Monday, September 5, 2011

Bank capital and zero Fed rates

This post aggregates some comments I made in previous posts. Thanks to questions and comments by the likes of Arthurian, Mario, and Hans, I'm able to to further refine my points, and try to understand better even my own specific views and position.

Money from government a.k.a. government deficit spending is added money that was not borrowed into existence. Whether it goes through a bank (via funding a bank loan), or government pays you direct (doubtful), it adds to reserves/deposits. Creating/printing money via a bank loan is riskier, and eventually gets unprinted when it's paid back. 'Printing' via government spending never has to be paid back if it was paid for services rendered, and therefore, more permanent.

Writedown of upside down private sector debt

Printing money to extinguish private sector debt seems like a good plan at first, but it doesn't take into consideration that a lot of the debt was incurred to finance non-productive endeavors, such as asset speculation. In other words, this plan would be like printing money without increasing productive capacity. This would likely lead to inflation. It's so much better to print money in exchange for work which leads to productive capacity. Plus, paying people for their debts is unfair. What would that tell people going forward? That it pays to get into debt? And what if people in the future get excessively into debt in order to get ahead, i.e, bid up asset prices while trying to corner assets in the economy. In the end, you'll have people with all the assets and no debt, and then people who never went into debt and don't have any assets. Not fair, and could lead to gross misallocation and crises.

But then, I see that this scenario causes the newly-printed money to be destroyed (along without the debt), and hence not cause inflation. It also frees private sector from the peachy burden of deleveraging, and get private sector demand moving again. Therefore, I gee that there should be an element of debt writedown in solving the current mess, but there should also be a rule that says people forgiven their debt should not turn around, and use their now increased net equity to again speculate on more assets. after all, with their debt erased, they can now sell their assets and bid up on new assets,(and especially if NGDP proponents are listened to, and money is thrown to people to BORROW again. After all, if people don't borrow, how does NGDP grow constantly?) If this scenario happens, we'll now have inflation, and we're right back to people with heavy debt.

End fed distortion of rates

I'm not sure if the Fed should do anything anymore to move rates, even if to make it go up. Right now, I'm thinking just keep rates at zero, but neither should it pay interest on reserves. This way, private sector banks don't make lending decisions based on fed rates, but on real market considerations. This is hardly a set position for me yet. I'm not sure if there's a downside to this approach, but I think Warren Mosler is proposing something on this line, and I think it considers a lot of the unseen pitfalls and distortions that interest rate setting does to the financial market.

The Fed just could lend at zero to a bank that needs reserves for payment purposes. It could also lend at zero to a bank that wants to lend, but it will now need to insist on a high capital equity ratio, higher than what it is now (Capital ratio pertains to bank capital. This is owner's equity that will bear the first risk of loss if the bank ends up with a soured loan, before depositors start losing their money. Basel recommends a loan ratio of no more than 15 times capital. Bigger than that, the depositors' money starts getting more at risk).

Increase bank capital requirements

Banks should hold a larger chunk of capital as buffer agains loan loss, and that should be the first to get a haircut when loans go sour. It will then be the cost raising equity capital that will keep the banks from making loans that could just be misallocated. The pain of losing their own equity therefore should be strong enough to keep them from making sketchy loans, despite zero fed rates. If any bank is left with any excess reserves, they shouldn't get any wild ideas, by lending it to the first subprime who promises high yield.

Fed setting of rates is too distortionary, and may result in misallocation. Having a mandated loan capital ratio of between 5 to 10 times capital helps keep excessive risk-taking at bay, without creating boom busts associated with gaming the interest carry spread.

