Mig noted that POMO is the current tool of choice for central bankers. The other major tool available is the "discount window", where banks can receive unrestricted funds for a specified term by posting performing mortgages, etc. with a "haircut" in return for cash, or "high powered money" which is one way banks turn a large portion of performing loans back into lend-able cash.

Yes, although I dislike the term "lend-able cash," because the bank creates bank-money by the stroke of a pen. And that bank money is perfectly lend-able in and of itself. The repo only comes in as a way to make the central bank happy, by having enough central bank money to cover regulatory requirements.

(Private banks want to make sure the CB is happy, because if the CB is ever unhappy with them, goons with guns will come and shut down their place of business.)

These operations are called repurchase agreements or "repos". The bank posts a $100K face value loan document, takes a 5% "haircut" and gets $95K for one week, one month, one year at a specific interest rate. At the end of the agreed time it pays back the amount loaned and the interest owed. The "haircut" was the margin that protected the CB against a decline in value of the collateral. Is the terminology used and the process described correct?

Yep.

Alternative words for the same process are "rediscounting" (since the original note is, in banker jargon, a "discounted note"), "discount window operations" (in the US) and "main refinancing operations," or MRO (in the €-zone).

I prefer to use "rediscounting," because "repos" may also be carried out between private entities, while rediscounting is only done at the central bank rediscount facility.

I'm also arguing that the haircut should be at least 10 percent, and that the haircut should be measured from the lower of the face value of the note or 80 % of the central bank's valuation of the collateral.

In a comment on his Minsky's Wheel diary Mig noted that CB practice, prior to the GFC, had been to rely on open market operations almost exclusively, as people had come to associate access to the "discount window" with a bank being in distress. But Mig noted that use of the discount window gave the CB a greater insight into the condition of the bank's balance sheet, and therefore should be a better way of controlling the monetary system than the comparatively crude means of using open market operations.

Yep.

It doesn't seem too surprising that the banks preferred less oversight by the central banks.

Yep. But private banks should not be setting central bank policy. The CB is, in the final analysis, the one who can dispatch goons with guns, so it has no business cow-towing to the wishes of private banks.

When we look at the GFC we see that one of the chief methods by which the great debacle was brought about was through the use of Mortgage Backed Securities, which were private market, presumably permanent alternatives to CB "repo" operations and which were highly profitable to the originators, but which were highly dangerous to the financial system. The same function as performed by the MBSs could have been performed by central banks, but they then would have been responsible to actually look at the mortgages they were taking in for "repo"

Yep.

and the loan originators could not have assumed that they were no longer responsible for any aspect of the loan, as they would be liable to repurchase the loans after a fixed time.

Weeell, a lot of the players who sold toxic waste in the last bubble also sold their marks repurchase agreements. This allowed them to move the toxic waste off their balance sheet for accounting purposes (and get paid for it), even though they retained the exposure in economic terms. So fully closing that loophole requires a reform of the accounting rules for contingent liabilities.

The strongest protection in the system I propose is that after the fact you'll be able to point to some specific dude at the CB who actively broke the rules if toxic waste gets on the CB's balance sheet and blows up. Whereas in the current system, you cannot point to the specific individual regulator who did not act - because everybody did not act. And the virtue of a full reserve system funded at the discount window is that almost everything important will end up on the CB's balance sheet in some form or another.

My suggestion will not prevent the private banks from creating mortgage-backed securities or other derivatives and playing games with them. Nor will it prevent suckers from being separated from their money when they buy into such scams.

But those are losing battles in any event. Con-men will be con-men and suckers will be suckers no matter how many sorts of snake-oil you outlaw - the only effective way to keep Joe Blow from losing his shirt is to keep him out of the money market altogether.

So effective reform will have to concentrate on protecting the core functions of the system, by giving the financial regulators direct access to the nuts and bolts (and balance sheets) involved. Then you can hang a big sign on the money markets saying "Abandon All Hope, Ye Who Enter Here" and let any sucker dumb enough to enter anyway get parted from his money in an orderly fashion that does not threaten to topple your entire economy into a serious industrial depression.

