Dodd-Frank is useless, but try this…..
Ralph Musgrave
On the subject of Dodd-Frank, Richard Fisher, president of the Dallas Fed said, “We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better.” He’s right. So how do we dispose of bank subsidies?
Well it’s easy. In fact the way to do it is set out in three hundred words below (in contrast to the thousands of pages of Dodd-Frank and Basel III which fail to solve the problem). And, the system set out below has an additional bonus: it makes SUDDEN bank failures impossible.
Obviously any poorly run firm should be allowed to ultimately fail, but it’s the SUDDEN failures or RUNS ON banks that are the big problem. Anyway, the solution is as follows.
Bank creditors (depositors in particular) have to choose between two types of account. First there are checking or transaction accounts. Money in those accounts is NOT LOANED ON or invested. It’s lodged in a 100% safe fashion (e.g. at the central bank). And that means no interest for those depositors.
Second, depositors can put some of their money into accounts where the relevant money IS LOANED ON or invested. Those “investment accounts” pay interest because the relevant money is being used. Moreover, depositors choose what’s done with their money. For example they could go for safety: e.g. have their money put into mortgages where the mortgagor had a minimum equity stake of say 20%. Or they could choose something more risky.
Next, the VALUE OF the stakes that depositors have in safe mortgages (or whatever they’ve chosen) varies with the value of the underlying assets (e.g. the mortgages). In essence, depositors buy into a mutual fund. Indeed Laurence Kotlikoff, one of the several people advocating this system, explicitly advocates mutual funds in this connection.
The net result is that there is no reason for any bank subsidy. The taxpayer WOULD STAND BEHIND transaction accounts, but since no risk is taken with the money deposited, there is minimal taxpayer exposure.
As to investment accounts or mutual funds, if a particular fund makes silly loans or investments, then all that happens is the value of stakes in the fund falls, just as it does at present when a mutual fund makes silly decisions. Those with stakes in the fund have little reason to run, in the same way as there wasn’t a catastrophic run on BP shares after the recent Gulf oil spill. And even if there is a run on a hundred mutual funds, that doesn’t have systemically disastrous results. As Mervyn King put it, “a sharp fall in equity values” does not “cause the same damage as a banking crisis”.
As to the impossibility of sudden bank failure under this system, George Selgin explained the reason very neatly. He said, “For a balance sheet without debt liabilities, insolvency is ruled out.”.
And that’s it. The solution in just over 300 words. And if you want to see the same solution set out by someone else, try this Bloomberg article by Matthew Klein, or this WSJ article by John Cochrane.
— Ralph Musgrave
Institutions that want to take deposits...must back those liabilities 100% by short-term Treasurys or reserves at the Fed. (...) There is no reason that the Fed and Treasury should artificially starve the economy of completely safe, interest-paying cash (John Cochrane)
ReplyDeleteThis seems to be a key point. Modern finance cannot function without a risk-free benchmark that only the government (the issuer of the currency) can provide.
The solution proposed by Cochrane would rely on deposits being 100% backed by either reserves or government bonds - or a mixture of the two.
If the guarantee were to be provided by government bonds only, it would have the added bonus of having the public demanding massive issues of public debt - for otherwise their bank deposits would cease being risk-free.
No T-bonds or bills, no safe deposits. Clear and simple, so that anybody would understand.
Of course, any further talk on debt ceilings and other absurdities would immediately cease, for no politician could afford the image of being against "guaranteed bank deposits for all those who save".
So, on balance, this proposed reform might be a step in the right direction, because it could likely transform a traditionally anti-deficit electorate into a strong supporter of public debt.
Functional finance could then become an uncontroversial principle, accepted by both the right and the left of the political spectrum.
Taking deposits isn't the problem; the ability of the banks to CREATE deposits is the problem.
ReplyDeleteThat said, I should the article, cause I can't believe something so obvious would be missed.
I'm sorry, but exactly which problems is this scheme meant to solve? The problem of the 2008 bank run on ordinary deposits that never occurred? The problem that the FDIC fixed in the 30's, after the Chicago school proposed their own plan to end depression-style bank runs?
