This paper was given to a
U3A Group. It's a look at settlement services and borrowing/lending practices.
It is not intended to be a blueprint, rather an accounting explanation of what
banks do and to question whether there's another way.
The Royal Commission into Misconduct in the
Banking, Superannuation and Financial Services Industry is appropriately named.
There’s been plenty of misconduct revealed. The aim of this seminar is not to
trawl through all the misconduct, but to have a closer look at what banks do.
Do we need them? If we were designing a new banking system would we come up
with the current model?
Intro
The Reserve
Bank of Australia (RBA)
is Australia’s central bank. It provides banking services to the Federal
government, issues notes and currency, conducts monetary policy and oversees the
banking system (together with APRA)
Money creation and
settlement services are outsourced to private banks. The RBA supervises the
settlement system. If the government needs to, it borrows money created by
private banks. It does not borrow from its own bank.
Private banks
are engaged in three principal activities.
· Settlement services
· Borrowing
· Lending
Settlement services
Settlement services involve receiving and making payments on behalf of customers.
To understand how settlement services work it’s best to introduce a bit of
accounting.
Imagine
there’s only one bank, the Bank of One. This is what its balance sheet would
look like.
Table 1:
A one bank economy
|
|||
BANK OF
ONE
|
|||
ASSETS
|
LIABILITIES
|
||
Cash
|
5
|
Deposits
|
135
|
Bonds,
investments
|
10
|
Equity
|
15
|
Loans
|
135
|
||
150
|
150
|
||
Assets consist
mainly of loans (to borrowers). There’s a little cash on hand and some
investments which offer a little more liquidity than loans, should liquidity be
needed.
The liabilities
are principally deposits from customers, both retail and large wholesale
lenders. The balance of the liability side is equity, essentially its share
capital and retained earnings. Equity=net assets.
Now let’s
imagine the bank has two depositors A and B. A has a deposit of $45 and B $90.
Now A needs to pay B $2. The bank debits A’s a/c and credits B’s a/c.
Table 2:
One bank/2 depositors
|
|||
BANK OF
ONE
Before
|
|||
ASSETS
|
LIABILITIES
|
||
Cash
|
5
|
Deposit from A
|
45
|
Bonds, investments
|
10
|
Deposit from B
|
90
|
Loans
|
135
|
Equity
|
15
|
150
|
150
|
||
After A pays B $2
|
|||
ASSETS
|
LIABILITIES
|
||
Cash
|
5
|
Deposit
from A
|
43
|
Bonds,
investments
|
10
|
Deposit
from B
|
92
|
Loans
|
135
|
Equity
|
15
|
150
|
150
|
||
A’s deposit
reduces by $2 and B’s increases by $2. Simple as one would expect. The bank’s overall
position doesn’t change.
But suppose
there are two banks. A banks with Bank One and B banks with Bank Two. How does
A pay B $2 in this instance?
This is the
‘before’ situation:
Table 3:
Two banks/two depositors before payment
|
|||
ASSETS
|
LIABILITIES
|
||
BANK ONE
|
|||
Cash
& investments
|
4
|
Deposit from
A
|
90
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
90
|
||
100
|
100
|
||
BANK TWO
|
|||
Cash
& investments
|
2
|
Deposit
from B
|
45
|
Exchange
settlement a/c
|
3
|
Equity
|
5
|
Loans
|
45
|
||
50
|
50
|
||
Total ES
a/cs
|
9
|
Total
deposits
|
135
|
The asset
side for each bank has been reclassified to show each with an exchange
settlement a/c. This is an a/c each bank has with the Reserve Bank (RBA). The
RBA is the central bank and it supervises settlement services for the financial
system. Large banks have a/cs with the RBA.
In this
instance total deposits across the two banks is $135 and total exchange settlement
(ES) a/cs $9. Now let’s assume A pays B $2. This is what happens:
Table 4:
Two banks/two depositors after payment
|
|||
ASSETS
|
LIABILITIES
|
||
BANK ONE
|
|||
Cash & investments
|
4
|
Deposit from
A
|
88
|
Exchange
settlement a/c
|
4
|
Equity
|
10
|
Loans
|
90
|
||
98
|
98
|
||
BANK TWO
|
|||
Cash & investments
|
2
|
Deposit
from B
|
47
|
Exchange
settlement a/c
|
5
|
Equity
|
5
|
Loans
|
45
|
||
52
|
52
|
||
Total ES
a/cs
|
9
|
Total
deposits
|
135
|
The
highlighted bits indicate where changes have occurred. Bank One debits A’s a/c
for $2 (reducing it to $88) and arranges for the RBA to transfer $2 from its ES
a/c (reducing it to $4) to Bank Two’s ES a/c (increasing it to $5. Bank Two
then credits B’s a/c with $2 (increasing it to $47). This all happens in cyber
space in an instant.
