Tuesday, March 26, 2013

Fiat Banking Fundamentals for Jane/Joe Sixpack

Commentary by Roger Erickson
(hat tip Scott Fullwiler, @stf18 )
Not perfect, but this really helps Jane/Joe Sixpack understand banking. Nicely worded.

Here's an avowed "gold bug" who actually understands banking operations post 1933. There's nothing incompatible with understanding fiat currency and investing in gold or other static assets. The two asset classes are NOT incompatible. Rather, they're inseparable. One's a static asset, the other's the dynamic unit of account that allows unlimited, on-demand liquidity between all asset classes. Can't have an agile, functioning system without both.

The issue is not whether we should have both. That faux argument just distracts us from the real issue of adequately regulating the crooks that creep into every avenue of human activity, especially banking.

How Banking Actually Works In Fiat World


14 comments:

Tom Hickey said...

Wow. That is a very clear and correct post. Rare combo.

Interesting that the comments reveal that most of the people reading it cannot understand it, as clear and concise as it is, and some commenters raise objections based on false ideas, too.

While it is likely the case that some resistance to understanding is ideological given the venue, it is amazing to me how difficult it is for very smart people to get this among the ranks of Post Keynesian economists and political progressives when it is so obvious. People can understand issuance through notes as obvious but cannot see that issuance using bonds and reserves amounts to the same thing.

I am beginning to think that as long as bond issuance in offset of deficits continues, so will the illusion of government borrowing from the private sector, with all the attendant confusion of loanable funds, taxes pay for spending, and like myths.

Roger Erickson said...

Yes. Seems that most of our citizens have received zero practice at juggling both static and dynamic value. It's a wonder we can develop sports teams, militaries, choreography and music ensembles.

We can do all those things?

Then we have a problem learning by association. Not enough practice at simply thinking? We don't seem to be comfortable with it.

JK said...

imo there is an aspect of the banking story that usually goes unexplained: exactly how are banks constrained?

It's a vital part of the story. Without discussing it, lay-people are left with the vague notion that any bank can just create a zillion dollars out of thin air and continue on it's merry way.

Tom Hickey said...

imo there is an aspect of the banking story that usually goes unexplained: exactly how are banks constrained?

Banks are only constrained in theory. They rely on governments backing up the financial system. Letting Lehman go down was a lesson for the US. It's the last time that a big financial institution, what Bill Black calls an SDI (systemically dangerous institution) will be allowed to fail. The EZ is about to learn the same thing in the case of Cyprus. Governments cannot afford loss of trust in their financial systems and in extremis will "do what it takes," or else good-bye government. The regime will be change on way or another.

JK said...

Tom,

What I meant was the idea that banks are 'capital constrained' … the question I think that most people have, after reading an article like this, is:

"So banks can literally just create an unlimited amount of money out of thin air?… there is no limit?…I don't believe that true…"

JK said...

I understand "in theory" and "over time" there really is no limit. But I think what needs to be better explained is what contrains an individual bank at any given point in time (not banking in the aggregate).

Tom Hickey said...

Banks are really not even capital constrained as a hard limit since they can and do access more capital in order to expand if the opportunity to do so is more profitable than the cost of capital. Capitalism is about capital formation and that includes finance capital along with productive capital since they go hand it hand, most lending being for investment.

Tom Hickey said...

But I think what needs to be better explained is what contrains an individual bank at any given point in time (not banking in the aggregate).

But what is a limit if it is only conceptual and not actual. It gives the impression that bank lending is constrained by some hard limit when it is not. All the limits are soft (variable) limits.

JK said...

Ok. This is new to me. I remember debates about this on MMT websites a year or so ago with a lot of MMTers saying "banks aren't reserve constrained, they are capital constrained" …. has something changed?

For example, let's say a billionaire walks into a very small town individual bank with no branches that only has $10 million outstanding on its balance sheet, and it's not a subsidiary of a larger bank, let's say this man is seeking a loan for $500 million. The loan officer at this bank, and for that matter any bank, can look at his financial assets, ok it, and create the $500 million deposit/loan on the spot? (only needing to seek out Reserves if the billionaire withdraws his deposit)

Tom Hickey said...

If the capital limit is reached and the bank doesn't choose to increase its capital, then the loan cannot be granted under the rules. But bank capital is flexible. Banks are not going to be turning down loans on which they can profit if it is cost-effective to add capital.

The capital requirement is not designed to limit the amount the bank can lend.

The increased capital requirement under Basil III is designed so that the bank has an adequate equity cushion in case there are performance issues with more loans than projected, e.g., as the result of a "shock" like the financial crisis.

geerussell said...

For example, let's say a billionaire walks into a very small town individual bank with no branches that only has $10 million outstanding on its balance sheet, and it's not a subsidiary of a larger bank, let's say this man is seeking a loan for $500 million. The loan officer at this bank, and for that matter any bank, can look at his financial assets, ok it, and create the $500 million deposit/loan on the spot?

As I understand it, while a bank can always add capital, that capital has to come from somewhere. Either the bank provides from its own pockets in the form of retained earnings, the bank owner kicks in or they go and try to sell shares to the stock market.

As a practical matter, it'd be pretty hard for a tiny bank to raise that kind of cash for the purpose of betting its entire existence on the performance of a single loan.

The tiny town banker would either have to turn away the billionaire or get on the phone to assemble a group of banks with each taking a piece of the action according to its size.

In this way, while they're a soft ceiling, capital requirements do effectively limit an individual bank from writing an arbitrarily large loan.

Roger Erickson said...

As I understand the actual operations (correct me if wrong) capital controls have nothing directly to do with ability to book fiat currency loans.

All capital controls impose is liability, after the fact, for covering SOME portion of the losses if the credit transaction "reviewed and guaranteed" by the rating agency (i.e., the licensed bank).

Note that the very concept of bundling and selling off loans makes a mockery of the very concept of capital controls in banking. As Bill Black harps on, our current banking industry is a joke unless loan underwriting remains tied to ADEQUATE regulation and transparency.

Keeping loan liabilities tied to the original lenders, and imposing the requirement to document availability of accessible capital to cover "reasonable" loss rates* is one, fairly simple way to do that.

* Note that estimates of what is/isn't reasonable always sets the bar for fraud enforcement.

Some bankers have argued that capital requirements as set the last 80 years restricted the agility of banks. Warren Mosler, among others, has bluntly denied that claim, and suggested that the only agility constrained pre 1980 was bankers agility in growing their proportion of net, national financial assets and income.

Given multiple lobbies with conflicting purposes and claims, we need to have a national debate.

1) Do we need more agility in banking?

2) If not, tell the bankers to spend more time on the golf course, and less time unproductively skewing national policy. Slap 'em down.

3) If so, what are sustainable methods for both increasing credit agility AND serving Public Purpose?

Roger Erickson said...

oops, meant to say

All capital controls impose is liability, after the fact, for covering SOME portion of the losses if the credit transaction "reviewed and guaranteed" by the rating agency (i.e., the licensed bank) [fails, i.e., produces a negative margin].

Unknown said...

http://www.dailypaul.com/279972/how-banking-actually-works-in-fiat-world-part-2

part deux