The bank owner should have main responsibility for solvency and prudence, that's why there should be enough owner's capital to begin with. However, with banks now owned hundreds of thousands of nameless shareholders, while bank decisions are made by executives whose only skin in the game is their bonus, this ideal is easier said than done. And yes, the government ends up having the main responsibility, when banks with insufficient capital take on more risk than they can. But I don't think keeping banks private (as opposed to widely-held) is a good contravening measure, even though being a public company dilutes bank ownership (and dilutes the prudential control and prudence that comes with concentrated ownership). If you prohibit banks from going public, it becomes harder for them to raise capital, and hence, to grow loans to help grow the economy during expansions (the more equity, the more loans they're allowed to make).

Better regulation and risk monitoring

The problem of widely-held banks should be solved by better regulation of executives. You can't run banks the way you run companies that maximize revenues. Executives who think sales are the prime objective are just talking their book, and thinking of their bonus. Because of the implicit government commitment to protect it, it should be run like a utility, and with risk management as prime objective.

The fed has a bias to protect banks because that was its original mandate, to be the lender of last resort. In an ideal world, the Fed monitors (and understands) the kind if risks banks take, because they will have to come in and rescue them if a run happens. Though Fed-injected reserves help against a bank run, it is a loan from the fed to the bank. It has to be paid back by either raising capital or getting back the depositors. If a bank is unable to, the fed essentially bails out the bank.

I'm not there yet on taking off the cap on FDIC. I think this will increase moral hazard among banks. Banks may increase their rates to depositors, knowing people would put their deposits on any bank that promises the highest rates, because they know all their money is guaranteed by the government. Although as mentioned, I'm not sure yet how the dynamics would change if rates are permanently at zero. 100% FDIC guarantee may induce banks to compete on higher rates to depositors, but then again maybe not.

...more discussion in the comments...

29 comments:

Anonymous said...

I am a bit confused. On your other post titled "Banks don't lend reserves, it's bank loans that create deposits", you had mentioned that Bank does not require reserves to make a loan.

Now in this post you said "If you prohibit banks from going public, it becomes harder for them to raise capital, and hence, to grow loans to help grow the economy during expansions (the more equity, the more loans they're allowed to make." Are you now saying that Bank needs deposit before it can make a loan?

Which is which? Please advice. Thank you.

Rogue Economist said...

A, when I say capital in this post, I mean bank equity. Banks are not reserve-constrained when they make loans, but they're capital-constrained. Central banks that enforce Basel standards want to see adequate capital in the banks.

Banks don't need to have the reserves/deposits firsthand when they make loans,but the central bank will want to see that they have adequate equity buffer for the loans they make. This means that at least 6% (the current standard) of their loans are backed by shareholder equity, and not 100% is funded by reserves/deposits. That implication is that if they make bad loans, there is an equity amount that will get the first haircut before depositors' funds are in danger.

That 6% is Basel-mandated. I'm suggesting that should be higher, so that even at zero fed rates, banks are not tempted to play the interest spread carry game.

Mario said...

awesome stuff here Rogue. Thanks for the mention too.

Anonymous...the main difference as Rogue has stated as well, is that Owners Equity is actually a part of the balance sheet of the business (that is the bank). That is to say that a brand new bank that has owners equity but no customers yet is still able to lend and make loans out so long as they OE is at Basel requirements. They do NOT need to have reserves already in their coffers so to speak since they don't have any customers to begin with yet. Once they make their first loan out, the Fed will automatically deposit the necessary reserve requirements. It's the OE on the bank's balance sheet that helps to assure the Fed that this reserve deposit they are making to this bank is a "sound" one. Recall that reserves are assets for banks but liabilities for the Fed.

Mario said...

Though Fed-injected reserves help against a bank run, it is a loan from the fed to the bank. It has to be paid back by either raising capital or getting back the depositors. If a bank is unable to, the fed essentially bails out the bank.

this is where I am fascinated with the relationship between the Fed and the banks. B/c I suspect that they can extend and pretend this scenario for as long as they want until "the market" takes notice such that people don't use those banks anymore...but even still if the Fed keeps propping up these zombie banks, how can any other competition in the banking industry really take root and get a foothold the market? It seems to me they really can't. And if that's the case then what options do people really have to go banking? They don't have a choice really. Especially in this day and age of electronic transactions. And with zero rates forever plus interest on the reserves, these banks can re-capitalize quite easily not to mention their books basically sealed up like the Ark of the Covenant. LOL This is a self-perpetuating cycle that feeds on itself and is a huge drag on the economy.