Overall total
deposits and total ES a/cs don’t change. There’s just a shuffle between banks.
Reserves
Exchange
settlement ES a/cs are an integral part of the current settlement system. The
ES amounts are more commonly referred to as bank reserves. They ’exist’ in the
financial system to enable banks to settle amounts of behalf of its customers.
In pre-digital days settlement procedures were more difficult, with cheques
being overwhelmingly used. But today settlements are done in cyber space.
Reserves are simply numbers on a spreadsheet at the RBA. Reserves are nominally
banks’ assets. They aren’t lent out. This is the biggest misunderstanding
people have. They are only used when payments are made on behalf of customers.
Payments to other banks and payments to the government.
How a bank deals
with a reserve shortfall can be shown with a reworking of the last case study.
Suppose A pays B $7 instead of $2. Bank One doesn’t have enough reserves for
the transaction.
Table 5:
Two banks/two depositors after payment (V2)
|
|||
ASSETS
|
LIABILITIES
|
||
BANK ONE
|
|||
Cash & investments
|
4
|
Deposit
from A
|
83
|
Exchange
settlement a/c
|
-1
|
Equity
|
10
|
Loans
|
90
|
||
93
|
93
|
||
BANK TWO
|
|||
Cash & investments
|
2
|
Deposit
from B
|
52
|
Exchange
settlement a/c
|
10
|
Equity
|
5
|
Loans
|
45
|
||
57
|
57
|
||
Total ES
a/cs
|
9
|
Total
deposits
|
135
|
The ES or
reserve a/c is negative. To fix this it borrows $2 from Bank Two. It swaps $2
of investments for $2 of reserves.
Table 6:
Two banks/two depositors after payment (V3)
|
|||
ASSETS
|
LIABILITIES
|
||
BANK ONE
|
|||
Cash & investments
|
2
|
Deposit
from A
|
83
|
Exchange
settlement a/c
|
1
|
Equity
|
10
|
Loans
|
90
|
||
93
|
93
|
||
BANK TWO
|
|||
Cash & investments
|
4
|
Deposit
from B
|
52
|
Exchange
settlement a/c
|
8
|
Equity
|
5
|
Loans
|
45
|
||
57
|
57
|
||
Total ES
a/cs
|
9
|
Total
deposits
|
135
|
It could
have borrowed from the RBA by swapping investment(bonds) for reserves. In this
instance overall reserves in the system will increase.
Reserves are
needed to settle on behalf of customer at different banks not to lend to customers.
The other crucial point about reserves is that when the government is included,
payments to government will reduce reserves and payments from government will
increase reserves. Before considering this in a little more detail let’s just
have a quick look at the borrowing and lending activities of banks.
Borrowing
What
distinguishes banks from other non-bank financial institutions is they are
permitted to accept deposits from the public. They are authorised deposit-taking
institutions (ADIs). Deposits are unsecured, guaranteed up the $250k by the Government. From an
accounting perspective deposits are liabilities.
Lending
If you were taught
economics in the 1960s you probably would have learnt about fractional reserve
banking or the deposit multiplier which argued that monetary authorities created
central bank money (base money or reserves which were deposited into the
banking system and which then were multiplied. by a factor of, say, 10, by
private banks to create more money. Whenever a bank received a deposit it could
then lend out 90% to a borrower retaining 10% as a prudent amount to provide
liquidity should one of its depositors require repayment. This would in turn
create another deposit of which 90% would be subsequently lent out to another
borrower, and so on. Additional base money of $100 would lead to $1000 of
deposits/money created by private banks.
This
description of how money is created is known as the loanable funds model of
banking. It presupposes banks are intermediaries which require deposits before
loans are made.
It’s a
nonsense view. It’s not what happens in practice. What happens …..as the Bank
of England pointed out in 2014…… and which our RBA confirmed as recently as a
month ago…..and heterodox economists have increasingly been saying for years ………is
that deposits are created by loans not the other way around. This is the model
sometimes called financing through money creation.
Let’s return
to a case study.
