The Grumpy Bank Holding Company Proposal

John Cochrane writes,

For $100 of assets, and $100 of bank equity, let, say, $10 of that equity be traded — enough to establish a liquid market. Then, let $90 of that equity is held by a downstream entity or entities— a fund, special purpose vehicle, holding company or other money bucket. I’ll call it a holding company, and return to legal structures below. The holding company, in turn, issues $10 of holding company equity and $80 of debt.

The good news is that the bank can never fail, and if the holding company becomes insolvent, Cochrane suggests that it could quickly force debt holders to accept a new mix of (less) debt and some equity.

The bad news is that the debt of the bank holding company, which is the closest thing to bank money in his world, will not trade at par. It will trade at a discount, which will be small if the bank seems to be doing well and large if the bank seems to be doing poorly. For transaction purposes, that sort of money is noisy, so it will not really work. If it would work, then nobody would be bothered by a money market fund that can “break the buck.” In order to avoid breaking the buck, money market funds have to stick to non-risky assets.

I think that in order to work as money, financial liabilities have to trade at par. If a firm has risky assets and most of its liabilities trade at par, then I think it has to be subject to runs (assuming no deposit insurance). I don’t see any way around that.

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7 Responses to The Grumpy Bank Holding Company Proposal

  1. Dave says:

    Why not full reserve banking? It seems like a credible alternative to government intervention in banking via deposit insurance and gaurantees.

    • Handle says:

      In the alternative, why not go to the other extreme and simply nationalize the “deposits taking and transaction processing” function of the banking industry? Everyone gets a zero-service-fee fully electronic (no paper checks) account at the Federal Reserve, and is entitled to receive whatever interest rate any other institution can get from the Fed. 100% or 0% reserves probably doesn’t even matter, as there is no limit to the Fed’s ability to provide liquidity.

      Why should these functions remain aggregated with companies in the investment business of offering new consumer and commercial credit, when they can easily obtain financing via the equity or debt markets?

      It seems to me that the technology already exists to make ordinary consumer deposit banking services so fast and cheap that things remain as they were decades ago mostly out of inertia than necessity, but that this inertia is nevertheless constraining the imagination of proposers of reforms.

      • Andrew' says:

        Both of these ideas defy (what I suspect are) the underlying objectives of Fed policy. The implicit guarantee and bailout serves to gird profit margins. Why would they then undo their hard-earned oligopoly by giving the deal to individuals?

      • Dave says:

        Handle,
        I fully endorse your proposal, possibly as a stepping stone to mine. I imagine that USG won’t like your idea because it rubs the entire world’s nose in the fact that the US government is entirely liable for nearly all US demand deposits today. It is much easier to pretend to a free market in finance when the base interest rate is set by something other than pure Fed fiat.

        On the other hand there are good reasons to actually have a free market in finance that is unburdened by price signals set by government fiat. However I cannot imagine the US government voluntarily surrendering control over the US dollar under any circumstance.

  2. Andrew' says:

    Shouldn’t all these things be offered the deal of less regulation so long as they can prove net reserve levels?

  3. Andrew' says:

    “(assuming no deposit insurance). ”

    They don’t just insure deposits, they also take over management and force sales. The trick is to make people get religion before the death spiral sets in. But in a systemic fire Sale even the largest insurer cannot keep up with the Fed and The Feds who can inflate and tax. That is why it is their job to lend freely on systemic outliers.

  4. Matthew Young says:

    The problem is term structured debt, time.
    If you make a time bet you need insurance because you have revealed your future payment stream and are subject to hedge. All the insurance calculations come out as term premium.

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