unit of account named “pound” was present in the colonies, even though its functioning was not very smooth given the excessively high scarcity of top monetary instruments and the localized emergence of bookkeeping transfers. Tobacco leafs were not part of this monetary system.
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT In 1991, the Somalian government collapsed but its monetary instruments continued to circulate.1 One can explain why by noting that: 1. The state was central in establishing the trust about the currency prior to 1991. This is what anchored the expectations about the face value of the Somalian shilling. 2. Given the confusion at the time the state collapsed, citizens just relied on habits, anchoring induced by the inertia provided by historical acceptance created by the state. 3. If citizens believe that the collapse of the state is only temporary and the shilling will be reissued later then there is an incentive to continue using it. This is very different from the case of the transfer to the Eurozone when states spent years educating and informing their population about the demonetization of their currency, and gave a clear date about when demonetization would occur. In Somalia, everybody was left in the dark. 4. The belief that shilling would be again the national currency was reinforced by two aspects: a) local governments did accept them for tax payments at least temporarily b) armed militia, that substituted for government, started to forge some shilling notes to fill up the void left by the collapse of the official government, and, in addition, may have allowed dues to be paid in that currency. All this is similar to shares that continue to trade even as a company goes through liquidation and reorganization. Bearers are hopeful that the company will come back and be great again.
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Summary of Major Points 1‐ The use of tax liability and tax enforcement as means to create a demand for government monetary instruments has been a common practice of government for hundreds of years. 2‐ A monetary system based on gold or other precious metal is very inelastic and subject to monetary instability if gold is given too much importance. 3‐ While an issuer of a financial instrument may default, it does not mean that its financial instrument will disappear if there is an expectation that the issuer will be able to restore its creditworthiness in the future. 4‐ Tobacco leafs were not monetary instruments in the US because nobody issued them, i.e. nobody made promises embedded in the tobacco leafs; they had no issuer. Keywords Debasement, legal tender laws, fraud, reflux mechanism Review Questions Q1: How did the inclusion of tobacco leafs in legal tender laws help the payment system? Q2: Why is crying down the coinage problematic? How did the existence of coins made of precious metal limit the ability to cry down the currency? Q3: Was debasement mostly about improving the finances of the king by being able to issue more coins with the same amount of precious metal? Q4: How did the issuance of precious metal coins help to deal with the uncertainty of the time but also created some instability. Suggested readings Bell, S.A.(2001) “The role of the state and the hierarchy of money” Cambridge Journal of Economics 25 (2): 149‐163. Boyer‐Xambeu, M.T., Deleplace, G. and Gillard, L. (1994) Private Money and Public Currencies. New York: M.E. Sharpe. Forstater, M. (2005) “Taxation and primitive accumulation: The Case of Colonial Africa.” In The Capitalist State and Its Economy: Democracy in Socialism, Research in Political Economy, Volume 22, 51‐65. Henry, J. F. 2004. “The social origins of money: The case of egypt.” in Wray, L. R. (ed.) Credit and State Theories of Money. Northampton: Edward Elgar. Hudson, M. and Wunsch, C. (2004) Creating Economic Order. Bethesda: CDL Press. Ingham, G. (2000) “Babylonian madness: On the historical and sociological origins of money,” in Smithin, J. (ed.) What Is Money? New York: Routledge. Littleton, A.C. (1956) Studies in the History of Accounting. Homewood: Richard D. Irwin 1 For a summary of the topic see David Andolfatto’s “Fiat money in theory and in Somalia” at http://andolfatto.blogspot.ca/2011/08/fiat‐money‐in‐theory‐and‐in‐somalia.html
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GLOSSARY Bearer: A person who holds a financial claim on the issuer. In most cases, the bearer can sue the issuer if the promise embedded in the claim in not fulfilled.
Collateral: Assets held by debtors that can be taken by creditors in case of default. Assets are usually sold to try to recover some of the funds owed.
Board of Governors: The head institution of the Federal Reserve System. It is composed of at most seven governors.
Commercial paper (CP): A security issued by private companies with a short term to maturity (one year or less).
Asset: Anything that is owned by an economic unit.
Bond: A security with a relatively long term to maturity. It pays a coupon periodically.
Asset‐based credit (also collateral‐ based credit): A promissory note underwritten with the expectation that income of the issuer will never be enough to service the debt.
Borrowed reserves: Reserves obtained by going through the Discount Window (reserves “borrowed” from the Fed).
Conforming mortgage: A mortgage that has financial characteristics that conform to criteria set by Fannie Mae, Freddie Mac, and Ginnie Mae.