ReplyDeleteWe already have this system. You don't need "reserves" to implement it. People deposit dollars in banks, and those deposits are insured by the government. At the same time banks buy treasuries and then sell them back at a profit, which feed interest income into the banking system so banks can pay interest to depositors. And now the Fed also dribbles interest on reserve account balances which also allows banks to pay depositors a bit. There is no by no means shortage of "safe assets". If anything, what there is a shortage of is high-yielding assets, because everyone in the country, from the piddly depositor to large corporations, has their money invested in safe, low-yield assets.
ReplyDeleteDefine useless.
ReplyDeleteDodd-Frank may be useless for the Middle Class. But it served a propaganda purpose for the Upper Looting Class.
It kept the entire country divided & conquered. Baffled with bullshit.
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ReplyDeleteF.Beard,
ReplyDeleteI agree that the ability of private banks to create deposits is a problem, at least according to advocates of full reserve banking. And in fact many advocates of full reserve advocate the above two account system PLUS a ban on private money creation. In fact the above two account system puts constraints on private money creation, but doesn’t outlaw it totally.
Dan,
Re the “bank run on ordinary deposits that never occurred”: there was a run by ordinary depositors on the Northern Rock bank in the UK. Plus the credit crunch in the US was largely a run on shadow banks. Obviously for the above system to work, shadow banks – or at least the larger ones – would have to obey the same rules as regular banks (as advocated by Adair Turner, head of the UK’s Financial Services Authority).
“We already have this system. People deposit dollars in banks, and those deposits are insured by the government.” Agreed, but in the case of the largest banks which are not covered by FDIC, its effectively the taxpayer that funds the insurance: and that’s a subsidy of the larger banks. FDIC just cannot cope with systemic collapse. There is also a fundamental nonsense behind any government sponsored insurance of bank deposits, as follows.
Where depositors go for a deposit which is the least bit more risky than investing in a near 100% safe investment like short term government debt, those depositors expect more interest. But the extra interest derives simply from the extra risk: nothing more and nothing less. But if government is going to insure that risk, it will have to charge a premium that reflects the extra risk: nothing more and nothing less. I.e. the premium wipes out the extra interest (assuming the interest and premium accurately reflect the risk).
It’s one big bureaucratic nonsense. The simplest and most logical rule is: “depositors who want to try benefiting from taking a risk must bear that risk”.
We already have this system partially in the United States. Money market funds are uninsured high yielding accounts. They were a huge problem during the crisis because people acted like a herd to avoid losses and then funds had to liquidate good assets at fire sale prices which roiled all credit markets. Their lack of insurance arguably caused the disorderly failures in the investment banking system. Regulators could shut down a TBTF like JP Morgan during a time of relative calm but without access to a discount window, markets will take their money before regulators detect a problem and create turmoil and panic.
ReplyDeleteRalph, I don't think segregating the risk-bearing from the non-risk bearing accounts in the way you suggest would have prevented the financial crisis, since the crisis was caused by the unwinding of a system of voluntary debt obligations created by people who were seeking higher returns by investing in vehicles that did carry higher risk - although much more risk than those investors realized. Part of the problem is that the system failed to price risk accurately. Fraud and other forms of control failure played a role in that, in addition to the fact that the more complex and derivativized a financial system becomes, the more difficult it is for even honest sellers to price that risk.
ReplyDeleteYour picture here is to divide the financial sector in two: "Risky investors over there; safe investors over here!" But what does that matter if most of the people who own everything and create most of the jobs go over and stand voluntarily with the risky investors, then fire a tenth of the work force when their highly-leveraged and interdependent investment schemes unravel.
Again, that separation of risk-bearing from non-risk-bearing accounts already exists for the most part.
All financial assets bear some risk. Government securities may not carry default risk but they carry interest rate risk and are subject to change in real value based on price movements and fx rate changes.
ReplyDeleteThere is no way to eliminate financial risk. All one can do is attempt to reduce it, and that has tradeoffs. Overly concentrating on reducing financial risk can affect growth and employment.