This whole process was endorsed by prize winning economists of the highest repute

Yep.

The remaining question is how many of those involved were consciously involved in a confidence game, how many were victims and how many were both.

That's easy. "Structured products finance" is a game of intentional obfuscation. Honest businessmen have no need to spend time and money on imaginative ways to obfuscate the nature of the product they are selling. So everybody who put together a "structured product" would have to know (or should be "deemed to have known") that it was toxic shit that would blow up in some poor schmuck's hands.

... they just didn't imagine that they might be the poor schmuck. (And indeed they were not - as they managed to promptly dump a lot of the toxic waste on Uncle Sam's balance sheet...)

The remaining task, if it is ever undertaken, is to prosecute those who broke laws. Normally, those who can be shown to have done so knowingly and deliberately would be dealt with more harshly. Who knows what will actually happen.

The most egregious offenders will receive a few Strongly Worded Letters from Congressional subcommittees. Maybe a subpoena or two. And have to suffer the indignity of having Matt Taibbi tear them a new one in Rolling Stone.

Other than that, nothing will happen to banksters in the best democracy money can buy. And in Europe not even that, as the crisis can be blamed on swarthy furriners who speak funny.

After all, unemployment is only at ten percent, and has almost stopped rising. Last time we had serious, systemic reforms, it involved 20 % unemployment, much greater hardship for the unemployed, a communist revolution still within living memory, and two world wars, which ensured that those 20 % unemployed young men knew how to handle a firearm.

And in only roughly half the places where that systemic change took place did it result in improvement. In the other half of the places, the brownshirts won.

- Jake

Friends come and go. Enemies accumulate.

The ambiguity of multiple interpretations of money workings is by design, surely enough.

I don't think so. But it is probably not a coincidence that there is no great effort made to dispel the confusion.

The bank knows that its overhead amounts to 1½ % of its portfolio

Seriously, is the overhead so practically proportional to the portfolio, or to the loan size?

No. If it were, it would not be "overhead."

The marginal cost for the bank of making a loan is basically the funding rate - aside from the need to obtain regulatory reserves, there is no direct cost to the bank. However, running a bank involves costs, and revenue must cover those costs. And since properly run banks in properly run economies have a more or less predictable portfolio size and more or less predictable overhead, you can divide one by the other to arrive at some overhead markup. Just like an industrial firm can divide its total expected overhead by its total expected sales volume to get its required markup, even though there is no direct connection between any individual sale and its particular contribution to the overhead.

Having lent Bob money, the bank now has more liabilities that it needs to provide regulatory liquidity reserves for. It therefore goes to the interbank market to borrow the money at the central bank's policy rate.

But the CB loan only increases liabilities!

No, it also increases assets, by providing the bank with central bank money.

The reason the bank wants to do this is that insured deposits must be covered by central bank money, but debt to the central bank must not. So borrowing from the central bank increases liabilities but does not increase the amount of regulatory reserves required.

This liquidity ratio is not the same as fractional reserve ratio, right?

Yes it is. Or, depending on how you define the fractional reserve ratio, it may be the inverse.

Does our bank has to borrow exactly the same amount from the CB as it lends to Bob?

No. Under current institutional arrangements, it only has to borrow between 5 and 10 %. However, if Bob takes the money he borrowed out of the bank, the bank must borrow the remaining 90-95 % of the amount he takes out.

If not,

The bank looks up the central bank's policy rate, which turns out to be 2 %.

why does it add the full 2% to the costs, rather than a fraction of it?

Because in principle Bob could take out the money he borrowed (by, for instance, paying somebody who banks with another bank). In that case, Bob's bank would have to borrow the money Bob takes out (minus the regulatory reserves it has already borrowed).

And of course, if our bank has excess reserves, it has to borrow from the CB (even) less if at all.

Yes, but that doesn't matter, because the bank can lend excess reserves either on the interbank market or directly to the CB. And the CB always makes sure that one of those two options would pay the policy rate. Because that's what CBs do.