Don't you think in such a scenario (which is really what we see today), the Fed is essentially putting its own legitimacy and trust on the line with "bailing out" these crony, phony banks? And what happens when the Fed (a government institution) is compromised by the market? I mean that surely can't be good. It seems to me that the longer the Fed "sticks up" for these banks, the deeper they dig themselves into the very same grave these banks are in. They can't just prop these guys up forever. Eventually the house of cards must fall. Why does the Fed seem to want to fall with them? It's just ludicrous to me and unfathomable. I don't consider this the responsibility of a Lender of Last Resort and for this reason I consider the Fed completely guilty as well as the banks for breaking the law and their real mandate. Part of the LLR's responsibility is to not let this happen again and they should break up and dissolve these crony, phony banks and re-regulate the industry so that these things can't happen again nearly so easily. In such an environment new banks that are sounder in practice and on the edge of expanding should be able to step into the market more forcefully and provide new options for the public and re-instill fresh, new confidence I would expect. Unless these thing happen, I don't see how the economy can really ever get back up again fully. We may muddle through and stocks will likely move up again, and some things may happen, but over all I think confidence will stay low, our potential will not be fulfilled, and more wealth we continue to be ciphoned off to the top of the barrel. What do you think?

Hans said...

Could someone explain the meaning of the title: The Natural Rate of Interest Is Zero...

Are the authors trying to be "cute?"

Mr Rouge, thank you for dropping my name!

Mario said...

Hans,

great question. Warren Mosler is the author and progenitor of the idea so definitely ask him over on his blog. Simply post a comment there...it is very likely that he will respond to you himself.

Here's the link to that article where you can post it:

http://moslereconomics.com/mandatory-readings/the-natural-rate-of-interest-is-zero/

I hope you do post over there. More than likely, I'll see your comment over there! LOL

cheers!

Hans said...

Thanks, Mario, you are the man!

Mario said...

you bet! :D

Mario said...

Hans,

I don't know if you noticed but Warren responded to your question. Here's his response:

"means what it said, as explained by the text."

LOL

cheers!

Rogue Economist said...

Hans, Mario, no seat. Thanks for improving th elevel of discussion here.

Hans, my take on 'The natural rate is zero' is that when the Fed stands ready to lend banks any reserves they need, then then it is tantamount to saying they are practically zero rate. Any amount is available as necessary.

My use of it in this post is that Fed discount is not what should determine cost of loans to the public (since the Fed manipulates it all the time, and cause a lot of distortions). What should determine cost is the level of risk. The riskier a loan a bank makes the more costly it should be. The most efficient way I think risk is costed is via the amount of equity capital a bank should set aside to back the loan.

Equity is not cheap. Shareholders will demand a higher return if they know a bank is being risky. Whereas fed rate can be made s cheap that it doesn't matter to banks whether they are extending risky loans (they know the Fed stands ready to bail them out). But if the banks stand to lose a lot of equity before the fed steps in, that's real cost, and determined by market sentiments, not the Fed's.

Mario, my take is the fed keeps bailing out the banks because it is culpable in making them extend so many loans because of the low interest it charged them, while at the same time deregulating banks and enforcing a low capital environment.

If the fed continues to throw money at banks and forces to make more loans than is prudent, then they will have to stand ready to bail them out again.

Mario said...

yeah I like that idea Rogue.

"What should determine cost is the level of risk."

so then bank rates would vary depending on the borrower and borrowers could compete for prices against various banks as well. I think that's a good idea...except that in an oligopoly situation the banks could control the price of money much like oil is controlled.