Table 7:
Bank lending before and after
|
|||
ASSETS
|
LIABILITIES
|
||
Before
|
|||
Cash & investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
90
|
||
100
|
100
|
||
After loan/deposit of $5
|
|||
Cash & investments
|
4
|
Deposits
|
95
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
95
|
||
105
|
105
|
||
There is no
need for the bank manager to check whether he has enough deposits to lend out.
If asked by a credit worthy customer, he simply creates a deposit (in this case
$5) and a loan of $5. Both sides of the bank’s balance sheet increase by $5. If
the deposit when spent is redeposited with the same bank, then the balance
sheet doesn’t change (as we saw above in Table 1). It may have become a little
more unbalanced. The extra loan may be for 20 years say, but the extra deposit
is likely for a much shorter term. Certainly, if spent and subsequently
deposited in another bank it will be. Let’s look at that situation.
Table 8:
Bank lending before and after (V2)
|
|||
ASSETS
|
LIABILITIES
|
||
Before
|
|||
Cash & investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
90
|
||
100
|
100
|
||
After loan/deposit of $5
|
|||
Cash & investments
|
4
|
Deposits
|
95
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
95
|
||
105
|
105
|
||
After spending new deposit of $5
|
|||
Cash & investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
1
|
Equity
|
10
|
Loans
|
95
|
||
100
|
100
|
||
The balance
sheet returns to its ‘before’ size, but the proportion of loans on the asset
side has increased and the reserves (ES) reduced to $1. The balance sheet has
become unbalanced. This is where extra deposits are needed to rebalance the
balance sheet. Deposits aren’t needed to finance loans, but to fix the balance
sheet after loans have been made. This is not a theory. It’s what happens in
practice.
Extra
deposits address the liability side of a balance sheet. But the asset side can
also be addressed. This is usually done via securitisation.
Securitisation
Loans are
assets which can be on-sold. Pooling loans and then issuing securities
representing a share of the pool is called securitisation. The securities can
then be sold to third parties. Being entitled to a share of a large pool is
less risky for an investor than being exposed to say one or two loans. For a
bank selling securitised loans, its loan portfolio has been reduced and its cash
a/c and/or reserve a/c boosted.
Table 9:
Bank lending before and after securitisation
|
|||
ASSETS
|
LIABILITIES
|
||
Before
|
|||
Cash
& investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
90
|
||
100
|
100
|
||
After loan proceeds of $5 spent
|
|||
Cash
& investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
1
|
Equity
|
10
|
Loans
|
95
|
||
100
|
100
|
||
After loan securitisation/sale of $5
|
|||
Cash
& investments
|
4
|
Deposits
|
90
|
Exchange
settlement a/c
|
6
|
Equity
|
10
|
Loans
|
90
|
||
100
|
100
|
||
Investors like asset backed securities (ABSs) if
they’re after income producing investments with reasonably predictable returns.
If the assets are mortgage loans for housing they’re called residential
mortgage backed securities (RMBSs). But other loans are also securitised, car
loans, credit card loans for instance. ABSs usually contain tranches with
varying level of risk. Lenders such as banks will make a commission when the
loans are securitised and transferred off their books. The balance sheet will
be in better shape for the next round of lending. It will be in better shape particularly
if the bank has managed to offload dodgy loans.
To
reiterate, securitisation is a means to restructure the asset side of a bank’s
balance sheet. Deposits or wholesale funding restructure the liability side. To
achieve securitisation in the example below, mortgages (1000) are tipped into a pool. Shares/securities(6)
are issued which gives security holder a proportionate share of all mortgages
in the pool. The securities are sold to larger wholesale investors.
Government activities
In this context we
are referring to the federal government.
Conventional wisdom maintains that the government
needs money in its account before spending. It does this by raising taxes or by
borrowing. Both have the effect of reducing bank reserves. But reserves only
arise when governments spend. Spending precedes taxation or borrowing, not the
other way around as is commonly believed.
Only the
government can create reserves and only the government can withdraw them. When
the government spends, reserves are boosted. Increased customer deposits (bank
liabilities) occur simultaneously with increased reserves (bank assets).
When
government borrowing occurs reserves are reduced, and the bank and/or bank
customers receive a bond, an IOU from the government.
