The Cowen-Cochrane dispute on banking

You can start with Tyler, and work backwards.

I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.

As spelled out in Specialization and Trade, my simple account of financial intermediation is this.

1. We start with a risky investment, fruit trees, and it is costly to observe how the fruit trees are doing and how much skill and dedication the entrepreneur is contributing.

2. It helps to finance these fruit trees in part with debt. This is not because debt is easier to trade than equity, but because it is a less expensive way to align incentives.

3. It helps to have a bank buy the debt and issue short-term, risk-free liabilities. This is because people do want to hold and exchange short-term, risk-free liabilities. An intermediary that backs the fruit-tree debt with a combination of bank equity and demand deposits makes people better off.

So I am afraid that I am with Tyler on this one.

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7 Responses to The Cowen-Cochrane dispute on banking

  1. Dave says:

    I agree with your argument. The pure equity (100% reserve) bank could only hold cash in its vault and issue notes (CDs basically) for nonzero terms. Isn’t it possible that there is at least some demand for a completely government-free bank which does not pay imterest on deposits? Consider how closely Bitcoin aligns with that model.

  2. Matthew Gelfand says:

    Clearly, there is robust demand for 100% reserve banking. They exist now in the form of government-only money market mutual funds. These funds are virtually 100% equity-funded entities holding only government obligations as assets and provide ample liquidity to shareholders.

  3. Handle says:

    Here is the question: Why do we need single companies called “banks” to perform this intermediation directly with “deposits”?

    We don’t, not anymore. The intermediation can be performed via ordinary markets.

    I still argue that this model represents the over-aggregation of the legacy finance model. What was more absurd than making Goldman Sachs a “bank holding company” in September 2008 in order for it to be eligible for emergency Fed lending?

    The fundamental finance functions no longer need to be combined, and so should be separated and firewalled, in a kind of neo-Glass-Steagall.

    1. Electronic Payment Systems: People want to keep a small amount of currency-equivalents as “100% reserve deposits” earning zero interest (or the Fed discount rate), for the convenience of making transactions over secure IT networks. Subject to legal constraints, this is already technologically feasible for the entire world population at practically instant speeds and at practically negligible costs. There is probably little difference in this being done in a competitive private market, by a single dominant private firm (e.g., PayPal), in some kind of technically exotic decentralized manner (e.g., Bitcoin) or by a state government itself.

    In particular, the whole concept of a “Money Market” fund with sweeps and the rest is now definitively obsolete and should be abolished. So too with the distinction between checking and savings accounts.

    2. Credit Issuance: Finance Companies in the business of loaning money to individuals or organizations for various purposes, (e.g., mortgages, auto loans, student loans, business loans, etc.)

    3. Investment Market-Maker Platforms: On the demand side, allows individuals or organizations to invest and hold title to, or exchange, equity, debt, currencies, funds, financial constructs, etc. available on the financial markets, and on the supply side, allows entities to issue debt and equity on those markets.

    4. Special Financial Services Companies (i.e. “Investment Banking”), which underwrite and help companies sell debt and equity to those investment markets, perform consulting, assist with mergers and acquisition, assist with creating financial constructs and vehicles to hedge certain risks, etc.

    5. Perhaps a special category for certain kinds of insurance companies.

    If people want risk-free or very-low-risk, very-low-return deposits, there are easy ways to provide for that outside the highly regulated legacy system of deposits / fractional reserve banking model with both clear and unclear state guarantees.

    The trouble is that people want both less risk and higher returns than the market will provide and the state wants to pretend it can give it to them. They want returns from risky investments, but want the government to bail them out at the end of the day anyway. That is, with a guaranteed but heavily regulated deposit system, the government wants to respond to these wishes by subsidizing demand and restricting supply for money too. This is the original sin of out system, and we should stomp that snake, scold Eve, and hang the apple back on the tree. We have the technology, we don’t need the apple.

    Cowen’s point seems to be that there is no way to prevent people from knowing making risky, guaranteed investments in their search for yield, and then demanding to get bailed out anyway when things go badly, and there is likewise no way to get the state to stand firm in a crisis, keep its pants dry, and not give in to the temptation to bail those people out. And because people kind of know and expect the state’s weak will in this regard, it encourages them to act in a way that preserves the option of begging in a crisis for those extra-legal bailouts. They will say, “I knew it was technically possible for my money market fund account to break the buck, but now that we’re in a crisis and it looks like it will actually happen, the state should make sure it never breaks the buck anyway,” or, “I knew it was technically possible to lose my FDIC-uninsured deposits above $100K, but now that we’re in a crisis, I want it to guarantee the next $150K too.” And the government will wet its pants and say ok, here’s your bailout.

    That is to say, there is just no good way for us to get out of that bad equilibrium, so we have no better choice but some “least worst” version of regulated finance within the constraints of the current deposit-banks / FRL model.

    I say the opposite. There is no way to make any real improvements or major changes in the current system so long as we stay wedded to the existing, obsolete banking model, which is now just as much a barbarous relic as gold. But if one abandons this system in favor of the disaggregation described above, all sorts of new financial institutional arrangements will prove possible.

    • Roger Sweeny says:

      The trouble is that people want both less risk and higher returns than the market will provide and the state wants to pretend it can give it to them.

      Similarly, one sixth of GDP goes to “health care” but nobody wants to spend one sixth of their income on “health care.”

    • Dave says:

      Well said Handle.

      I would add that the current regulatory regime seems to be going away on its own, given how easy it is to become an “unofficial bank” and how easy it is becoming to trade Bitcoin.

  4. Matthew Young says:

    My corner shopkeeper runs a bank.

    He runs a tab for his largest customers, no money required, just walk past the counter he will count it up and put it in the bank. We pay our tb about every two weeks.

    He is intermediating between the ad hoc arrivals of customers and the arrival of trucks. Dollars do not work for this purpose because the ATM fees are not flexibly priced and foul his book up. Thus, we run a tab so as to minimize out ATM fees, saving as much as $30/month.

  5. Tom G says:

    We might not get around the desire of the rich to have risk-free AND high yields, with bailouts when crapped out, but we can do more to separate them from those willing to accept lower yields and risk-free.
    100% equity, low risk, low yield banks reduces the gross size of the yield seeking & bailout whiners, so there’s a better chance of anti-bailout resistance.

    The taxpayers are also getting wiser. Lots of normal folk are saying the Big Banks want/ don’t want Dodd/Frank, or some new Regs — but really don’t want higher capital requirements. So it’s pretty clear that higher capital requirements are what is needed to reduce the risk.

    None know now what the next financial crisis will be – bitcoin or some other gov’t cryptocurrency? – but we all know that in the crisis, the irresponsible rich who were risking a LOT of money will be claiming they need to be bailed out to “save the real economy”. Saving the reckless 1% will be a much lower priority next time; maybe enough lower that the populists allow the elites to lose a LOT of money.

    That would result is a lot of post-destruction creativity.

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