"If the fed continues to throw money at banks and forces to make more loans than is prudent, then they will have to stand ready to bail them out again."

and again and again and again...until the market can't stand it anymore

Rogue Economist said...

Mario: "...except that in an oligopoly situation the banks could control the price of money much like oil is controlled."

Well, banks are already an oligopoly now, and they already try to control the price whatever way they can (but always around fed's determined rate). My focus on this point is not so much on how they want to price each individual loan, but how much more equity buffer they will be required to raise for each loan they make.

If they have to raise more equity, their cost of capital gets higher the more risk they take. This is of course assuming shareholders are given the right assessment of the bank.

Mario said...
This comment has been removed by the author.
Mario said...

true. I think the operative word in any of our "ideas" comes to down to "regulation." B/c that's the joke these days isn't it! haha!! Regulation!!! Why do I have this nagging feeling that someone is bending me over? LOL

fascinating to think that after years of growing up and people telling us we can be whatever we put our minds to...we are here putting our minds (and our insane college education costs) into solving the problems of today only have to "our parents" (at the social level that is...our elders) being the corrupt and asinine ones holding us all back from doing "whatever we put our minds to"!!! Oh god I feel like I'm stuck in a Macbeth play or something!! LOL

ellen1910 said...

. . . government deficit spending . . . adds to reserves/deposits. RE

This is so hard!

As a matter of law (that is, selfimposed) deficit spending is "funded" by the issuance of treasury securities.

Reserves representing the demand deposits of bank customers are reduced in an amount equal to the sales proceeds the Treasury receives. Immediately thereafter, the Treasury issues its checks; the checks are deposited; and the reserves go back up to where they were before the sale.

Leaving the fiscal multiplier aside, what is the mechanism by which government deficit spending "adds to reserves"?

Rogue Economist said...

I'm not sure i'm getting your question, are you asking how the deficit adds to 'net' reserves?

Aside from the fiscal multiplier, the discout window of the fed allows banks to create loans 'out of thin air', creating net new reserves/deposits that wasn't there before. New lending by a a bank creates deposit for the borrower. If he uses it to buy or pay someone, that someone earns income, which he can now deposit. That someone's bank can now lend that new reserve/deposit back it to the borrower's bank, thereby enabling bank 1 to pay off the fed discount window.

ellen1910 said...

Thanks for the quick response, RE, but you're right -- you don't understand my question (maybe I put it badly):

I'm not asking about reserves created by banks (via lending or in any other way). What I'm asking about is "government deficit spending" and its role in adding to reserves -- your terms.

What is the mechanism by which government deficit spending "adds to reserves"?

Ellen1910

Rogue Economist said...

Well, if you consider central bank part of government, its lending is deficit spending. In terms of pure fiscal policy, though, I could see the fiscal multiplier as the main deal. I discussed this recently here, here, and here .

Other than the fiscal multiplier, it's otta be bank lending, and trade surpluses that add to reserves.

ellen1910 said...

So --

Just in order that I don't have to puzzle about this any longer, can I assume you've withdrawn your assertion -- namely, that ". . . government deficit spending . . . adds to reserves/deposits"?.

Rogue Economist said...

well, you'll end up puzzling forever, because I haven't said anything to withdraw my assertion.

If you have no deficit spending, there's no new currency to go around, nothing to save, no money to use to spend, no money to buy Treasuries with.

Why is the belief that money should be existing first before government can borrow it more believable than government has to issue money first by spending before people can lend to government?

Did some people create money first before government decided to take it away? how did those people decide when to stop creating it? and what made everyone stop together? what framework are you working on?

But out of curiosity, what made you think I withdrew my assertion?

Mario said...

this is cool guys. I don't exactly understand the original question by ellen either, however that being said, doesn't the mere fact that the government has spent money (whether that be a social security check, a government contract, a wage, etc.) explicitly and directly mean that there is now a new deposit in someone's bank account that was not there before?

