Depository vs non-depository financial institutions?

Today's dumb question(s) from teaching monetary and financial institutions:

1. What is the difference between a "depository" and a "non-depository" financial institution?

2. Why is that difference economically important?

The textbook I am using (by Stephen Ceccetti and Angela Redish) makes this distinction, and has a separate chapter discussing each of the two types of financial institutions. It gives examples of the two types of financial institutions, but it doesn't really define what the difference is, or say why it is economically important. An internet search is giving me lots of very similar results. I sense that a lot of people make this distinction and think it is important. But I don't get it.

The usual answer I find goes something like this: "a depository institution accepts deposits, while a non-depository institution does not accept deposits". It then lists examples of "depository" institutions (banks, credit unions, savings and loans); and examples of "non-depository" institutions (mutual funds, pension companies, insurance companies).

But what is the definition of a "deposit"? I can "deposit" $1,000 in my chequing or savings account or in a term deposit at my bank (a "depository" financial institution). But can't I also "deposit" $1,000 in my mutual fund or pension plan?

I can "deposit" my grandfather's watch, or my $1,000 in Bank of Canada notes, in a safety deposit box. And then return later and get back the exact same watch or banknotes I deposited. Unless there's a fire, or someone (including the bank) has stolen them. I know exactly what "deposit" means in that case. But that's not what modern banks do with our money. Even banks with 100% reserves don't do that exactly (though what they do is economically equivalent, since I don't care whether the serial numbers on the notes I get back match those on the notes I deposited).

Pawnshops would be a perfect example of "depository" institutions under that definition, but they seem to be counted as examples of "non-depository" institutions.

Maybe what they mean by "deposit" is when I "deposit" $1,000 the bank promises to give me back exactly $1,000, even if it's not the exact same notes with the exact same serial numbers. But that definition doesn't work when there is interest on deposits.

Maybe what they mean by "deposit" is: when I "deposit" $1,000 the bank promises to give me back some fixed amount of money, where the amount promised is not contingent on anything. If that's how we define "deposit", then a defined benefit pension plan is not a "deposit", since the total amount paid to me depends on how long I live, so the definition works in that example to rule out pension companies as "depository" institutions. But a fixed term annuity, that was paid out to me or my heirs, would count as a "deposit" under that definition. And if I bought a Bank of Montreal bond that would also count as a "deposit" under that definition.

(And a term deposit is no different from a discount bond in that sense, because both promise to pay a fixed amount of money at a fixed future date. And a demand deposit paying a variable rate of interest is no different from a money market mutual fund that implicitly promises never to "break the buck" in that sense either. Nor is buying shares in an equity mutual fund that included sufficient put options to prevent the value of those shares at some future date dropping below the initial "deposit".)

I can't come up with a definition of "deposit" that would work to divide financial institutions into "depository" and "non-depository" institutions to match the lists of examples of each. And even if I could come up with a definition that did work, I'm not at all sure it would be an economically relevant distinction.

I'm beginning to think it is a legal distinction rather than an economic distinction, and it reflects a difference in how the two are regulated. Which suggests that those regulatory differences might not make economic sense.

My preferred distinction would be between financial institutions whose liabilities are and are not used as media of exchange. Some financial institutions issue money, and some do not, and that is an economically important distinction. The liabilities of pawnshops and mutual fund companies (their receipts) are not used as money, but the liabilities of banks (or some of their liabilities) are used as money (whether they be 100% or fractional reserve banks).

Over to you guys. Maybe one of you can make sense of it.

Comments

[Herbert]

A "deposit" is a bank account from which you can transfer money to other people's accounts or draw cheques. Together with bank notes and coins, deposits in this sense constitute the money supply (e. g. M1).

Therefore, deposit banks are considered as creators of money whereas non-deposit banks are not.

[Nick Edmonds]

The IMF manual defines "depository corporations" as the central bank plus other depository corporations, where "other depository corporations" is defined as "all resident financial corporations(except the central bank) and quasi-corporations that are mainly engaged in financial intermediation and that issue liabilities included in the national definition of broad money." Not sure that helps, really.

[Tom]

Nick,

NAICS defines depository and non-depository institutions. A depository institution would be your typical bank where you can go in and make a deposit. The non-depository institution would be your credit card issuing companies. Mutual funds and pension companies and not defined as non-depository institutions but under the category of Funds, Trusts, and Other Financial Vehicles. Insurance companies are also not defined as non-depository institutions.

