Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

The trouble with [talking about] banking

by JakeS Fri May 13th, 2011 at 05:40:01 AM EST

One of the major problems in discussing the financial sector is that we have at least three main narratives of what banking is.

The Conventional Wisdom:


  1. Alice goes up to a bank and gives it one hundred gold coins, and the bank gives her a note saying she owns 100 gold coins in its vaults.
  2. Bob goes up and asks the bank to borrow fifty gold coins. The bank looks at Bob's business plan and decides to give him fifty gold coins. In return, Bob gives the bank a note saying that he will pay it back, with interest.
  3. Charles goes up to the bank and asks for thirty gold coins. The bank looks at Charles' business plan, decides that it wants nothing to do with it and tells him to sod off.

You can add various complications, such as fractional reserve banking, checking accounts where the gold never leaves the vault once deposited (except during bank runs), and such. But the basic narrative is that Alice deposits money, which the bank then uses to make loans.

Paper money, it is imagined, works the same basic way. Except that instead of digging it out of a mine you print it at a central bank, a notion which is slightly ominous and invokes images of wheelbarrows and invading Poland.

[editor's note, by Migeru] Originally posted as a comment


The orthodox liturgy


  1. The central bank prints money, and sells it to private banks, in exchange for securities of unimpeachable value (such as gold or government bonds).
  2. Private banks use fractional reserve banking to create new money. The ratio between bank money and central bank money is the "money multiplier."
  3. Alice, Bob and Charles go up to the bank and ask for loans. The bank looks at how much money it can create from the reserves it has, realises that it can only lend to one of them
  4. The bank asks the prospective borrowers what interest rate they are prepared to pay. Alice says 4 %, Bob says 5 % and Charlie says 12 %.
  5. The bank looks at Charlie's business plan, and tells him to sod off.
  6. The bank looks at Bob's business plan. Since it looks OK, and Bob offered a better return than Alice, the bank lends to Bob.
  7. By adjusting the supply of central bank money, the central bank can determine how many of the three the private bank is able to lend to. Allow it to lend to too many, and you get inflation. Allow it to lend to too few, and you get economic paralysis due to lack of investment.
  8. If the central bank overshoots the money supply enough to enable the private bank to lend to all three, the bank will have an incentive to lend to Charles even though he has a dodgy business plan, because it has free money lying around.

Again, you can add various embellishments to this (such as the interbank market), but this is the core narrative.

What actually happens


  1. Alice, Bob, Charlie and Dennis go up to a bank and ask for loans.
  2. The bank looks at the borrowers' business plans. It then tells Charlie to sod off.
  3. The bank asks how much margin the remaining three candidates are prepared to put down. Alice says 20 %, Bob says 20 % and Dennis says 15 %. Charlie doesn't say anything, because he isn't there anymore, but if he had been there he would have said 10 %. (Margin is the "money down" that you pay for out of your own pocket. So if you post a € 100.000 house as collateral for a mortgage at 20 % margin [or "20 % down"] then it means that you only want to borrow € 80.000.)
  4. The bank wants 20 % down, so it tells Dennis that it must regretfully decline his application.
  5. The bank asks what they are willing to pay. Alice says 4 % and Bob says 5 %. Charlie and Dennis aren't there, but if they had been they would have said 12 % and 5 %, respectively.
  6. The bank looks up the central bank's policy rate, which turns out to be 2 %. The bank knows that its overhead amounts to 1½ % of its portfolio, and estimates that Alice and Bob both have a 1 % risk of going bust. So it adds that as well, for a total interest rate of 4½ %.
  7. Since Alice can pay less than that, the bank must respectfully decline her application. Since Bob can pay more than that (and still have a viable business model), he gets to borrow.
  8. 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.
  9. If the central bank discovers that banks can borrow in the interbank market for less than the policy rate, it sells some bonds. Since bonds are not valid for covering liquidity requirements, this removes liquidity from the interbank market, forcing the interbank market to ration liquidity by price. Conversely, if the central bank finds that banks must pay more than the policy rate to borrow in the interbank market, it buys some sovereign bonds, to depress the interbank rate.

