Wednesday, May 25, 2016

Equity financed banking video


Video of my talk at the Minneapolis Fed's "Ending Too Big to Fail" symposium. A link to the video (youtube) in case you don't see the above embedded version. The event webpage, with links to the other talks and the agenda.  Summary: AM: Dodd Frank is a big failure, we need a big fix. PM: We'll get it to work with little fixes here and there. I posted the text of my talk earlier.

9 comments:

  1. John

    are you saying that in your proposal that when someone deposits money into a bank , they become a equity holder, because if so , it seems that was lost in the seminar, as the discussion went onto issuing equity.

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  2. How would money creation / monetary policy work with 100% equity funded banks?

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    Replies
    1. Justin,

      My short answer is that most people would go the international route. There are literally hundreds of countries each with their own central bank. U. S. monetary policy might be crippled, but that wouldn't stop the world from turning.

      But for John's answer see:

      http://johnhcochrane.blogspot.com/2016/05/equity-financed-banking.html

      The diagrams that he includes map things out. Presumably your question would be - where does the $100 come from to buy the equity sold by the bank - and that's a good question.

      The way things are structured today in the U. S. - the central bank injects money into our economic system in one of two ways - they either lend the money short term to a private bank who in turn lends that money longer term (maturity transformation) or they conduct open market operations by buying government debt from private banks.

      Now eliminate short term lending by the central bank. The only tool left for the central bank is open market operations - buying and selling government debt.

      That begs a lot of questions:

      1. Where do private banks get the money to buy government debt at auction when they can no longer get short term loans from the central bank or anyone else for that matter?

      2. John would say that a private bank gets the money to buy government debt by selling equity shares but where does the money come from to buy the equity shares? It's not like the central bank would be able to print the money to buy the shares.

      Finally, I would like to add that money is fungible. Here is my auto dealership balance sheet:

      Liabilities
      a. $5 million in short term debt
      b. $15 million in long term debt (mortgages / land leases)
      c. $10 million in share holder equity

      Assets
      a. $1.5 million in car inventory
      b. $10 million in land / buildings / equipment
      c. $5 million in medium / long term car loans

      Question #1 - Am I a bank that shall be precluded from borrowing short and lending long?

      Question #2 - How does any regulator prove that the $5 million I received in short term loans is the same $5 million that I lent out in medium / long term car loans?

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    2. Thanks for the thoughtful reply.

      I'll challenge in one area: I believe John would argue that open market operations are monetarily neutral - open market operations basically issue short term government debt (reserves) in exchange for slightly less short term government debt (treasury bills).

      The crux of my question for John is: If the open market operations don't do anything, and banks don't have any debt, how would the central bank impact the money supply?

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    3. Good question. Answer: It wouldn't. Central banks haven't controlled money supplies in years. The central bank will and will continue to set interest rates by setting the rate it pays on reserves, or the rate at which it will lend reserves to banks. We can continue to be awash in interest-paying money.

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    4. John,

      "The central bank will and will continue to set interest rates by setting the rate it pays on reserves, or the rate at which it will lend reserves to banks. We can continue to be awash in interest-paying money."

      The interest that the central bank pays on reserves is simply the interest that it receives on it's government bond holdings. That interest rate is set at auction and is NOT set by the central bank. It's not like the central bank can elect to pay 5% on reserves when the auction rate for government bonds is 2%.

      Justin,

      "The crux of my question for John is: If the open market operations don't do anything, and banks don't have any debt, how would the central bank impact the money supply?"

      John's answer:

      "The central bank will and will continue to set interest rates by setting the rate it pays on reserves, or the rate at which it will lend reserves to banks."

      John, your response does not make sense. You want to eliminate short term borrowing and maturity transformation by private banks but also want the central bank to lend reserves to banks? Are you advocating that the central bank should lend reserves for a long time to private banks?

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  3. Got it. If I'm understanding right, the entertaining story they tell in macro 101 about Bank A lending to Bank B, which lends to Bank C, isn't really how the theory works.

    Instead, the Federal Reserve sets a minimum interest rate for the economy.

    I wonder if legislative fiat would be equivalent ("no one shall lend to anyone else at an annualized rate of less than 0.25%")

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  4. I think it is important to draw a distinction between short term debt that is "safe" (i.e, as good as cash) and short term debt that has default risk. The problem comes when bank deposits, perceived as having no default risk, suddenly are perceived as having some.

    The solution is to require that institutions accepting "deposits" (or issuing any kind of debt that is perceived to be risk free) be required to maintain some kind of line of credit with another financial institution or the fed equal to such deposits, minus their reserves. The terms associated with such lines of credit would effectively be a way for the market to set the rate of "tax" on short term debt.

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