Given this I understand your confusion. Ceccetti and Redish have led you astray. Also, Pawnshops are classified as non-depository institutions.

[Vladimir]

The essential characteristic of deposit instruments is that they constitute zero-term debt with the expectation that it will be rolled over indefinitely by most of the people for the most of the time. This in turn means that if issuers (i.e. the banks) commonly act on this latter expectation and not hold 100% reserves, we get a situation where the Diamond-Dybvig model applies, and a relatively minor shock that reduces the rate at which people roll over their deposits can trigger a sudden and dramatic phase shift into the bad D.-D. equilibrium (i.e. a bank run). This, of course, has tremendous economic importance, which motivates government deposit insurance and a host of special regulations for depository institutions.

In contrast, when you put money into a mutual fund, you buy equity, not a debt instrument. This means that the dual-equlibrium Diamond-Dybvig model doesn't apply, since bad luck for the mutual fund causes the value of all shares to diminish instantly -- and there's no incentive for everyone to line up for a run on the fund, because you gain nothing by bailing out ahead of others.

On the other hand, any deposit business dealing with fungible things that doesn't back its deposits (i.e. zero-term debt in kind) with full reserves is vulnerable to the same phenomenon. There's nothing special about money here, except that a monetary bank run wreaks far greater havoc than a run on other zero-term obligations without full reserve backing.

This principle also extends to other cases that involve debt (both zero- and non-zero term, and denominated in either money or other assets) backed by maturity-mismatched assets. This is basically what makes the whole "shadow banking system" so fundamentally unstable. What's necessary, in my opinion, is to extend the useful insight about traditional deposits to these cases, while keeping in mind the essential dual-equilibrium nature of the problem.

[Nick Rowe]

Herbert: "A "deposit" is a bank account from which you can transfer money to other people's accounts or draw cheques."

That definition of "deposit" makes sense to me. If you can use it as a medium of exchange/money it's a "deposit", and if you can't it isn't. And that to me is an economically important distinction. (We can argue about what precisely is and is not "money", but aligning the two definitions -- "deposits" and "money" -- seems logical.)

But that's not how I read what other sources are saying.

Nick Edmonds: that is helpful. Again, that is aligning the two definitions: "deposits" and "money". The IMF and me seem to be in rough agreement, which is nice to know. We can have one argument, not two separate arguments, about how we define "money" and "deposits".

Tom: "A depository institution would be your typical bank where you can go in and make a deposit."

But what's a "deposit"? If I give my stockbroker a cheque, to put in my account, why isn't that a "deposit"?

"Also, Pawnshops are classified as non-depository institutions."

That's what they all say. But I deposit my watch with a pawnbroker.

[Nick Rowe]

Vladimir: Can I read you as saying that a "deposit" is a liability to which the Diamond-Dybvig model of bank runs (or something like it) might apply? (Or saying that is the distinction we *ought* to make.)

I agree that would be an economically useful distinction, and one that matters for regulation and lender of last resort applications. It makes sense as a distinction. But I'm not sure if that is the definition/distinction I'm reading from other sources. Because, for example, a bank with 100% reserves would not be vulnerable to bank runs, so would not be a "depository institution" by your definition (if I'm reading you right).

[Vladimir]

Nick,

The definition I propose, which I think coincides pretty well with the usual meaning of the term, is that "deposit" is zero-term debt for which there is expectation of indefinite rollover by most creditors (i.e. depositors).

This also includes full-reserve deposits, but these are not studied or regulated much, simply because they are neither very interesting nor very dangerous. However, without full reserves, the Diamod-Dybvig model kicks in, with its dramatic implications that motivate the interest in the subject.

So, it's not like the danger of D-D runs is the defining feature of deposits -- but it is the reason why a certain subset of depository institutions is of such great interest, while others (the 100% reserve ones) are so uninteresting that as an economist you might as well forget they exist.

Overall, I think these distinctions ought to be made more clearly and explicitly, but the existing terminology is already based on them, if in a somewhat muddled form.

[Vladimir]

Nick,

The definition I propose, which I think coincides pretty well with the usual meaning of the term, is that "deposit" is zero-term debt for which there is expectation of indefinite rollover by most creditors (i.e. depositors).

This also includes full-reserve deposits, but these are not studied or regulated much, simply because they are neither very interesting nor very dangerous. However, without full reserves, the Diamod-Dybvig model kicks in, with its dramatic implications that motivate the interest in the subject.