The most important difference to notice is that the marginalist narrative pretends that the central bank prints money first, and then the private banks lend it out. Whereas in the real world, private banks lend out money, subject to the constraint that the loan must be remunerative given the interest rate target defined by the central bank. And only after the fact does the central bank prints money in order to defend its interest rate target.

So the central bank can't cause bubbles by "printing too much money" in an effort to keep interest rates low. What happens instead is that private banks fail to perform due diligence in steps 2 and 4. If the private bank allows Charlie and Dennis to slip past steps 2 and 4, then the central bank can't do anything about that. If the central bank wanted to crowd out Charlie and Dennis - who are bad risks - by raising interest rates, it would have to raise interest rates above 12 %, which would kill Bob's application stone cold dead as well.

Further, you will notice that Alice was actually a good risk (same margin and default risk as Bob), and was able to pay more than the bank needed in and of itself (the bank needs 2½ %, she could pay 4 %). So why did the central bank kill her investment by imposing a further 2 % return requirement? Because 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.

What Mig was proposing is that instead of steps 8 and 9 above, the central bank should offer to lend the bank money directly to cover its liquidity requirements. Because that way, the central bank can get to take a look at the bank's balance sheet (since the bank has to post collateral).

What I did was take it a step further, and argue that the central bank should demand that private banks put up the whole loan amount, but then offer to lend the bank the money that it needs to post, up to a certain margin requirement. Because then, if the private bank allows Charles and Dennis to slip through bullets 2 and 4, the central bank can say "look, Charlie is a bad risk - we won't lend you any money with his note as collateral," and then the private bank will have to go gamble with its own money (as opposed to being able to gamble with money it borrows, in effect, indirectly from the central bank through the interbank market).

Moreover, the central bank can also say "look, Dennis may be a good risk, but we're only lending you 72 % of the value of his house (and only 90 % of the value of his mortgage), because you need to put up ten percent margin on your loan, and someone - you or Dennis or someone else, we don't care - has to put up twenty percent margin on Dennis' loan." So the bank is allowed to lend to Dennis, but it has to find the proper margin somewhere.

As an aside, the Austrians are conceptually stuck in the Conventional Wisdom "commonsense" view of money. Which is why they seem to be superficially in agreement with people who actually understand money: Both groups criticise the orthodox liturgy, from a perspective that focuses on the interaction of debt with financial stability.

The difference is that the Austrians (a) are actually a step further removed from understanding money than the marginalists. And (b) have taken leave of their sanity.

- Jake

Display:
... comment rescue.

Most of my diaries these days seem to start their lives as comments, for some reason. But I think it was worthwhile to keep this around in a more easily searchable format.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 13th, 2011 at 06:11:42 AM EST
Always good to have another run through the reality of the system, and here you address the monetary myth of 'fractional reserve banking'.

The 'tax and spend' myth - that taxes are collected and then spent - is just as pernicious, and just as pervasive.

The trouble is that we are up against a completely pervasive 'Big Lie', and any alternative narrative is treated as financial pornography, and not allowed to pollute our weak minds.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Fri May 13th, 2011 at 05:01:55 PM EST
This diary/comment illustrates and greatly clarifies the mechanisms by which the Central Banks use Public Open Market Operations, POMO, such as purchasing bonds, to control interest rates. So let me see if I have got this right.

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. 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?

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. It doesn't seem too surprising that the banks preferred less oversight by the central 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" 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. Actually, the HFA, Fanny Mae and Freddy Mac were facilities for underwriting and permanently holding mortgages while returning money to the originators, but they had standards, even if inadequate. There were no such problems with the MBS packagers.

This whole process was endorsed by prize winning economists of the highest repute who worked at universities that were supported by people who believed that businessmen should have the fewest restraints possible and would, in their own self-interest, police and restrain themselves. The result is the ongoing, unacknowledged process of debt-deflation which we are experiencing. And in this climate it is acceptable to use the discount window because no one now trusts the large commercial banks that remain to put together a mortgage backed security and not design it to fail and simultaneously bet against it with a CDO.

