Why can't all banks be as safe from insolvency as the Bank of Canada?
I put a question on my final exam:
"What is a bank? Should banks have legally required minimum reserve ratios? What about 100% reserve ratios? Should banks have legally required minimum capital ratios? What about 100% capital ratios?"
I wanted the students to talk about illiquidity and insolvency. I only threw in the bits about 100% ratios to get them to think about trade-offs, by thinking about the two opposite extremes.
There is a long literature on banks with 100% reserve ratios. Forget that.
There is a literature on capital ratios. But sometimes it helps us get our thoughts clear by imagining an extreme case. What about banks with 100% capital ratios?
What would a bank with a 100% capital ratio look like?
I can think of two very different answers:
1. The bank has (say) $100 in chequable demand deposits on the liability side. And $200 in (say) loans on the asset side. So its net worth (shareholders' equity) is $100, and equal to 100% of its demand deposits. Basically, the shareholders give $100 to the bank in return for shares, and the bank lends out that $100, plus another $100, and creates $100 in demand deposits. But that bank (unlike the 100% reserve bank I told you to forget about) can still become insolvent. If its loan portfolio loses more than 50% of its value, that bank would become insolvent. It would need an infinite capital ratio to completely eliminate the risk of insolvency. (Or capital equal to 100% of its assets, which means it has no deposits at all, and isn't really a bank.)
2. The bank has $100 in loans, and $100 in chequable demand deposits, but those demand deposits are themselves shares in the bank. They do not have a fixed dollar redemption value. So if you want to say they are not really deposits, OK. But they are chequable. If you write a cheque for $20, the bank debits your chequing account by S shares, where S = $20 divided by the current price of shares. So the shares are not the medium of account (Bank of Canada currency remains the medium of account), but the shares can be used as a medium of exchange, provided those shares are "deposited" in the same bank whose shares they are.
That second 100% capital ratio bank cannot become insolvent, unless its loans lose 100% of their value. Because its own shares are its only liability.
There is a risk that cheques might bounce if the share price dropped too much in the short delay between looking up the share price to see what's in your account, writing the cheque, and the cheque clearing. But electronic debit cards could help resolve this problem, by shortening that delay.
(It's a bit like writing cheques on a closed-end mutual fund, where the mutual fund owns shares that are not themselves traded. I vaguely remember reading some monetary or finance economist writing about something like this. Was it Fischer Black? Or Fama? Both my memory and Googling skills have failed me. [Update: Bill Woolsey says "It's Fama. But Greenfield and Yeager's first pass at the BFH (for Black-Fama-Hall) emphasized purely mutual fund banking."])
[Just as an aside: what would happen if those banks bought put options on their own shares, to make their shares safer?? Do companies ever do that? It's too weird to think about.]
You can think of the Bank of Canada as a bank like that second case. Owning a $20 note is like owning 20 shares in the Bank of Canada. They are worth whatever the market thinks they are worth. Except they are non-voting shares. And they don't pay dividends. (They do pay dividends if you deposit them in your chequing account at the Bank of Canada, but only commercial banks and the government are allowed to do that). And the management turns over most of its profits from its loan portfolio to the government, the voting shareholder. The management issues new shares, and buys back old shares, to try to make capital gains on the shares stay at roughly minus 2% per year. In a worst case scenario, the Bank of Canada might fail to prevent the shares depreciating at only 2% per year. But the Bank of Canada can never go insolvent. Because it has a 100% capital ratio. Because its own shares are its only liability. It's a bank whose own shares are used as money.
Why can't all banks be as perfectly safe from insolvency as the Bank of Canada? They could be, if we imposed 100% required capital ratios on all banks, interpreted in that second sense.
(BTW, I didn't expect my students to give that answer.)
[Update: I now realise this post wasn't clear enough, so I am going to add this, from one of my comments below, to make it clearer how my 100% capital version 2 works:
Suppose I bank at BMO, and I have 100 BMO shares in my chequing account at BMO. The bank is like my stockbroker.
Suppose I write a cheque for $20 to buy a bike from someone who banks at TD. That cheque is an instruction to my bank to sell $20 worth of my BMO shares and transfer the cash proceeds to TD bank, which buys $20 worth of TD shares and deposits those shares in the bike seller's account.
Presumably other people who bank at TD are writing cheques to buy things from people who bank at BMO. So there is a central clearing house which is transferring reserves between banks (just like today), but is also buying and selling bank shares, just like the stock market does today.
If I want to withdraw $20 in currency from my account at BMO, the teller would give me $20, send an instruction to their broker to sell $20 worth of BMO shares on the stock market on my behalf, and debit my account the appropriate number of shares, depending on the current market price.
If the stock market were closed, because it's a weekend, so that the current price of BMO shares was not observable, BMO might need to impose a haircut on immediate withdrawals. You can only withdraw 80% of what is in your account based on Friday's share price, just in case BMO shares drop by 20% when the market reopens Monday morning. I think that is the only case where a delay comes in, and it's only a delay in withdrawing the full 100% of what is in your account.]