Too many
reserves will lead to banks requiring a better rate of return on those
reserves. Issuing bonds achieves this. Banks pay interest to depositors, so
they will want a return on the increased reserves that they are holding. The
RBA pays banks the official cash rate less 0.25%. The official rate is
currently 1.5%. If banks run out of
reserves the RBA will lend them but charge the official rate plus 0.25
%. If banks are short of reserves, remembering they always have to maintain a
positive balance in their reserve a/cs, they are more likely to borrow from
another bank at the official cash rate. That is the purpose of the official
rate, to set a price on default borrowings. Whilst the official rate may
influence mortgage rates it is by no means the sole determinant.
Bonds pay a
higher rate of interest than money in reserves. Government borrowings, if only
to ensure the government’s a/c is in credit before spending, are therefore a
form of corporate welfare for banks. It must be noted that governments borrow,
thereby reducing reserves, for reasons of monetary policy, not just to raise
money.
The government
transacts most of its business at the RBA. The following is a snapshot of the
RBA balance sheet.
Table 11:
RBA balance sheet $ billions
|
|||
ASSETS
|
LIABILITIES
|
||
Investments
|
176
|
Bank
notes/coins on issue
|
76
|
Reserve
a/cs
|
30
|
||
Aust
government a/c
|
40
|
||
Other
liabilities
|
16
|
||
Equity
|
14
|
||
176
|
176
|
||
Reserve a/cs which are assets for private banks
appear as liabilities on the RBA’s balance sheet. As does the Australian
government’s a/c. At last glance there was $40 billion there, roughly 2 months’
worth of outlays. When private banks require more notes and coins for their
customers, the RBA swaps reserves for the notes and coin. Currently there’s
about $76 billion in circulation. The RBA’s assets of $176 billion consists of
bonds and other investments, gold and foreign currencies.
The government adds to its a/c via taxation or
borrowing from the private sector. In both cases there is simply a decrease in
banks’ reserve a/cs and an increase in the government’s deposit a/c. When it
spends the process is reversed.
The government could if it wished, spend without
raising taxes or borrowing from the private sector. Using the above figures imagine if it spent $60
billion, which is $20 billion more than the balance of its deposit a/c. The RBA
could lend the government $20 billion. In practice it would follow a more
circuitous route by buying bonds that the government had issued. The effect is the
same. Issuing bonds reduces bank reserves. The RBA then buying the newly issued
bonds would restore bank reserves. The RBA’s balance sheet increases by $20
billion with just a click of a mouse. Incidentally it increased by $30 billion
in 2017 and no-one noticed. This is what would happen:
Table 11: RBA balance sheet after govt overspend
|
||||
ASSETS
|
LIABILITIES
|
|||
Investments
|
176
|
Bank
notes/coins on issue
|
76
|
|
Loan
government
|
20
|
Reserve
a/cs
|
90
|
|
Aust
government a/c
|
0
|
|||
Other
liabilities
|
16
|
|||
Equity
|
14
|
|||
196
|
196
|
|||
Reserve a/cs rise to $90 billion. Reserves may get shuffled from bank to bank
but only government can reduce them. As we have noted reserves attract interest
at 0.25% less than the official rate, in other words only 1.25%. One reason for
reducing reserve a/cs by borrowing and issuing bonds is to give the banks and
their customers a higher rate of return.
Shadow banking
Shadow banks are essentially vehicles designed to
avoid banking rules. They are involved, as are banks, in borrowing and lending
financial products. If banks as most
people know and experience them, is the iceberg above the surface, then shadow
banks are the below surface out-of-sight part of the finance industry. What distinguishes
banks from shadow banks is the structure of their balance sheets. A bank can
accept deposits, essentially unsecured loans from lenders. Governments even
guarantee the unsecured deposits. Shadow banks are not authorised deposit
takers. The liability side of their balance sheet is usually made up of equity.
When one invests one receives a unit certificate representing a share of
equity, not a deposit certificate representing an unsecured loan. Banks
accordingly require more regulation. The asset side of shadow banks is also different.
Direct loans are rarer. Instead the assets are ABSs and other securitised
products transferred from banks, often crappy loans given questionable ratings
by conflicted rating agencies. Once ABSs move across into the shadow world of
investment bankers all hell breaks loose. ABSs are sliced and diced into
tranches with varying amounts of risks, combined with tranches from other ABSs
to produce new products called collateralised debt obligations (CDOs). Other
investors and hedge funds acquire CDOs.
Summary and discussion points
·
Banking as
currently practiced principally involves the creation of money out of credit.
Money is essentially a medium of exchange and credit is a method of deferred
payment. The two functions, however, can
and should be separated. They are conjoined twins overdue for separation.
