Cochrane and Wolf on Full Reserve Banking

House of Debt's recent piece on full reserve banking opens with the following line.

"So both John Cochrane and Martin Wolf are advocating 100% reserve banking."

I found this interesting, not so much for the idea of the same proposal coming from rather different sources, as for the differences in their approach.

Wolf's article describes the system proposed by Positive Money (PM).  This involves strictly limiting bank deposits to two types, effectively transactions accounts and savings accounts.  Banks would have to hold 100% reserves against the balance of transaction accounts.  Savings accounts, being all bank accounts that are not transaction accounts, would then have to have a minimum notice period of, say, a month.

By requiring banks to hold reserves in full cover of their demand liabilities, it is intended that this structure would reduce the risk of bank runs.  A bank could still find itself unable to repay savings accounts when they fell due, but because of the notice period on such accounts, it is hoped that this risk would be easier for the central bank to manage.  It should be noted that the proposal would not prevent additional liquidity requirements applying to savings accounts, such as the BIS Liquidity Coverage Ratio.

Because of the 100% reserve requirement against transaction accounts, additional lending by banks would deplete their liquid asset holdings.  As they would be constrained by the need to maintain minimum liquidity levels, additional lending would have to wait until the liquid assets get redeposited again.  The intention is that this would slow up the pace of credit creation.

So it's not unreasonable to refer to this proposal as 100% reserve banking.  However, it is important to recognise that the full reserve requirement is only proposed for transaction accounts.  This differs from, for example, the full reserve proposal of Benes and Kumhof.

Reserves appear on the asset side of the bank's balance sheet.  John Cochrane focuses on the liability side.  His concern is with what he calls run-prone liabilities.  This is principally short term fixed value debt, but he also worries that longer term liabilities can still be problematic.  He would like to see an incentive system that pushes financial institutions (he does not treat banks as special here) towards drawing a greater portion of their funding in the form of capital.  As he sees it, the problem is the extent of funding taken in the form of fixed value liabilities that are shorter in term than the underlying assets and the solution is to reduce this.  This proposal has some similarities to the Limited Purpose Banking concept of Chamley, Kotlikoff and Polemarchakis.

So, in a sense there is quite a big difference between Cochrane's proposal and that of PM.  Cochrane says little about reserves and is instead concerned with bank capitalisation.  It's not clear that this is really 100% reserve banking at all.  In PM's proposal, on the other hand, reserves play a central role; they are less concerned about the capital structure of the intermediation aspect of banking.

One of the interesting differences between the proposals, I think, is in the way they conceive of money.  Cochrane sees much less of a need for fixed value liabilities in the future.  He describes how technology substantially changes the requirement for conventional transactional account balances.

"With today's technology, you could buy a cup of coffee by swiping a card or tapping a cell phone, selling two dollars and fifty cents of an S&P 500 fund, and crediting the coffee seller's two dollars and fifty cents mortgage-backed security fund."

This is a world with payments and balances, but where the division between money and non-money is less clear.  This fits quite well with my own way of looking at things.  PM's concept of money is rather more conventional and their analysis relies on a clearer concept of what constitutes money.

Yet, despite the differences, there is clearly a common theme in reducing the mismatch in bank balance sheets.  The concept appears to be attracting support from a variety of commentators.  If anything does come of it, it will likely be a watered down version, but it will be interesting to see where it goes.

The Cross-Currency Liquidity Exposures of Banks

I recently attended a very interesting presentation by William Allen, formerly of the Bank of England, on international liquidity.

Much of this concerned the use of central bank swap lines in response to the financial crisis.  One of the immediate consequences of the collapse of Lehmans, was a substantial repatriation of short term cross-currency investment.  For example, European banks had large short term dollar borrowings funding longer term dollar assets.  The pressure on US money market funds led to a lot of this funding being pulled, leaving the banks trying to fund the gap.  And although the Fed was providing liquidity in the US, the state of the interbank market meant that not much of that was finding its way to the foreign banks.

The interesting thing about this is that the liquidity crisis affecting banks in many countries was substantially taking place in a currency that was not their domestic one.  And whilst a central bank's ability to provide liquidity support in its own currency is theoretically unlimited, that is not the case in a foreign currency.  Central banks with large foreign reserve holdings may be able to cope.  Otherwise, the central bank swap lines provide a way for them to get hold of the currency.  Thus, to deal with the pressure on European banks post-Lehmans, the ECB exchanged euro for dollars with Fed, using the dollars to provide liquidity to the banks.

Nevertheless, it highlights an important issue when it comes to thinking about the role of banks in the economy.  Many economists would consider that the health of the banking sector is an important factor in the state of the economy due to the consequences for the flow of credit to the non-financial sector.  But even those models that attempt to incorporate some representation of banking tend to assume an essentially domestic operation.  In reality, banking is very international.  Over 50% of the assets of UK resident monetary financial institutions are denominated in currencies other than sterling (over 30% for those MFIs that are also UK owned)*.  The implications for credit exposures are reasonably well understood as a result of global fallout from problems with US sub-prime.  The implications for liquidity are perhaps less well known, but it raises important issues about the abilities of central banks to deal with bank runs.  The monetary authority may exercise a high degree of control over its national currency, but not necessarily over its national jurisdiction.