A Advance: Quantity of funds provided by a bank to a customer in exchange of the customer’s promissory note. Applied vault cash: The dollar amount of Federal Reserve notes that banks choose to use to comply with reserve requirements.
Asymmetry of information: A situation in which an economic unit knows less than another economic unit at the time of a contractual negotiation. Automatic stabilizers: Changes in the level and growth rate of government spending and of taxing that occur because of change in economic activity, and not because government decided to change its spending or taxing habits. For example, unemployment insurance goes up automatically in a recession and goes down automatically during an expansion. Similarly, tax revenues fall (rise) automatically during a recession (an expansion) because less (more) income is earned by the private sector.
Borrowing: Temporarily using the assets of someone else. C CAMELS rating: A rating that measures the soundness of a bank. Capital: See net worth. Capital requirement: Quantity of capital that a financial institution must keep relative to the size and quality of its assets in order to protect its balance sheet against unexpected losses. Cash flow: Inflow or outflow of monetary instruments. Cash management: A deliberate management of the level and structure of monetary balances to reach a specific goal.
Balance sheet: An accounting document that shows what is owned and owed by an economic unit.
Certificate of deposit (CD): A promissory note issued by banks with a term to maturity varying from short to medium term. It is similar to a savings account, except that it is illiquid until maturity.
Basis point: A one‐hundredth of a percentage point, 0.01%.
Clipping coins: The act of cutting bits out of coins.
B
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Consolidation: The act of merging two or more balance sheets into one. Consumption (also final consumption): The use of goods and service for personal enjoyment. Contingent liability: A claim that is due when a specific event occurs. Conventional mortgage: Any mortgage issued by non‐ government financial institutions. Unconventional mortgages are those insured by government agencies (such as the Federal Housing Administration) and that have unconventional characteristics that accommodate the needs of economic units with a higher chance of defaulting (e.g., low interest rate even though creditworthiness is not very good). Convertible: The ability to hand back to the issuer its promissory note and to get something else in exchange. Coupon: The income received from a bond and other similar securities. It is an interest income, that is, its payment is due periodically and represents a proportion of the face value of a bond. Bonds used to be in
GLOSSARY paper form with small coupons attached to them that needed to be detached and handed backed to the bond issuer to receive the interest payment due. Credit‐card receivable: Amount of debt outstanding on a credit card. Credit risk: The probability that an economic will default on its promise. Credit standards: Criteria used by bankers to determine how creditworthy an economic unit is. Creditworthiness: Expected ability of an economic unit to service its debts on time in full. Currency in circulation: Officially, it is mostly the value of Federal Reserve notes in the hands of economic units others that the Federal Reserve banks, the U.S. Treasury, and banks. Theoretically, coins held by others than the previously cited economic units are also included in the definition.
Debt management: The deliberate change in the level and structure of outstanding debt to reach a specific goal. Debtization: The growing use of debt in daily economic activities. It is the counterpart of the financialization of the economy. Default: The action of declaring the inability or unwillingness to service debts, either at all or according to the previously‐agreed time table. Deficit: A budgetary situation for which spending exceeds income. Demand liability: A claim that is due at the will of the bearer. Discount trading: The market price of a security is below fair price. Discount Window: A means for the Federal Reserve System to provide collateralized advances to banks.
D
Discount Window operation: An advance of reserves to bank. Banks sign a promissory note and in exchange get reserves. All promissory notes must be collateralized so if banks default, the Fed takes the assets banks put as collateral.
Dated liability: A claim that requires payments at specific periods of time.
Dividend: The income received from a stock. Its payment is a proportion of the profit of a company.
Debasement: A legal or illegal decrease in the quantity of precious metal included in a coin.
E
Crying up/down the coinage: The act of increasing/decreasing the face value of coins by decree.
Debt deflation: An economic situation in which overindebtedness and prices interact in such a way that it results in deflation, defaults, and a general decline in economic activity. Debt liquidation: The act of reducing the quantity of outstanding debts either by repaying them or by writing them off.
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Economic unit: An economic entity that, depending on the level of analysis, can be a household, a firm, a government, a country, or other entity that makes decisions. Elastic currency: A currency that can be injected and ejected from the economic system as needed. Excess reserves: Quantity of reserves that is kept by banks beyond what the Fed requires them to hold.
