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I just read Tobin
http://cowles.econ.yale.edu/P/cm/m21/m21-01.pdf
It seems like he touches on a similar topic when describing reserve requirements and other regulations on banks being what set them apart as financial intermediaries (as opposed to "savings banks" or insurance companies... two examples he mentions), not the liabilities they issue. You don't agree with that "1st Tobin" completely I know, but is that an area of disagreement, or do you just disagree on the reflux part?

Tom: the point about required reserves being a tax on banks is not really controversial. Nor is it controversial to say that in some countries "banks" are regulated differently from things the law does not consider to be "banks". It would be more controversial to say that regulations like reserve requirements are the only thing that makes "banks" different.

Nick, thanks for this post. That is why it is important that ABRR also be applied to shadow banks - a point I make in my paper.

Best,

Tom

Given the trillions recently donated by taxpayers to banks, it’s a bit odd to talk about there being any sort of tax imposed by the country on banks. It’s the other way round: banks impose a tax on the country at large. I.e. there are a host of ways banks are subsidised: taxpayer funded guarantees for depositors, lender of last resort facilities, TBTF, etc.

Banks are inherently fragile. They borrow short and lend long and often take that process too far, with the result that they go running to government (aka the taxpayer) begging for free money: a tax by banks on the country at large.

In contrast, a 100% reserve bank or “full reserve” bank cannot possibly go bust. So it cannot impose a tax on the country. But of course it cannot lend either. But that’s not a problem: all we do is allow a different form of bank funded entirely by shareholders which IS ALLOWED to lend. But that can’t go bust either: i.e. if it makes silly loans all that happens is that the value of the shares falls.

And that’s full reserve banking for you. It’s beautiful. It cannot fail, so no more credit crunches and no more taxes imposed by banks on the country at large.

Banks with reserve accounts may be required to hold some reserves but they also get a whole range of benefits that come with having direct access to the central bank.

Nick, here's Mark Sadowski's response to me about M0 (basically it was never used in the US, only Japan consistently uses M0 the way Wikipedia does in their table I referred to (and thus the way I intended: paper notes and coins in circulation amongst the non-bank private sector, which is what I think Nick Edmonds meant by his Hn as well)): http://www.themoneyillusion.com/?p=26552#comment-328757

A related question is how many reserves a bank would choose to hold in the absence of a reserve requirement? Basel III regulations are pushing banks to do more to line up the cashflows of their assets and liabilities under the Liquidity Coverage Ratio (LCR). So I would say that banks will elect to structure their balance sheet in a more liquid way now than they did in 2007. If a bank pays an above market interest rate on its deposits they are subject to a 100% outflow assumption which is very punitive, so there's little incentive to attract deposits in this way. Ergo, short term deposit rates will tend to converge towards the overnight rate because any bank that would pay more than this will weaken their LCR. In other words, if required reserves are a tax, it's not a tax on bank shareholders, but rather on bank depositors as they receive less interest income than they otherwise would due to bank's needing to maintain higher levels of liquidity. Perhaps the required reserves ratio will end up disappearing as Basel III becomes the new regulatory benchmark.

Shadow banks raise funding through repurchase agreements and collateral rehypothecation to leverage up their balance sheets and make new loans. But they don't really replace traditional deposit taking instituions since their liabilities aren't checking and savings deposits. So I think it's still the depositor who ends up paying for the liquidity requirements that banks are forced to maintain.

Ralph,

"But that’s not a problem: all we do is allow a different form of bank funded entirely by shareholders which IS ALLOWED to lend."

Federal Government tells primary dealer banks: You must now issue equity when you want to buy our bonds
Primary dealer banks (voting shareholders) tell Federal Government: Piss Off

Constitutional crisis ensues.

Tom P: Thanks for your comment.

The way I see it, we can't avoid having a tax on currency, because of the risk of the ZLB, and because of the practical difficulties of (positive or negative) interest on currency. So the question is: where do we draw the line between taxing and not taxing substitutes for currency? No easy answer. And I'm not sure how easy it would be in practice to impose reserve requirements on "shadow banking".

Now if banks get benefits that shadow banks don't, like deposit insurance for deposits up to $X, then it would be reasonable to charge a fee on deposits up to $X to reflect the cost of providing that insurance. Deciding what that expected cost is won't be easy, but that isn't really a tax, but payment for a service. But I think that shadow banks are used for amounts that are much bigger than would be covered by deposit insurance.

I'm a bit hesitant to play the "Canadian card", because maybe we were just lucky, or too boring to get into big trouble, but is it a coincidence that we don't have don't have required reserves and also didn't have much of a financial crisis? Dunno.

Ralph: see my reply to Tom above. Plus the banking sector would be much smaller, and shadow banks much bigger, with 100% required reserves.

Philippe: yep, but see my above.

Tom B: wrong thread.

Dismal: "In other words, if required reserves are a tax, it's not a tax on bank shareholders, but rather on bank depositors as they receive less interest income than they otherwise would due to bank's needing to maintain higher levels of liquidity."

If we tax apples, and not pears, the shares of the burden of the tax that will be borne by buyers or sellers of apples will depend on the relative elasticities of supply and demand for apples. But either way, we would expect to see fewer apples and more pears.