So, it's not like the danger of D-D runs is the defining feature of deposits -- but it is the reason why a certain subset of depository institutions is of such great interest, while others (the 100% reserve ones) are so uninteresting that as an economist you might as well forget they exist.

Overall, I think these distinctions ought to be made more clearly and explicitly, but the existing terminology is already based on them, if in a somewhat muddled form.

[Bill Woolsey]

How about--a matter of regulation. Probably U.S. regulation.

An institution that offers transactions accounts, the current way of describing checkable deposits, s a depository institution. It might be able to offer other types of financial instruments as well, but if it offers transactions accounts, then it is a depository institution and is subject to regulation applying to such institutions. For example, reserve requirements against transactions accounts.

Depository institutions are permitted/required to have deposit insurance.

Nondepository institutions have no reserve requirements, make reports to other regulatory bodies (not the Fed or FDIC, but instead the SEC, for example.)

Hey, maybe a depository institution can (or must?) call its short term borrowing "a certificate of deposit.) But if a nondepository institution called short term commercial paper it issued a "certificate of deposit," it would be in trouble. Even though they are basically the same thing.

Maybe a depository institution with no transactions deposits still has to file with the Fed every week a form that says "transactions deposits -- 0"

Now an institution that issued commercial paper and funded commercial loans would not be a "depository institution." An depository institution that only issued CDs and made commercial paper would be the same, but subject to different regulations.

If a firm as a commercial bank charter, and S&L charter, or a credit union charter, it is a depository institution. And firm incorporated in Delaware, issuing commercial paper and buying 30 year corporate bonds is not a depository institution because of the charter it has.

(I am not certain of this, but I think this is where it is coming from. Regulation.)

[Frank Restly]

Nick,

Would it help to classify various financial instruments based upon their liquidity and assumed risk?

A deposit would have no default risk (by legal mandate), but would be slightly less liquid than cash on hand.

[Herbert]

I believe that some of the definitions given above are beside the point, both economically and legally. Let me explain.

1. Interest: In some countries, such as Germany, deposits are interest bearing. I remember that in the 1980th I got 7 per cent on my deposits. In other countries, such as the US or France, interest on deposits is unusual but not forbidden, reminiscent of former regulations such as "regulation Q" in the US.

2. Reserve requirements: In countries such as Canada banks are not required to hold minimum reserves on deposits.

3. Insurance: Which bank liabilities are insured by an agency like the FDIC in the US varies from country to country.

In sum, the defining feature of a "deposit" is that it serves as a means of payment. This holds for transferable accounts and chequing accounts only. So deposits are a part of the money supply. This definition is economically meaningful and in accordance with the IMF definition given above by Nick Edmonds.

@Nick ("If I give my stockbroker a cheque, to put in my account, why isn't that a deposit?") Of course you are making a deposit in the colloquial sense. But you stockbroker's account is not a deposit account unless you can transfer it or write cheques on its behalf.

[Nick Edmonds]

Herbert,

"In sum, the defining feature of a "deposit" is that it serves as a means of payment. This holds for transferable accounts and chequing accounts only. So deposits are a part of the money supply. This definition is economically meaningful and in accordance with the IMF definition given above by Nick Edmonds."

Note though that the IMF definition of deposit is wider than this. I'm taking this from the Monetary and Financial Statistics manual, so it's a guide for distinguishing types of asset for the purposes of producing financial statistics, rather than having any regulatory or legal implication.

[Squarely Rooted]

This is an extremely interesting question that I think lacks a definitive or conclusive answer, but some thoughts...

I think deposits, more than anything, are a matter of intent. It's cash, given to a depository institution for the purposes of short-to-medium-term secure storage, with no intension of converting it to anything but cash or cash payments. This differs, say, from a pension plan (because of the length and also because the money will be invested in securities) or a mutual fund (because the money will be used to purchase securities).

This can of course get a little muddled because for example all the money my household earns at least stops in our checking account before some of it is transferred to our brokerage account for investment. It is also a little muddled because we also have a checking account WITH our brokerage firm that basically serves as a waiting room for money between investments.

But basically the thing that distinguishes "deposits" from other forms of non-paper-money instruments is that they are treated as being cash by people. When I think "how much cash do I have to pay my bills over the next month" I don't worry so much about the $100 bill in my wallet as I do about the money in my checking account and whether it and future paychecks are sufficient to cover my debts.