F Face value: The price at which the issuer promises to take back its financial instrument. The outstanding principal due by the issuer. Fair price (also fair value): The price at which a security ought to trade. It may or may not be the price at which a security actually trade (the market price). Fannie Mae: A government‐ sponsored enterprise that buys conventional and government‐ insured mortgages from banks as long as they conform to a set of standards it sets. It does so in order to encourage them to acquire more mortgages at more affordable rates. It buys mortgages by issuing mortgage‐backed securities. Federal funds: The dollar value of the accounts at the Federal Reserve banks. Federal funds market: A market in which participants borrow and lend federal funds. Federal funds rate: The interest rate that is paid (received) by an entity that borrows (lends) federal funds in the federal funds market. Federal funds rate target: The federal funds rate that the central bank wants to see in the market. Federal Open Market Committee (FOMC): A committee of the Federal Reserve System composed on the board of governors and the presidents of the Federal Reserve banks. It formulates monetary policy by meeting every six weeks or so and voting on the course of action in terms of the federal funds rate target. Presidents (except the president of the New York Federal Reserve bank) rotate their voting
GLOSSARY power and only five out of the 12 can vote at any time. Federal Reserve Bank: One of the twelve banks part of the Federal Reserve System. Federal Reserve System (Fed): A government agency created to provide the currency of the nation, to facilitate interbank payments, to regulate member banks, to promote an elastic currency, and to manage economic activity. While it is structured with some for‐profit features, its activities and goals are oriented toward fulfilling the public purpose expressed in its functions. Also the Fed can operate without making any profit. Financial asset: A claim held against someone that involves contractual monetary payments. Financialization: The growing importance that the financial sector plays in daily economic activity. Financing phase: A phase of economic activity in which bank credit is needed to start production Fine‐tuning the economy: Policy strategy used by the central bank and the U.S. Treasury to ensure that an economy stays close to full employment with stable prices. It involves nudging incentives in the private sector and the use of automatic stabilizers to move the economy in a specific direction and to ensure it is neither too hot (inflation pressures) nor too cold (high unemployment). Fiscal deficit: See deficit. It results in the issuance of new Treasuries. Fiscal surplus: See surplus. It results in the repayment of existing Treasuries. Forward guidance: A monetary policy that involves influencing expectations of the future path of
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federal funds rate target through a specific wording of current monetary‐policy decisions. Fraud: The act of gaining the trust of a person and then abusing that trust. It is the act of deceiving for personal benefit. Freddie Mac: A government‐ sponsored enterprise that competes with Fannie Mae. Free reserves: Non‐borrowed reserves held beyond what is required. Funding phase: A phase of the economic process in which finance plays a role for the acquisition of what has been produced. Funds: An outstanding quantity of monetary instruments. G Ginnie Mae: A government‐owned company that guarantees the timely payment of principal and interest on mortgage‐backed securities collateralized by federally insured or guaranteed mortgages. These mortgages are issued mostly by low‐ to‐moderate income households and by veterans. By doing this, Ginnie Mae encourages banks to fund homeownership for veterans and the poorer section of American households. Government‐sponsored enterprise (GSE): A for‐profit firm created by Congress to fulfill a public purpose. Such enterprises have been created to promote homeownership, education, the electrification of the country, among other goals that have been deemed relevant to fulfill the public purpose. They do so by encouraging banks to lower the interest rate and underwriting requirements on promissory notes issued to fulfill the activities that comply with the public purpose.
That is done by buying those promissory notes from banks or by insuring banks against defaults on the promissory notes. H Hedge finance: A financial situation in which an economic unit is able now and in the future to service its debts with its income. Household: A person of group of persons living in the same dwelling. I Illiquidity: Temporary inability to pay creditors. Income‐based credit: A promissory note underwritten with the expectation that the income of the issuer will be sufficient to service the debt, if not now at least sometime in the future. Income distribution: The distribution of national income among, wage earners and profit earners. Inconvertible: A promissory note that is not convertible. Inflation risk: The probability of a substantial fall in the purchasing power of future cash flows and outstanding financial assets Interest on reserves: Interest rate paid on reserve balances. Intrinsic value: The market value of material (paper for banknotes, gold for gold coins, etc.) used to make a monetary instrument. Insolvency: Permanent inability to pay creditors. Investment: The purchase of goods and services for the purpose of producing goods and services. Irrational behavior: Behavior that deviates from the standard neoclassical hypothesis about
GLOSSARY behaviors (maximization preference ranking).
and
Issuer: An economic unit that created a promissory note and gave it to others. That economic unit must now fulfill the promise embedded in the note. J Job guarantee program: An economic policy that provides the opportunities to work for all persons willing and able to do so. This helps make a person more employable, use her skills for more social purpose while unemployed, and provide some training experience. L Lease: The loan of an asset with the option to buy it after a period of time. Legal tender laws: Laws that dictate what is/are the ultimate means of payment. A creditor cannot pursue further legal actions against its debtors if it refuses payment in legal tender. Lending: Temporarily parting with an asset. Level‐1 valuation: Financial assets are valued based on their market price. Level‐2 valuation: Financial assets are valued based on a proxy market. Maybe because there is no readily available organized market for the assets held. Level‐3 valuation: Financial assets are valued according to a model created by the economic unit that holds them. Leverage: A measure of the indebtedness of an economic unit. Liability: Anything that is owed by an economic unit.