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. 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.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri May 13th, 2011 at 05:06:30 PM EST
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.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 13th, 2011 at 06:36:36 PM EST
[ Parent ]
ARG:
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" 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. Actually, the HFA, Fanny Mae and Freddy Mac were facilities for underwriting and permanently holding mortgages while returning money to the originators, but they had standards, even if inadequate. There were no such problems with the MBS packagers.
Jake:
"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.
Myself (2 years ago)
Let me give you a couple of quotes. (Emphasis mine)
Role of the SPV

To understand the role of the SPV, we need to understand why a corporation would want to raise funds via securitization rather than simply issue corporate bonds. There are four principal reasons why a corporation may elect to raise funds via a securitization rather than a corporate bond. They are:

  1. The potential for reducing funding costs
  2. To diversify funding sources
  3. To accelerate earnings for financial reporting purposes
  4. For regulated entities, potential relief from capital requirements

We will only focus on the first of these reasons in order to see the critical role of the SPV in a securitization.2
----
2For a discussion of the other reasons, see W. Alexander Roever and Frank J. Fabozzi, "Primer on Securitization," Journal of Structured and Project Finance, Summer 2003, pp. 5-19.
(This is from Chapter 14 of Fabozzi's Bond Markets, Analysis, and Strategies)

Wikipedia: Frank J. Fabozzi

Frank J. Fabozzi is the Frederick Frank Adjunct Professor of Finance at Yale School of Management. He has taught at Yale University since 1994. Fabozzi, an investment management expert, is a Wall Street authority and editor of the Journal of Portfolio Management. He is a consultant to several financial institutions. He was inducted into the Fixed Income Analysts Society Hall of Fame in November 2002. He is also a Fellow at the Yale International Center for Finance.
Wikipedia: Special purpose entity
Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.


Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sat May 14th, 2011 at 05:34:51 AM EST
[ Parent ]
IIRCC, there is a single building in Grand Turks that is home to several hundred corporations, one of which the Houston, Texas former billionaire felon Stanford owned. Enron had SPVs there. Others are there for tax purposes. An international corporation will show the majority of its profits as originating out of a file cabinet in that building in Grand Turks so as to shelter them from taxes in real countries, etc.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 09:47:05 AM EST
[ Parent ]
I dislike the term "lend-able cash," because the bank creates bank-money by the stroke of a pen.

Point taken. I was unsatisfied with the term myself and artlessly rewrote the sentence at least once, but still came up with garbage. Compliance with regulatory requirements is the concept. Perhaps I should have written "...to reload their pen with Central Bank approved ink."

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 09:57:04 AM EST
[ Parent ]
....or to charge their computer system with Central Bank approved electrons.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 10:02:18 AM EST
[ Parent ]
I like the ink pen analogy. It is perhaps the only universal symbol of true business power - the expensive traditional phallic pen, and the signature. The pen also denotes a resistance to IT and technological innovation.

It's all about contracts and signatures. The rest of us use PIN codes.

You can't be me, I'm taken

by Sven Triloqvist on Sat May 14th, 2011 at 10:18:47 AM EST
[ Parent ]
The ambiguity of multiple interpretations of money workings is by design, surely enough.

But the stated scenario does not give a full picture to me.

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? Would love to see how this proportionality works.

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!

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

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

And of course, if our bank has excess reserves, it has to borrow from the CB (even) less if at all. In a booming economy, the newly created money gets deposited in some bank, and liquidity reserves increase for virtually all banks, right? So there is hardly any need to borrow from the CB at those times, I guess.

Of course, things are very different when the credit market is collapsing and loans are underperforming. But then I see problems only in the assets/liabilities ratio, not in liquidity...

[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. Certainly I don't see inflation following wages during a hyperinflation. If the problem is excessive money creation, then it is happening during a credit boom (like pre-2008). Why no one was crying about inflation then? At these times of desperate debt paybacks monitory obligations and volumes are actually being destroyed. How much does the CB "printing" offset decreasing M-volumes?

Then I have a problem with the assumption that the bank tries to balance it costs and profits like any other business. 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. And then they get into problems when they should only enjoy asset returns?!!

Banking has more social impact than governing. Even if banks underperform as businesses, most of them are having better lunches than ever.

by das monde on Thu May 19th, 2011 at 06:46:58 AM EST
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.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu May 19th, 2011 at 07:05:40 PM EST
[ Parent ]
Thank you a lot. A few further questions.