The largest economic difference, I'd wager, that is the basis for the legal one, is whose wealth is at risk. If I am extremely rich and start a non-depository bank that fails, unless I am too big to fail the primary victim is myself. If I start a depository bank, however, my failure implicates the daily liquidity and solvency of large numbers of average people. Ergo deposit insurance - and why we have deposit insurance as opposed to security insurance.

[Dan]

The difference is the FDIC. Deposit Insurance turns a bank liability from 0 term to infinite term. This makes an economic difference. And yes, Deposit Insurance is a regulatory distinction, but it is one that creates an economic difference.
Your objection that a single institution with 100% reserves excepts the distinction doesn't stand because while that is true for the individual institution, the question is for the system as a whole, so unless an entire economy switches to 100% reserve banking system, the difference stands.
So yes, it's an economic distinction that is created by regulation and one that is conditional on the system having a fractional reserve banking system.

[Peter N]

Deposits are universally accepted bank liabilities that always trade at par. Under free banking, banks issued banknotes, which definitely didn't trade at par. The current system replaced that one, because of banknotes' overheads. By coincidence there's this recent posting by Izabella Kaminska on Alphaville -

http://ftalphaville.ft.com/2013/10/28/1679132/gortons-battle-of-light-and-dark-money/

linking to this recent paper by Gary Gorton

http://papers.nber.org/tmp/8080-w19540.pdf

It's definitely worth reading.

[Roger Sparks]

"Depository" and "non-depository" as designations is a word-twist that poorly describes an important process distinction.

The action-of-banks to accept deposits and then use the deposits as a base for loans creates a "situation". The "situation" is the real difference between the two kinds of institutions.

I describe the "situation" as a condition where two owners have claim on the same underlying asset. This "situation" is created when banks lend money by the "loans create deposits" process. The bank, once a deposit has been made, can loan that deposit to a second party. With loan in place, the second party has identical claim on deposits-at-the-bank as does the original depositor.

A new "two claims on one deposit" event constitutes an increase in the money supply, with macroeconomic effect.

[NickRowe]

Dan: suppose a bunch of lawyers made a big distinction between term deposits of less than 42 days and term deposits of 42 or more days, for weird legalistic reasons. And policymakers insured the first type and didn't insure the second type. That insurance would then create an economic distinction. But economists would still say the lawyers were being silly, because there's nothing economically important about 42 days.

The sense I'm getting, from reading your comments, is that it's mostly a legal distinction that reflects current regulatory practice (and mostly US legal distinction??), but also an economic distinction between money and non-money, and that there is a lot of fuzziness over whether it's legal or economic, and that the two distinctions don't always coincide.

[Tom]

"That's what they all say. But I deposit my watch with a pawnbroker."

You deposit your watch as collateral to borrow money. The pawn shop is extending credit to you and your watch is collateral. Non-depository institutions are primarily engaged in extending credit based on credit market borrowing.

[Dan]

I love how you push and test everything to the breaking point. I suspect your students leave your class terrified of jumping to hasty conclusions, they're lucky.

I agree that if 42 days was the law, it could very well be economically silly. However, hasn't the experience of bank runs (or more generally, short term liability runs at financial companies) shown that there is an economic motivation for deposit insurance. Liquidity matters in a system that is leveraged. the distinction between making sure there is liquidity even when some shock happens and having a system that goes illiquid in a shock does seem more than silly.

I suppose, if the FDIC is the answer to your question, part of the distinction has to be whether it's systemic or not. Pawnbrokers are deposit taking institutions, but they are not systemic in our current system, and let's hope it stays that way, but I don't think it makes much difference whether it's money or non-money.

[Nick Edmonds]

Conceptually, deposits should be seen as being driven by the requirement of the depositor to invest funds, as opposed to loans which are driven by the requirement of the borrower to raise funds.

I think a classic (money) deposit will typically have the following characteristics:
- It will have no final maturity date, but the investor can require full or partial repayment of the balance at any time or with a notice period.
- The balance of the deposit will be equal to amounts deposited less amounts repaid plus, possibly, interest added from time to time.
- The deposit-taker will act as a price-setter and quantity-taker, setting the interest rate and accepting whatever amounts the investor places from time to time.

Institutions that are in the business of accepting funds in this form are deposit-takers. Other liabilities of deposit-takers may then also be classified as deposits even when they don't exactly meet the criteria above.

[Raimondas Kuodis]

in Europe we distinguish between Monetary Financial Institutions (MFIs) and not. MFIs can create money (deposits) by extending loans, that's why they are Monetary. This is much more helpful classification. Otherwise you can still believe that banks are financial intermediaries:)

Deputy Chairmanf the Central Bank of Lithuania

[Roger Sparks]

Nick,

"Conceptually, deposits should be seen as being driven by the requirement of the depositor to invest funds, as opposed to loans which are driven by the requirement of the borrower to raise funds."