Overall, there was good central bank co-operation in the crisis, which went a long way to preventing things getting even worse.  However, cross-currency exposures of banks will remain an important risk issue going forward.  

More from William Allen on international liquidity . 

* Figures for November 2013.  Source: Bank of England.

Capital Arbitrage and BIS Risk Weightings

A recent article on VOX looked at some of the issues with risk weightings for bank regulatory capital under the revised BIS rules.

These rules require that assets with different perceived credit risk are valued differently for the purposes of determining a bank's minimum capital requirement.  Originally, the rules were very basic with assets falling into a small number of categories, with a different weighting assigned to each.  The system has now become much more complex, allowing detailed criteria against which each asset can be assessed.

One issue which has attracted much comment is the fact that banks are allowed to design their own criteria for determining risk weightings, known as the internal ratings based (IRB) approach.  Although the criteria have to be approved by the regulators, it is argued that they are not well placed to second guess the banks.  This is therefore likely to result in weaker criteria than would be designed by an outside party.

Another issue, more relevant to the VOX article, is capital arbitrage.  The problem here is that the actions of banks are not independent of the risk weighting criteria.  To some extent that's fine.  If banks choose to invest in safer assets on the basis that it has a lower capital requirement, then things are operating as intended.  The difficulty is that however detailed the criteria, they are merely a rough approximation of true risk.  There will always be an imperfect match with elements that don't fit well and it's those elements towards which business tends to gyrate.

A good way to illustrate this process is by looking at the world of asset-backed securities and ratings criteria.  When the ratings agents rate corporate borrowers, they assess the different companies as they are and decide the ratings.  Within any particular rating, there will therefore naturally be better and worse borrowers - some who are nearly at the next rating up and some who are barely above the rating below.

In rating asset-backed transactions, the rating agents use a set of criteria to determine what rating to give.  But now the game is different, because the structurer has the ability to design his transaction.  Improving credit risk costs money, so of the structurer's objective is to get away with as little credit enhancement as possible, whilst still achieving the desired rating.  In other words, he is always aiming for the very bottom of the range of credit risk for that rating.  And because the criteria are only really rules of thumb, that can mean a risk that is below what would normally be expected for that rating.

So, a similar issue can arise in banks that are subject to capital requirements based on a set of rules.  One aspect of this that was highly relevant to the financial crisis was the banking book / trading book distinction.  But the problem arises, albeit it in smaller way, even within the normal loan portfolio.  And making the rules more and more granular is unlikely to solve the problem in a practical way.  This is one of the main reasons why alternative capital requirements, such as the Leverage Ratio, are so important.

Economic Orthodoxy and the Relevance of Shadow Banking

Various bloggers have commented recently on economic orthodoxy and whether changes are needed to the teaching of economics.  Paul Krugman (largely) defends the mainstream.  I was particularly interested in one comment he made (in this post).

"It’s true that few economists tracked the rise of shadow banking that bypassed the traditional safeguards — but that was a problem of vigilance, not bad theory."

I'd agree that vigilance was lacking when it comes to regulatory matters, but I suspect that theoretical orthodoxy is also partly to blame here.

There were lots of things happening that contributed to the crisis, which is why you hear so many different explanations.  However, the following process played an important part.

1. In the years leading up to the crisis, developments in the financial sector increased the supply of credit to households.

2. The greater flow of credit increased household spending at the same time as it led to rising debt to income ratios.

3. The higher the debt to income ratio goes, the more likely it is that the flow of credit will slow or go into reverse.

4. When the supply of credit eventually slows, household spending will fall.

To understand why the financial sector was lending so much requires some knowledge of the regulatory environment and things like shadow banking.  However, you didn't need any knowledge of these things to be able to see the growth in household debt.  Even if you had never heard of shadow banking, the growth in debt should have been clear from the data.

I would not expect any economist to be able to predict the details of a crash.  The things that determine timing and extent are too complex and vague to be the subject of forecast.  It's not usually even possible to say whether a crash will in fact occur, or whether there will simply be a slow unremarkable correction.

My point here is that the process I have described is very easily explained and understood within a simple Post Keynesian analytical framework.  There might be disagreement on the precise mechanics, but the basic picture is clear.  It is less easy to see within a framework of maximising representative agents.  Sure - it is possible to extend these ideas to incorporate all sorts of things, as supporters of the mainstream would be quick to point out.  But making the models more complex does not help highlight the important issues.  After all, the important issue here is not the rationality or otherwise of financial institutions - it is the hard fact of credit growth.

The relationship between credit supply and spending should be basic economics.  If the orthodox approach means we can't spot it when it's going on right before our eyes, then that approach is lacking.  This is the problem with not taking the pluralist view in economics.  Economies are by their nature too complex to be captured by any one method of analysis.  All any approach does is provide us pointers and clues to help see what is going on.  Ignoring those that seem to contradict our preferred worldview can blind us to what is really going on.