Surely the obvious answer to this is an irrefutable "yes."

And if so, then the bank must increase their reserves appropriately to account for that new increase in deposits.

Ergo, government spending directly increases bank reserves and deposits.

ellen1910 said...

RE -- banks create money -- not the Treasury. Therefore, your assertion that "that ". . . government deficit spending . . . adds to reserves/deposits" must be wrong.

Mario -- you're examples are limited to one bank. When we're discussing reserves, we want to be talking about the bank system -- that is, one bank's increase in reserves is another bank's decrease.

Both of you should read and understand (and where appropriate, refute) the little narrative which accompanied my original question.

ellen1910 said...

In the further hope that either of you will make a good faith effort to answer my question, let me make the example even simpler.

Suppose Geithner wishes to send a $1000 check to a SS recipient, but the Treasury has a zero balance in its accounts. The laws of the United States require that theTreasurer must obtain money by borrowing it before he can issue a check. So --

Geithner prints up a $1000 security and sells it to a buyer in consideration of receiving $1000 from that buyer. That's how we do deficit spending in this country.

How does the transaction affect banking reserves?

The buyer's demand account with his bank is reduced by $1000. The buyer's bank's reserve account with the Fed is reduced by $1000.

The Treasury issues the $1000 check to the SS recipient who deposits it in his bank. The SS recipient's bank's reserve account at the Fed is increased by $1000.

Reserves in the banking system after the act of "deficit spending" are identical to those that were in the system before.

Deficit spending has not increased reserves.

Refute it if you can.

Rogue Economist said...

Ellen, you have think beyond the domestic system here. Where did the Treasury buyer's money come from? Obviously he had reserves. In the extreme that everyone in the domestic system is short money, perhaps because in the last period they all spent their last cent buying the latest gadget from Mr foreigner, then those dollar reserves now owned by Mr. Foreigner is brought back into the domestic system.

Those dollar reserves could not have come to Mr Foreigner's bank account unless they were issued into existence first. That's why there's a buyer when the government issues a dollar, the previously issued dollar eventually gets to someone who just needs to save it for future consumption.

Now the domestic system already has added reserves, the government can deficit spend. if there was never any money going out of the economy, there is less chance anyone in the economy would be short money. In which case, the government could simply sell treasuries to that local guy who ends up with money but wat to save it,

Lastly, as I said, bank lending 'out of thin air' is facilitated by the presence of a Government Program caled the fed discount window. Without this Government program, people by Government Workers, and following a Congressional Charter (Government), then banks cannot lend without having money first.

ellen1910 said...

Sorry, RE -- you don't get to define "government deficit spending" (your words) any old way you want to. Loans from the Fed discount window to banks that are short of reserves aren't deficit spending -- period.

I'm still waiting for a good faith effort to explain where I'm mistaken re: my little narrative. And how my conclusion that under U.S. law "government deficit spending" does not lead to an increase in banking system reserves is in error.

N.B. I consider MMT's criticism of conventional finance theory to be sound. My problem is that I'm not confident that I fully understand MMT. When a statement such as government deficit spending . . . adds to reserves/deposits seems to contradict MMT, I question it. If I were more confident I'd probably reject it and pass it by.

Rogue Economist said...

Ellen, you still haven’t answered my previous questions. Why is the belief that money should be existing first before government can borrow it more believable than government has to issue money first by spending before people can lend to government?

If you have no deficit spending, there's no new currency to go around, nothing to save, no money to use to spend, no money to buy Treasuries with.

Did some people create money first before government decided to take it away? how did those people decide when to stop creating it? and what made everyone stop together? If you can answer these question, then maybe you can address your confusion.

Mario said...

"Deficit spending has not increased reserves.

Refute it if you can."

note: I haven't read the rest of your guy's comments before posting this. I only have so much time but I do hope to get to it later.