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Liquid asset: An asset that can be traded quickly without incurring large losses of capital. An asset with a relatively stable fair price. A perfectly liquid asset has a stable nominal value. Liquidity risk: The probability that the price of an asset will fall substantially when its owner tries to sell it quickly. M Monetary aggregates: Measures of the money supply. M1 is the narrowest indicator. Monetary base: The sum of reserves and cash in circulation. Monetary instrument: A security with specific financial characteristics such that its fair price is parity. Money supply: The sum of currency in circulation and other monetary instruments held by the public. Moral hazard: An increase in the risk taking of an economic unit once it knows it is protected against specific adverse events. The increase in risk taking increases the probability that such specific adverse events will occur. Mortgage: A promissory note backed by a residential or a commercial property. Mortgage‐backed security (MBS): A bond that is backed by mortgages. The cash flow for the interest and principal payments for the bond comes from the servicing of mortgages. N Natural growth rate: The growth rate of productive capacities induced by a given set of allocation, preference and technique of production.
Net acquisition: Acquisition minus reduction in the quantity of assets or liabilities. Net borrowing: The opposite of net lending. Net capital gain: Capital gains minus capital losses. Net cash flow: Cash inflow minus cash outflow. Net clearing of debt: The act of acknowledging what two (or more) economic units owe to each other and to calculate the net amount due by one of the economic unit. X owes $10 to Y, Y owes $3 to X, then X owes $7 to Y. Net clearing allows to simplify the settling of debts by reducing the number of transfers between debtors and creditors. Net financial accumulation: See net lending. Net lending: A positive difference between the change in the quantity financial assets and the change in the quantity of financial liabilities. Over a period of time, an economic unit acquires more claims on others than others acquire claims on that economic unit. Net income: expenses.
Income
minus
Net saving: See net lending. Net worth (also net wealth): The difference between the value of assets and the value of liabilities. Nominalism: A legal view that states that changes in the purchasing power ought not to impact the amount of principal owed. Non‐borrowed reserves: Reserves obtained through open‐market operations with the Fed or borrowed from other banks. Non‐financial asset: Something owned by an economic unit that does not involved contractual
GLOSSARY monetary payments to its owner. That includes machines, software, and goodwill, among others. Normalization: A monetary‐policy strategy that aims at bringing the FFR back to more normal levels in an environment of an abnormally large quantity of excess reserves. The strategy also aims at removing most of excess reserves in the long run. O Open‐market operations: The sale or purchases of securities by the central bank, on a permanent or temporary basis, respectively to remove or add reserves. The frequency of this market intervention varies depending on the central bank, with the Federal Reserve intervening daily while the European Central Bank intervening weekly. Originate and hold model: Banks acquire promissory notes and hold them to maturity. Originate and distribute model: Banks acquire promissory notes and sell them almost immediately. Output gap: The difference between the growth rate of aggregate demand and the growth rate of aggregate supply. Outright purchase: The action of permanently buying a financial asset, i.e. buying with the intention of holding it. This is done when the Fed expects that some of the reserves available will not be needed for an extended period of time. Overdraft: A negative balance in a bank account. Overnight interbank market: The market in which banks lend and borrow reserves to each other for the night.
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P Par value: See face value. Parity: See par value. Ponzi finance: A financial situation in which an economic unit is not able now and in the future to service its debts with its income. It must refinance or must sell assets to service the interest and principal due, at least for a period of time. Portfolio: The set of assets held on a balance sheet. Position: The dollar value of a specific asset held on the balance sheet. This position can be long (one owns the specific assets) or short (one borrowed the specific asset). Premium trading: The market price of a security is above its face value. Principal: Outstanding amount of debt left to be repaid. Promissory note: A contractual agreement to make one or several monetary payment(s) in the future. Public debt: The face value of outstanding Treasury securities. It goes up with a fiscal deficit and it goes down when Treasuries are repaid. R Rate of return: A measure of monetary gains in percentage rather than dollar amount. The amount earned relative to the cost of getting access to that earning. Real Bill Doctrine: A view according to which the financial assets of the Fed should only be composed of self‐liquidating assets, i.e. promissory notes that are issued and destroyed in relation to economic activity. Firms issue commercial papers to finance production and take back the papers when they make a profit.