·
The Australian
government can create money without debt. We need a mixed system of money creation. Outsourcing all money
creation to private banks hasn’t worked. Has the public interest been best served?
·
Money is a public
good. The government can create money/deposits just as private banks currently
do, simply by spending and crediting depositors’ a/cs at the RBA.
·
Government spending
increases private assets. Bank reserves increase simultaneously. The question
then become….. does the RBA pay interest on the extra reserves or does it
create a debt for itself by draining reserves and issuing a bond? That’s why
bond issues can be seen as welfare for banks. Why create a debt when it’s not
necessary?
·
If you look at the
Australian government’s balance sheet there was negative equity of $318 billion
at 30th June 2018, due mainly to the $585 billion of bonds on issue.
At that time the RBA had positive equity of $14 billion. If one were to combine
the two, present a consolidated view, which is quite appropriate because the
government owns the RBA, then the consolidated negative equity position would
be $304 billion. If the RBA lent the government money or bought purpose issued bonds as suggested above, its
consolidated net equity positions wouldn’t change. It’s essentially lent money
to itself. This is how governments can create debt free money.
·
Reducing the
ability of private banks to be the sole creator of money is a serious option.
Recently, in June 2018 there was a referendum in Switzerland aiming to prevent
money creation by private banks. 24% voted to remove the ability of private
banks to create money and to confine the practice to government. It was a
surprisingly high vote in favour of curbing bank behaviour.
·
Prima facie, money
creation by the government is no more inflationary than money creation by
private banks. In fact, it may be less so. Inflation occurs when too much money
chases too few goods or services. In today’s economy we have masses of
unemployed resources and a huge demand for more services, but supposedly no
money to employ the resources to help satisfy the unmet demand. Money creation
by banks has mainly been channelled into buying second hand housing, not
boosting the real economy. The effect has seen house prices growing faster than
the real economy, necessitating increased extractions from the real economy to
service the increased loans. As we have seen, loan repayments, if and when they
occur, won’t provide a source of funds to be then lent out to the real economy.
That notion is based on an incorrect view of how banks operate.
·
Banks
have distorted the economy for their own ends. Banks create money to maximise
the returns to banks, their managers and shareholders. What’s the most
profitable area? To businesses which may grow the economy? Too risky? Mortgages
to home owners are easier? With a taxation system that encourages investment in
residential property, the demand for homes is governed by the supply of
finance. Credit is essential for growing economies. But if credit grows much
faster than the economy itself, an imbalance must occur. That imbalance in
modern Australia is a growth in house prices faster than the economy
itself. A good thing? Not if the money needed to service the ever-increasing
loans must come from the real economy. Where else? We’ve granted banks the
exclusive right to create money and it’s been channelled into excessive
mortgages which increasingly need funds to be extracted from the real economy
to service the loans and keep profits flowing to banks and their shareholders.
The biggest loser in all of this is the real economy as distinct from the
financial world of paper shufflers, bankers, accountants and real estate
agents. Evidence of excessive mortgages have been revealed
at the banking Royal Commission. Possibly as much as $500 billion of total
mortgage debt of $1.8 billion has been based on ‘liar loans’ using dodgy income
figures for borrowers and a massive understatement of borrowers’ ability to
service loans, based not on actual or estimated expenditure by households but
rather on HEMs (Household Expenditure Measures). Westpac has just received a
$35 million fine for a breach of consumer protection laws for using HEMs as a
measure of borrowers’ ability to service loans. Many have labelled this banking
behaviour as fraud. Regardless it massively undermines the real economy. The
following shows how banks have been forced to revise estimates of household
living expenses, which directly affects the loans that banks will approve. Reductions
of up to 42%.
Table 10: Major banks’
reduction in borrowing limits
·
GFC in part caused by fraudulent behaviour involved
with securitisation. Securitised products sold to unsuspecting buyers. The
sellers knew they were dodgy and in some cases designed them to fail so they
could take bets against them ….…The Big Short. The Royal Commission hasn’t
looked at this problem in Australia.
·
Outsourcing settlement services to a few private
banks is no longer necessary. To
facilitate settlements following the digital revolution it would be a simple
matter for everyone to have an account at the RBA. It’s called competitive
neutrality. We buy airline tickets direct from airlines rather than travel
agents, online newspapers directly from the publishers rather than newsagents,
yet we are forced to deal with a few banks if we want settlement services. Why
shouldn’t we be able to access settlement services directly from the wholesale
operator, the RBA rather than having a private bank clipping the ticket? It would
be more efficient. Additional assistance could be given by settlement
providers. We don’t necessarily need private banks to provide settlement
services. There are other ways.