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.
But are those running costs so high that they are comparable to a fat % of the portfolio, in properly run economies? I see only own real estate upgrades as comparably substantial costs.

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,

Wikipedia says somewhat otherwise:

In the United States the required reserves, also called the liquidity ratio, is set by the Board of Governors of the Federal Reserve System. Requirements vary based upon the size (in total amount of transactions) of the depository institution. For institutions with up to $10.7 million, there is no minimum reserve requirement. Institutions with over $10.7 million and up to $55.2 million in net transaction accounts must have a liquidity ratio of three percent. Institutions with more than $55.2 million in net transactions must have a liquidity ratio of 10%.

These requirements apply only to transaction accounts such as checking accounts (collectively called M1 transactions in the analysis of money supply), and do not apply to time deposits such as CDs, savings accounts, or deposits from foreign corporations or governments. For these account classes, the fractional reserve requirement is one percent (1%) regardless of net account value. When a bank falls below its reserve requirement, it can take out a very short-term loan (often for a period of 24 hours of fewer) from the Federal Reserve or from another bank with excess reserves.

What is then the difference between liquidity and solvency? For any other business entities, the liquidity ratio is just the quotient Liquid assets / Total assets.

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.

So, consumers have to pay to compete with the lending excess reserves option. Does this mean that the banks automatically get the CB rate gains of the liquidity reserves? Or does, in effect, the CB claims that rate out of all M1 circulation? Do the CB assets increase at all times?

by das monde on Fri May 20th, 2011 at 03:32:26 AM EST
[ Parent ]
What is then the difference between liquidity and solvency?
Solvency is the abstract quality of being able to use one's assets to meet one's liabilities. Solvency is in principle, assuming the book value of an asset allows it to be used in payment of the liabilities.

Liquidity is the ability to use an asset for payment of momentarily maturing liabilities, or more narrowly the ability to liquidate the asset for cash with which to pay the liabilities.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Fri May 20th, 2011 at 05:21:28 AM EST
[ Parent ]
But are those running costs so high that they are comparable to a fat % of the portfolio

Well, profits alone is a cost that can't go much below half a percent of the portfolio: 5 % return on equity is not outrageous, and you don't want banks to be gearing harder than about 10 or 20 to 1 in the ordinary case.

Wikipedia says somewhat otherwise

No, it says the same thing.

So, consumers have to pay to compete with the lending excess reserves option.

Yes.

Does this mean that the banks automatically get the CB rate gains of the liquidity reserves?

Yes, any excess liquidity will be remunerated at the policy rate.

Do the CB assets increase at all times?

Yes, if the CB is doing its job right, its balance sheet should continually increase.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 20th, 2011 at 08:32:45 AM EST
[ Parent ]
One more thing.

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

I reckon this is a social-political preference, not an economic imperative. Where are Randians on this?

by das monde on Fri May 20th, 2011 at 03:44:56 AM EST
[ Parent ]
I reckon this is a social-political preference, not an economic imperative.

Yes. See Mig's sig.

Where are Randians on this?

Insane. And blaming the government in defiance of obvious facts. As they are on every other subject.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 20th, 2011 at 08:25:57 AM EST
[ Parent ]
This diray strating as an answer to a question of mine, I have a follow-up.

My question was:

But how is this related to the story of the wheel of loans and deposits that Migeru quoted?

So if we view this in the same terms as the wheel of loans and deposits I think it looks something like this:

Bob needs 10 units of currency to invest.

His plan is sound and he has 2 units of his own (thus reaching the margin of 20%) so the bank creates another 8 units for him.

Now the bank needs to cover this with central bank money to meet the reserve requirement (say 10%) so they borrow 0.8 from the central bank (Or does the interbank market mean they borrow it from other banks? Does it matter?).

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.

So the point of deposits is to offset further loans from the interbank market? And if there is excess it can be loaned to other banks via the interbank market?

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?

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Fri May 20th, 2011 at 07:20:04 AM EST
(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.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 20th, 2011 at 08:39:17 AM EST
[ Parent ]


Display:
Go to: [ European Tribune Homepage : Top of page : Top of comments ]

Top Diaries