"But they don't really replace traditional deposit taking instituions since their liabilities aren't checking and savings deposits."

That may be true, but they would still be a substitute. The question is: how close a substitute.

Frank,

The proportion of government debt held by banks in the US and UK is a small proportion of total government debt (2% in one country and 10% in the other last time I looked at the figures). So if banks stopped buying that debt altogether I don’t see there’d be a big problem.

As to primary dealers, they are just a particular way of distributing government debt. Their job could easily be done by a collection of bureaucrats in the Treasury / central bank . . . problem solved.

Nick,

Re your claim that the banking sector would be smaller under full reserve banking, you’re quite right: the present banking system is subsidised. Full reserve doesn’t need to be subsidised. Ergo the banking sector is smaller under full reserve.

And given that the banking sector is now TEN TIMES as large relative to GDP in the UK as compared to 1960, without our having reaped any obvious benefits, I don’t see that a smaller bank sector would be a problem.

Re you claim that shadow banks would be much bigger under full reserve, I don’t see why – as long as the rules governing big and small / shadow banks are the same (which they should be). Under full reserve you’d still get mega banks doing the big loans, and smaller ones doing smaller loans.

BTW my above points about full reserve are not 100% on topic, so thanks for putting up with me.

Ralph,

"As to primary dealers, they are just a particular way of distributing government debt. Their job could easily be done by a collection of bureaucrats in the Treasury / central bank . . . problem solved."

So could the distribution of any form of debt - tell me again why we need banks selling equity to lend when a bunch of bureaucrats in the Treasury could handle it - see:

http://en.wikipedia.org/wiki/First_Bank_of_the_United_States
http://en.wikipedia.org/wiki/Second_Bank_of_the_United_States

I think this post is pretty much dead on. How important it is is hard to tell, since there are multiple things going on in the data at important dates.

The Fed Funds rate being more or less equal to IOR is diminishing the tax problem nowadays, so you would think that traditional banks would be better able to compete with shadow banks. What you see is a big increase in checkable deposits after the policy change in 2009 where prior CD had decreased since the mid nineties:

http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=wO6

I feel pretty confident that the decrease in the nineties was the failure of commercial banks in the U.S. to compete with shadow banks, etc. After the innovation of IOR repo is down, which would seem to fit the logic:

http://s.wsj.net/public/resources/images/BN-AZ525_fundin_E_20140106120604.jpg

This all sounds great except for the fact the Fed start paying IOR right when the shadow bank sector blew up. There was a run on the shadow banks (repo) back to the traditional banks, right when IOR came on line. I might look at the data at higher frequency to see if anything can be seen.

Nick: Shadow banks are more about the other tax: capital requirements. Reserves are generally required for demand deposits and not term deposits so it's only a tax on those who want instant access to money, so it looks like a wash to me. The UK dropped its reserve requirement but still managed to get in a shadow bank mess. Most shadow banks had lines of credit back to their parent banks as well, so were (in theory) liable for the tax anyway. Finally, I don't fully get Palley's idea but it looks like reserve requirements on assets (is it banks only?) would encourage even more asset transfers to the shadow banks. I think he mentions the possibility of varying the requirement by asset type, what are the implications for the capital regulations that do this now? The Fed has a large balance sheet of income-earning assets, what's the problem with IORs?

youngecon: interesting first graph. It would probably be too much for me to claim: "All the 2009 shift from shadow banking to the regular banks happened because of IOR!", though it is tempting! What happened in 1994 in the US to cause bank checkable deposits to go down? Anyone know?

HJC: capital requirements aren't obviously a tax. Would laissez faire banks have bigger or smaller capital ratios? You can think of capital ratios as like haircuts on repos, so the shadow banks would have capital ratios too.

Nick: Capital requirements are imposed by the regulator just like reserve requirements. The shadow banks generally covered credit risk with CDS, not capital.

Nick,
"What happened in 1994 in the US to cause bank checkable deposits to go down? Anyone know?"

In January 1994 the Fed permitted depository institutions to implement so-called "sweep" programs, which transferred perceived excess amounts in checkable deposits to money market accounts.

http://research.stlouisfed.org/wp/2000/2000-023.pdf

The reason why banks wanted to do that was of course that checkable deposits have formal reserve requirements whereas money market accounts have no reserve requirement.

Mark: Aha!

Whether it's sweeps for MM accounts, or Shadow Banking purchases of bonds, the bank buys an asset from someone else (perhaps the issuer, perhaps a current holder). That purchase moves deposit money, and the associated reserves, to the seller. Now the seller's bank must maintain the associated reserves. So is it accurate to say that an individual bank might do things to lower its reserves, those actions have no effect on the system-wide level of reserves? What am I missing?