·
Without reserves
there would be a lesser need for the government to issue bonds (IOUs) which it
does now in part to drain reserves. Government borrowings would be lower.
· If a bank’s balance sheet ends up
being the same, regardless if one accepts the view that loans create deposits
or the alternative hypothesis that deposits are needed to lend, is it not just
a nit-picking question? No, it’s not. Accounting identities often give a
valuable snapshot of reality but give no clue as to the direction of causation.
The direction of causation is crucial if one is trying the model the macro
economy. The loanable funds hypothesis doesn’t adequately explain that if
savings being an alternative to consumption are a prerequisite to lending, then
why did money expand as rapidly as it did over the last 20 years, not only here
in Australia but on a global basis. In any event loans creating deposits is
what happens in practice. How can one model the economy if one gets the
direction of causation wrong? The loanable funds theory allowed banks to be
ignored in economic models because they were simple intermediaries linking
borrowers with lenders. That’s one reason economists failed to predict the GFC.
But slowly acceptance of how loans create deposits is filtering thru the
profession. As recently as Sept 19th, Assistant Governor Kent of the
RBA gave a speech on money, in part noting that loans create deposits. Deposits
are money.
· People think when a bank accepts a
deposit it has more money to lend? What
else would a bank do with “my money” is a not an uncommon reaction. But it
shows a misunderstanding at both the macro and micro levels. At the macro level
there is no change. The aggregate level of deposits and reserves across the
economy does not change as we saw when we discussed settlement involving two
banks. At the micro level an additional deposit is accompanied with a similar
increase in reserves. But as we have seen reserves aren’t lent. Increased
reserves simply give the bank a little more liquidity. If the additional
deposit is then use to reduce a loan, then both sides of the banks’ balance
sheet are affected…. the deposit on the liability side and the loan on the
asset side are both reduced. The bank doesn’t have a pile of money it can lend to
someone else. The bank can and will create a new loan out of thin air when the
next eligible customer asks.
· A similar misconception occurs when
the almost universal belief in the need for a federal government surplus as
soon as possible is trotted out. A surplus doesn’t result in a pile of money
accumulating somewhere which provides a buffer for the future. The government can
create money out of thin air if it wishes just like a private bank. It’s
actually better than a private bank because it can be debt free money.
· As an aside a government surplus
implies a private deficit. Thanks to greedy banks Australia has the second
highest household debt to GDP in the world. The private sector is not ideally
placed to take on more debt which inevitably must follow if the government
moves to a surplus.
·
Banking requires
regulation because of the way balance sheets are structured. There are financial
products on both sides of the balance sheet. The asset side contains loans and
the liability side contains deposits. Regulations are avoided by shifting
assets and liabilities into the shadow world. Players jump the boundary and
continue playing where the rules don’t apply. Regulation is hugely difficult
because of this boundary problem. One person’s financial liability is someone
else’s financial asset. Balance sheets become linked like a daisy chain. A fall
in the value of one asset can have a domino effect thru the system as happened
in 2007/08. One proposal which will prevent daisy chains is a solvency rule
that would require a company’s equity to exceed its financial assets at all
times. This would apply to all companies not just banks. The effect on other
companies would be negligible because few have financial assets exceeding
equity. Special rules would be needed for insurance companies. The boundary
between banks and shadow banks would disappear.
·
Banks would have
additional competitors providing credit whose source of funds would come from
equity not unsecured loans. If asset values fell then losses are borne by
equity holders. No need to give banks an implicit subsidy by guaranteeing
deposits/liabilities. This subsidy is currently estimated to be worth $5
billion annually. Banks could still create loans provided they had enough
equity. Banks could still transfer loans, via securitisation to others to allow
room to create of more money/loans provided the transferee had enough equity.
Credit could be provided by anyone with equity. The provision of credit would
be largely separated from money creation. Banking as we know it, the creation
of money out of credit would end. Governments would create money as required to
pursue economic and social goals in addition to that raised by taxation and
bond issues.
Further reading
Nicholas Gruen’s op ed https://www.thesaturdaypaper.com.au/opinion/topic/2017/04/15/making-the-reserve-bank-peoples-bank/14921784004504
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