Recourse: The ability of creditors to ask for more funds from debtors if the sale of collateral has not been sufficient to recover the funds expected. Redemption: When the issuer takes back its promissory note from the bearer(s). Redeemable: A security can be returned to its issuer at some point in time through some reflux mechanisms. Reflux mechanisms: The means available to the bearers to give back a financial instrument to its issuers. Refinance: The act of repaying an old debt by issuing a new debt. Repurchase agreement: When a party agrees to sell/to buy something today and to buy/to sell it back in the future. Required reserves: Quantity of reserves that a bank must have. Reserves: See total reserves. Reserve balances: Accounts of banks at the Federal Reserve. Reserve requirements ratio: Proportion of total reserves that a bank must have in relation to its transaction accounts. Return on asset: The value of monetary gains relative to the value of assets. Return on equity: The value of monetary gains relative to the value of net worth. Risk management: Means used to protect a balance sheet against expected and unexpected adverse shocks. S Saving: Depending on the context, it can be the unconsumed monetary income or the change in net worth.
GLOSSARY Scarcity: An economic situation in which there are limited resources to fulfill unlimited preferences. Secured: Backed by a piece of collateral. Security: A promissory note that is tradable. Depending on its financial characteristics, a security can take a different name such as stock, bond, or commercial paper. Settlement of debts: The act of paying debts. Speculative finance: A financial situation in which an economic unit is not able now and in the future to service its debts with its income. It must refinance the principal due at least for a period of time or must sell assets to do so. Speculation: The act of buying an asset with the view of reselling it to make a capital gain. Stock (also equity or share): Security that represents a share of the company. The bearer is the owner of the company. Common stocks allow the bearers to vote on the major strategic decisions of the company. Preferred stocks do not give a voting right but guarantee the payment of a dividend. Surplus: The opposite of deficit. Surplus vault cash: Federal Reserve notes that banks have in excess of what they use to meet reserve requirements. Sweating coins: The act of shaking coins in a bag to remove tiny bits of precious metal. A less easily detectable means of debasement than clipping. T Tax receivable (or payable): Taxes that recorded as due but not yet paid.
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T‐bill: A security issued by the U.S. Treasury with a term to maturity of at most one‐year and that does not provide a coupon payment. T‐bond: A security issued by the U.S. Treasury with a term to maturity of more than ten years. More loosely, the term is used to mean any treasuries with a term to maturity greater than one year. Term to maturity: Time left before the principal on a security is due. Total reserves: The sum of reserve balances and applied vault cash. Treasury’s general account (TGA): Account of the Treasury at the Federal Reserve that Treasury uses to spend. Treasury securities: See Treasuries. Treasury’s tax and loan account: Account of the Treasury at private banks that Treasury uses to collect funds received from taxes and the issuance of Treasuries. Treasuries: Securities issued by the U.S. Department of the Treasury. Triffin dilemma: If a currency is both convertible and in high demand by the rest of the world, the issuer of that currency must supply enough but as it supplies more the promise of convertibility becomes harder to fulfill. U Underwriting: The act of determining the creditworthiness of an economic unit. Unit labor cost: The ratio of wage over the productivity of labor. Unsecured: Financial claims that is not backed by any collateral (e.g., credit receivables). They may still be some recourses for bearers. V
Vault cash: The Federal Reserve notes in the vault of banks. Valorism: A legal view that argues that the principal owed should be adjusted to maintain its purchasing power constant. Volcker experiment: A change in monetary policy operations toward a looser targeting of the federal funds rate and a focus on targeting monetary aggregates. Y Yield: See rate of return. Yield to maturity: The yield obtained if a security is held until it matures. Z Zero‐coupon security: A security that does not pay any coupon.
ABOUT THE AUTHOR Eric Tymoigne is an Associate Professor of Economics at Lewis and Clark College, Portland, Oregon; and Research Associate at the Levy Economics Institute of Bard College. His areas of teaching and research include macroeconomics, money and banking, and monetary economics. His current research agenda includes the nature, history, and theory of money; the detection of aggregate financial fragility and its implications for central banking; the coordination of fiscal and monetary policies; and the theoretical analysis of monetary production economies. He has published in numerous academic journals and edited volumes. His most recent book, coauthored with L. Randall Wray, is The Rise and Fall of Money Manager Capitalism: Minsky’s Half Century from World War Two to the Great Recession. Tymoigne holds an MA in economic theory and policy from the Université Paris–Dauphine and a Ph.D. in economics from the University of Missouri–Kansas City.
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