Frank,

I still can’t see the problem in government or central bank (where they want to borrow) simply announcing the fact, and selling their debt to the highest bidders: e.g. the Chinese government, rich individuals, banks wanting to operate as primary dealers, you name it. In fact the Chinese already bypass primary dealers. See:

http://www.reuters.com/article/2012/05/21/us-usa-treasuries-china-idUSBRE84K11720120521

Another point is that advocates of full reserve are not agreed amongst themselves as to whether money that depositors want to be 100% safe should be lodged in the form of just base money, or whether that money can be put into government debt as well. If the latter is allowed, then there’d be no need for primary dealers to be funded by shares. I.e. they could be funded by depositors seeking 100% safety. But that’s obviously a grey area.

Squeeky: For simplicity, ignore currency. Start in equilibrium. Now suppose commercial banks figure out a way to halve the quantity of reserves they want to hold, as a ratio of deposits. But the central bank holds the actual stock of reserves constant. Individual banks would now hold excess desired reserves, and would expand loans and deposits, which would double the money supply and double the equilibrium price level. Just like the first year textbook money multiplier story. But if the central bank were sensible, saw this coming, and didn't want to double the price level, it would need to halve the stock of reserves, to prevent it happening.

Nick Rowe: "For simplicity, ignore currency. Start in equilibrium. Now suppose commercial banks figure out a way to halve the quantity of reserves they want to hold, as a ratio of deposits. But the central bank holds the actual stock of reserves constant."

What do you mean by figuring out a way to halve the quantity of reserves they want to hold? If required reserves are a tax on banks, why would they want to hold any reserves at all?

Min: read Squeeky's question. By switching from those deposits that do require reserves to those deposits that don't. For example.

Ralph,

"I still can’t see the problem in government or central bank (where they want to borrow) simply announcing the fact, and selling their debt to the highest bidders"

They already do this. My problem is with banks (and bank like enterprises) being required by law to fund lending operations by issuing equity. Presumably banks would not be able to capture spread between short term borrowing from the Federal Reserve and long term lending to the Federal Government.

That is the only reason banks get involved in that racket - risk free profits.

Put the lending decision to a shareholder vote where profits are not guaranteed and the increased equity requirement results in share depreciation - you will find less dependable funding for government borrowing.

Instead, have federal government sell equity claims of its own. Banks would still be able to do credit intermediation, but total credit in the economy would still fall.

Ralph,

Also, the "highest bidder" is a bit of a loaded term. Any borrower gets the best deal when he / she can borrow for the lowest interest rate AND the longest period of time.

When the Federal Government conducts Treasury auctions, the term structure of the debt is set by the Treasury (not by auction process).

For instance, Treasury announces that it has $500 billion in 2 year notes to sell, and then conducts an auction for the interest rate. The Treasury does not say it has $500 billion in notes / bonds and auctions them with bidders setting both interest rate and duration.

Minsky wrote a lot about this. Reserves are one part of the regulatory costs that shadow banking avoids. But capital requirements probably matter more, as not all bank liabilities require reserves. U.S. banks have been sweeping deposits between categories for decades to reduce required reserves.

I just ran across this quote on a Fed website:

"The interest rate paid on balances maintained to satisfy reserve balance requirements is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions."

http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

"the central bank holds the actual stock of reserves constant. Individual banks would now hold excess desired reserves, and would expand loans and deposits"

So I'm trivially right, in that the banks can't change the actual total level of reserves. They can't destroy the aggregate reserve balances (excess + required - assuming zero requirement all reserves are excess anyway). But the banks can push the ratio of reserves:deposits down, which has roughly the same effect.

Moi: "What do you mean by figuring out a way to halve the quantity of reserves they want to hold? If required reserves are a tax on banks, why would they want to hold any reserves at all?"

Nick Rowe: "read Squeeky's question. By switching from those deposits that do require reserves to those deposits that don't. For example."

How would switching alter their desires?

"Nick: Shadow banks are more about the other tax: capital requirements."

This is correct. The bankers themselves have made this quite explicit.

Almost everything the banks have done in recent years has been aimed at avoidance of capital requirements. Think about why for a minute.

Suppose that you're trying to juice reported bank profits per share. (Perhaps because you're a CEO and you can extract a larger bonus if profits per share are larger.) Or, more directly, suppose you're trying to juice reported rate of return on capital (again, because you can extract a larger bonus).

However, there's no real way to increase profits; the lending business is going down the drain because nobody wants to borrow. You're already paying 0% to your depositors. Cutting costs? You've eliminated your document storage facilities and shredded your loan documents, and are evading the mortgage recording taxes, relying on forging documents if you need to foreclose. (Yes, this is all happening in the US.)

What's next? Well, profits are the numerator: what you try next is reducing the denominator. If you can run the bank with zero equity and zero capital, you'll have infinite rates of return on capital.

Next step: massive evasion of the capital requirements. Which is exactly what happened in the US, with "off-balance-sheet vehicles" all over the place.

I'm not kidding when I say that the bankers are openly saying that they are setting up shadow banks to avoid capital requirements.

They were publishing descriptions of their "capital minimization" schemes in the Financial Times and Wall Street Journal back in the mid-2000s, and were still doing so in 2010. You can read about the "off-balance sheet activities" in the annual reports, and they're explicitly described as being done to minimize capital requirements.

It was sometime around the fourth or fifth time I read this that I started getting very suspicious of the major financial institutions' stability.

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