Dan,
ReplyDeleteI’m not suggesting the two account system (risky and safe) would have completely prevented the financial crisis. Indeed, my quote from Mervyn King above made the point that crises will still happen. But as he also suggested they ought to be LESS SEVERE when all the “risky” bank creditors are loss absorbers.
Lehmans collapsed because it ran out of ready cash. Same goes for every bank that collapses. Under the two account system, banks do not owe cash to anyone (except in the case of safe accounts) so they can’t run out of cash.
Re “separation of risk-bearing from non-risk-bearing accounts”, I agree there is already plenty of separation. E.g. re “safe” there are money market mutual funds. And re “risky” there is the stock exchange. But banks still accept billions in deposits (or from bond holders), promise to return the exact sum deposited, while using the money to make risky loans or investments. That’s fraud, and it should be stopped.
Tom,
You implicitly ask the question: what’s the optimum amount of risk to allow? My answer to that is a very standard one given in economics: assume that the free market gets it right unless someone can point to specific reasons why the market doesn’t. In the case of banks, they are currently subsidised and subsidies distort the market. So I suggest removing subsidies would be a move towards the optimum, and the two account banking system does not need subsidising, so it must be nearer the optimum than the existing system.
All financial assets bear some risk
ReplyDelete"Risk-free" means that the investor is sure to receive the promised interest payments as well as the principal at maturity.
In that sense, only government debt is a risk free asset.
That’s fraud, and it should be stopped.
ReplyDeleteIf it's a US bank and the deposit is less than $250,000, it's not fraud since the deposits are FDIC guaranteed.
"Risk-free" means that the investor is sure to receive the promised interest payments as well as the principal at maturity.
ReplyDeleteIn that sense, only government debt is a risk free asset.
Yes, but still inflation risk. Bondholders are expecting that they are correctly estimative inflation risk and there is interest rate risk, too, if they decide that their expectations were wrong and sell before maturity.
Government securities of a currency sovereign are default risk free operationally, but not politically, Governments can and do decide to strategically default.
Yes, but still inflation risk
ReplyDeleteFor TIPS, there's no inflation risk.
And no interest rate risk for investors (that is, not speculators) who wish to hold them until maturity.
As for strategic default, in the U.S. case it is simply unthinkable.
This means U.S. Government inflation-protected debt is really risk-free.
Dan,
ReplyDeleteRe your latest comment above, if a deposit is FDIC insured, then you’re right to say a promise by the bank that the deposit is safe is not fraud. However, my answer to that is that all deposit insurance is a farce and makes no economic sense and for reasons I set out here:
http://ralphanomics.blogspot.co.uk/2013/08/government-sponsored-insurance-of-bank.html
Briefly, my argument is that the insurance premium will wipe out interest earned by the investment or deposit (if the premium is charged to the depositor, which it should be). Or if the cost of the insurance is born by the taxpayer, that amounts to a subsidy of banking, which is also a nonsense.
I guess a lot of this issue hinges on where fraud begins and ends.
ReplyDeleteIn my mind, any bank that makes properly documented loans to consumers or business and those loans would be profitable if unemployment and incomes fall within a reasonable deviation from government economic forecasts, then the loans should never be categorized as fraudulent or particularly risky. We have to assume in a democracy that government works hard to ensure prosperity for its citizens and any other outcome is an anomalous. To assume that vanilla lending to citizens is inherently risky implies certain biases about government, politics and economics that I think need to be discussed openly.
I see no proof that the cost of deposit insurance to the public is greater than the cost of no insurance.
Unsophisticated depositors who need interest income to survive need the support and protection of government regulators. When I think of myself having to suss out whether my life savings is being placed in the hands malicious banker who is offering a slightly higher yield by risk taking or if the bank is just well run and is able to offer a bit more, I have no way to do that. A government regulator can force the Banker to open up the books and meet minimum criteria in exchange for insurance and then give them a stamp of approval or a cease and desist letter.