Hmmm. Banks have an enormous money holding business. I think of this business as holding the operating funds for every organization conceivable, including persons organized as an individual. I helped count the church offering Sunday. Those funds were mostly bank checks with very little currency. The total bank deposits from all organizations would be a very large number, I think.

Hmmm. Would non-depository institutions have bank accounts that hold deposits from their customers-who-use-bank-checks?

[Christiaan Hofman]

I guess that the economic difference is the economic difference that arises from the difference in regulation that is a result of its legal difference.

[NickRowe]

Squarely: "If I am extremely rich and start a non-depository bank that fails, unless I am too big to fail the primary victim is myself. If I start a depository bank, however, my failure implicates the daily liquidity and solvency of large numbers of average people."

I vaguely remember Adam Smith saying something similar. IIRC, he didn't want to allow small denomination banknotes, for fear that average unsophisticated people would suffer losses if the bank defaulted.

Peter N: I had Gary Gorton on shadow banks vaguely at the back of my mind when I wrote this. Definitions for regulation not matching economic relevance.

Tom: "You deposit your watch as collateral to borrow money. The pawn shop is extending credit to you and your watch is collateral. Non-depository institutions are primarily engaged in extending credit based on credit market borrowing."

Compare a pawnbroker to a bank giving me a mortgage. My house replaces my watch. But the bank lets me continue to use it. It is exactly as if the pawnbroker put a lien on my watch, but let me keep wearing it rather than taking physical possession. The difference is that the pawnbroker cannot issue his own money.

Dan: thanks! But I wonder if some students roll their eyes and just want to know what to write on the exam.

There's the systemic vs non-systemic distinction, and the money vs non-money distinction. I tend to think the two maybe coincide. Money is systemic.

Nick Edmonds: but my account with my stockbroker, or mutual fund, seems to meet those criteria.

Raimondas: then I think the Eurpoean distinction is much more economically relevant.

Christiaan: Maybe. But one would hope that differences in regulation had some prior motivation in some economic difference?

[Biagio Bossone]

Being able to act as a depository institution is a necessary (albeit not sufficient) condition for a bank to be able to create money by extending loans, as against intermediating funds already existing. The bank issues money by crediting the deposit account open on its books in the name of the borrower. The money created is both a loan asset and a deposit liability of the bank. Any non depository institution could only lend money by transferring (existing) funds from its account (held with a depository institution) to the account of the borrower (held with another or even the same depository institution). A non depository institution could never create money as it might not credit an account on its own books with its own (deposit) liabilities.

[Redwood Rhiadra]

Nick Rowe: "but my account with my stockbroker, or mutual fund, seems to meet those criteria."

Your account with your stockbroker or mutual fund fails the second of Edmonds' criteria: "The balance of the deposit will be equal to amounts deposited less amounts repaid plus, possibly, interest added from time to time." This criteria means the account balance must not be affected by market losses or gains.

[brookside]

In the US all depository institutions have to maintain reserve accounts at the Federal Reserve. Depository institutions can perform the banking functions of taking demand deposits (or other checkable deposits) and making loans.

[Tom]

"Compare a pawnbroker to a bank giving me a mortgage. My house replaces my watch. But the bank lets me continue to use it. It is exactly as if the pawnbroker put a lien on my watch, but let me keep wearing it rather than taking physical possession. The difference is that the pawnbroker cannot issue his own money."

Nick,

Very good comparison. Did you know that Mortgage banking is considered non-depository lending? It's true. Pawnbrokers and mortgage banking are both considered as non-depository credit intermediation activities.

[Patrick R. Sullivan]

In the United States, section 21 of the Banking Act of 1933-aka Glass-Steagall--defines a depository institution as one;

'to engage...to any extent whatever in the business of receiving deposits subject to check or to repayment upon presentation of a passbook, certificate of deposit, or other evidence of debt, or upon request of the depositor....'

Which happens to be still the law (it was NOT repealed in 1999 by the Gramm, Leach, Bliley legislation). However, it is somewhat moot, as it was never workable as written, and several regulatory decisions have made exceptions for its provisions. It was used in the 1970s to prevent Wells Fargo Bank from instituting an indexed mutual fund, but eventually that was superseded by newer regulatory decisions.