First off let me state I am not an expert in this field. This is a good question and I'm going to post it up over at Mosler's site when I get the chance to see what those guys have to say about. Here's my thoughts:

The banks' baseline reserves cannot be used to buy those bonds b/c they are required to have those at all times. Therefore we're talking about EXCESS reserves. What you're not including in your scenario is that the banks now ALSO have the securities too plus that interest in their reserves. I believe there are cash reserves and bond reserves but I'm not sure about that. Recall that this is how the Fed reaches its target Fed Funds Rate through buying/selling reserve bonds appropriately.

So you're correct in what you said about excess cash reserves...however the banks total reserve balance HAS increased b/c they now also have the bond that is earning interest too. This is why MMT considers the current treasury/primary dealer/fed song and dance required for the Treasury to deficit spend as useless and should be done away with. MMT considers this requirement as only providing a subsidy for banks for no reason at all. Operationally it is unnecessary. MMT people have various views on how to make the change as I'm aware. Some say to merge the Fed and Treasury balance sheets into one. Other say take away bonds all together as they are useless to our economy. I'm sure there are other options too. Regardless it is an irrefutable fact that banks' balance sheets DO IN FACT GROW when the government deficit spends. The only difference might be the TERM STRUCTURE of those assets. That is to say cash (with no term structure) versus bonds (with a longer term structure).

Not only this but as more people in the economy have more money, bank reserves MUST increase b/c of reserve requirements which the Fed provides to banks. This is the Fed's liability and the bank's asset. It's not until the government gets dollars back (through taxation primarily) that those reserve levels would ever decrease. Or I suppose if a customer moved their banking to a non-US bank in which case the aggregate reserve levels would drop in proportion.

I think that satisfies you're question. However I encourage you to take this great question of yours over to Warren Mosler's site to see what they have to say. They know much more about this stuff than me. I am just a peanut player. ;)

Here's the link to his site and frankly you can post your question on any post and they will answer it with equal rigor. Cheers!

http://moslereconomics.com/

Mario said...

hans I don't know if you saw this or not but I asked Warren a more in-depth question regarding the meaning of zero rates as the natural rate and this is what he said. I thought you might appreciate this too.

"all it says is that in the absence of govt measures to insure otherwise, the ‘risk free’ rate for that currency will be 0%.

And an economy with a 0 rate policy, the natural rate, still needs the right fiscal balance to achieve full employment, etc."

http://moslereconomics.com/mandatory-readings/the-natural-rate-of-interest-is-zero/comment-page-2/#comment-70822

Calgacus said...

ellen1910, deficit spending, correctly defined, certainly does add to reserves. One just has to be careful on the terminology. What you are calling "deficit spending" is not what MMT (properly) calls "deficit spending".

I agree, MMT expositions can be confusing on this - and many other points - the usual late 20th century defect of scientific exposition of using far too many words to say something simple. And as usual, the master, Abba Lerner, was crystal clear. He pointed out that people conflate (deficit) spending and borrowing into one thing "borrowingandspending".

Yes, if by "deficit spending" you mean borrowingandspending, it does not change reserves. What it changes are the bondholding, NFA, national debt. But that is not good, general terminology. The US Treasury does have authority to create currency for spending without what is misnamed "borrowing" (government borrowing is not borrowing) - I think a $300 million T-note limit & the coin seignorage we all know & love. In any case, the (un)"borrowing" & the spending are two different acts. (Deficit) spending adds to reserves, "borrowing" drains them. So "borrowingandspending" has not increased reserves - that is what it is designed to do.

Saying one precedes the other is not necessarily true. They both go on all the time. The US started out by "deficit spending" - before there were really any bonds. Conceptually, it is usually better to think of spending as preceding "borrowing".

Mario: MMT does not consider the bond song&dance (or reserve interest) to be entirely unnecessary. It is necessary if you want positive interest rates, which may have some real function.