In a booming economy, the newly created money gets deposited in some bank, and liquidity reserves increase for virtually all banks, right?

No, because liquidity reserves are decreased by exactly the same amount when you take the money out of the first bank as they are increased when you put it into the second one. The only way you can "put money into" the banks without taking it out first is by running government deficits. Which you typically do not want to do in a boom, unless you have a serious foreign deficit that you really should be doing something about.

[The] central bank wants to suppress investments that would be profitable on their merits, in order to create enough spare capacity (read: Unemployment) in the economy to prevent inflation.

The implied wages/inflation "mechanism" is still not convincing to me.

That is because you have a good bullshit detector. The implied wages/inflation mechanism is a nonsense. But as a matter of contemporary institutional reality, it is a nonsense that sets central bank interest rate policy.

Now, you certainly can suppress domestic inflation with higher interest rates. Because if you increase interest rates, you can create excess capacity in the economy. And when there is excess capacity, businesses can not well afford to raise prices, for fear of losing market share. But that is the dumb way to control inflation. It is also completely ineffective against imported inflation, and for countries with large hard-currency debts it creates a very real risk of a currency collapse.

Certainly I don't see inflation following wages during a hyperinflation. If the problem is excessive money creation,

But it's not.

Hyperinflation is what happens when a country with a structural foreign deficit (due to import dependencies, war reparations or failing to default on unpayable hard-currency debts) suddenly loses access to hard-currency credit. It has only the most platonic of relationships with the ordinary, everyday version of inflation (and the latter can certainly not turn into the former unless the country's currency policy is grossly mismanaged).

then it is happening during a credit boom (like pre-2008). Why no one was crying about inflation then?

Because the inflation was happening to asset prices. Which lazy money likes. It's consumer price inflation that lazy money doesn't like.

How much does the CB "printing" offset decreasing M-volumes?

In the €-zone it does not. In the US it does to some extent, since the US has made a reasonably determined fiscal response to the depression.

Then I have a problem with the assumption that the bank tries to balance it costs and profits like any other business.

Well, that's what they should be doing.

What they are actually doing at the moment is aiding and abetting (and participating in) asset-stripping the productive economy.

From what I could notice in post-Soviet transitions, banks were prospering well immediately, while they were basically just collecting liabilities (like saving accounts), not taking streams of asset returns yet.

Oh, but the banks in the post-Soviet transition were taking in rather a lot of asset streams. They were in the middle of the scams that let various mafiosi and oligarchs (but I repeat myself) rise to power and wealth. In fact, privatising and deregulating the financial sector may well have been the single most pernicious policy of the Yeltsin era, in terms of both economic consequences and deterioration of the rule of law.

Banking has more social impact than governing.

Banking is a form of governing, which is why it needs to be accountable to the government.

- Jake

Friends come and go. Enemies accumulate.

(Or does the interbank market mean they borrow it from other banks?

Yes.

Does it matter?).

No.

In the final analysis, the additional liquidity comes from the CB, since the CB is actively preventing the interbank rate from rising.

Now if Bob pays his money to someone who deposits them somewhere else then the bank in question (another bank, or a keeps it in a moneybin), then the bank needs to borrow another 7.2 units. This can be achieved from the interbank market or from deposits.

Yes.

So the point of deposits is to offset further loans from the interbank market?

From the point of view of the receiving bank, yes.

And if there is excess it can be loaned to other banks via the interbank market?

Yes. Typically to the bank the money is taken out of, because it's the one that'll need it.

That covers most of the money, except the 2 units Bob had to have in order to enable the creation of the rest. That had to come from government deficit spending right?

Either that or from Bob accumulating real capital that he can post as collateral. If you build a house yourself (and pay the appropriate tax on it), nothing in principle prevents you from taking out a mortgage on it.

But for all practical purposes, yes, government spending precedes investment, which precedes capital accumulation in a modern industrial society.

- Jake

Friends come and go. Enemies accumulate.