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This doesn't sound right, the monetary base is mostly backed by assets on the CB balance sheet. That's not 100% capital.

I think you're looking for the fiscal theory of the price level here, like Cochrane's "Money as Stock" paper.

Adam P: suppose a company issued two sort of shares: voting and non-voting. And invested in government bonds. And suppose the management could discriminate between the dividends it pays to voting and non-voting shares. The management decides to pay no dividends to non-voting shares, and issues new non-voting shares, or buys back non-voting shares, whenever it feels like it. At the moment, the management says it will issue new non-voting shares, or buy back old non-voting shares, to ensure they depreciate at 2% per year. And it uses its assets (those government bonds) to finance share buybacks.

Are those government bonds capital that backs the non-voting shares? Yes and no. Because non-voting shareholders have very few rights (none at all, except what management chooses to give them).

This is like Cochrane's Money as Stock, but it isn't Fiscal Theory of the Price Level. (The book I'm vaguely remembering was older.)

Bank #2 is a CDO. No? Or more specifically, some kind of credit-fund, whose shares are linked to a CDO, and that is willing to redeem at any time rather than only in specific periods.

This is not what most people think of as 'bank'. :-)

I think the fundamental question you're getting at is, what's the best way to turn an illiquid asset into a liquid one? Banks are one answer, stock markets are another.

The problem with an open ended (you said closed end, but I think you meant open end) mutual fund that holds illiquid assets is, how do you price the shares? If the shares are mispriced, then you can have wealth transfers between shareholders. People who don't want to be exploited will avoid such funds.

Rwcg: I don't think its a Collateralised debt obligation. More like a mutual fund.

Max: I did mean "closed end" when I wrote that. Because shares in closed end mutual funds are themselves traded. But the bank would be free to increase or decrease the number of shares, to maximise profits, so it's more like an open ended mutual fund in that sense. And it is unlike both an open-end fund and a closed end fund in that its assets will be very illiquid, so do not have an observable market price. Nobody knows for sure what a bank's loan portfolio is worth, just like with the assets of any regular business corporation. Their shares are worth whatever the market thinks they are worth.

Yep, banks and stock markets are two ways to convert illiquid assets into liquid assets. This is like putting the two together.


"what would happen if those banks bought put options on their own shares, to make their shares safer??"

It would be the opposite of the case where a bank holds calls on its own shares, and it would act to stabilize share values. Unfortunately, central banks hold bonds denominated in their own shares (i.e., their own money), which is like holding calls on your own shares, and acts to destabilize their money through an inflationary feedback effect.

But as you observed, a bank that has issued inconvertible money is immune to insolvency (and bank runs).

It's a mutual fund whose assets amount to (explicitly or implicitly) exposing its shareholders to a CDO. Such things exist currently, as 'total return credit funds' and the like.

Mike: thanks for confirming what i suspected.

"Unfortunately, central banks hold bonds denominated in their own shares (i.e., their own money), which is like holding calls on your own shares, and acts to destabilize their money through an inflationary feedback effect."

Hmm. I never thought of it that way. Plus deflationary positive feedback effect, in reverse.

It's Fama.

But Greenfield and Yeager's first pass at the BFH (for Black-Fama-Hall) emphasized purely mutual fund banking.

The first bank has a 50% capital ratio.

The second bank has a 100% capital ratio.

The ratio is capital to assets, right?

By the way, if the monetary instruments were like preferred stock, it could work more or less like a conventional bank except when earnings are negative.

Thanks Bill. I guessed you would know the answer. I have updated the post to add your comment.

Bill: "The ratio is capital to assets, right?"

I was wondering about that. I always assumed it was the ratio of capital to deposits, like the reserve ratio. But I wasn't sure, which is why I hedged a bit at the end of my first example. If the capital ratio is small, it doesn't matter much which way we define it. But it does matter at 100%.

I don't see ad the end in the second case if it is a bank. Can it have a transformation function? - deposit into credit?

Miguel: sure. You take a $20 note to the bank, it credits your account with an equivalent number of shares, and makes a $20 loan. Just like a regular bank, except what you have in your account represents a certain number of shares rather than a certain number of dollars.

I'm now waiting for someone to jump in and say: "BUT LOANS CREATE DEPOSITS!!!!"

So let me forestall them. The bank makes a loan of $20 by crediting the borrower's chequeing account with S shares in the bank, where S = $20/(share price), in return for the borrower's IOU for $20.

Yep, that is possible too!

"Hmm. I never thought of it that way. Plus deflationary positive feedback effect, in reverse."

I believe we talked about some of this stuff back in 2009:


JP: I just re-read that old post, and all our discussions in comments. Yep. Your memory is good. Mine is failing.

1. "But those demand deposits are themselves shares in the bank" - you have described bitcoin here!
2. "Why can't all banks be as perfectly safe from insolvency as the Bank of Canada" - here it is useful to distinguish between accounting insolvency and policy insolvency. BoC is safe from accounting insolvency, but is vulnerable to policy insolvency, and policy insolvency is what interests us.

Vaidas Urba: "policy insolvency is what interests us."

What do you mean by policy insolvency? The Bank acts as though it were insolvent?

Min - policy insolvency means that the central bank is unable to achieve its policy objective unless it receives transfers from the government. Think Iceland (2008) or Zimbabwe.

Vaidas: If you destroyed the Bank of Canada, and all its assets, but left the fixed stock of currency in circulation, you would get Bitcoin.

The problem in Iceland was that the commercial banks went bust, and the central bank couldn't bail them out.

The problem in Zimbabwe is that the government required the central bank to make transfers to the government that were bigger than the maximised present value of the central bank's seigniorage profits.

" If you destroyed the Bank of Canada, and all its assets, but left the fixed stock of currency in circulation, you would get Bitcoin."

Like other dotcom companies, bitcoin has got plenty of assets - intellectual property, brand value, etc. And indeed markets value bitcoins similarly to dotcom shares. Fortunately, Bank of Canada has got plenty of intangibles too, as we should definitely include the present value of future seigniorage on the balance sheet. One year ago there was a serious debate in the UK about cancelling the QE debt - imagine the inflation UK would get in the absence of intangibles on the balance sheet.

Regarding Iceland, my guess that the policy insolvency has happened before the commercial banks went bust. The central bank was already policy insolvent in the summer of 2008 when the Krona crashed in the foreign exchange markets to a level incompatible with policy targets.

I agree that the fiscal policy is the reason why Reserve Bank of Zimbabwe became policy insolvent. It remains unclear if Reserve Bank of Zimbabwe is insolvent in the accounting sense - the latest balance sheet is dated 23 September 2005, with tiny but positive capital.

Policy insolvency is an extreme scenario, but fear of policy insolvency is an important factor that constrains central banks. Good examples are the Fed in 2008 and the ECB right now. Central banks do think that money is their liability. That's why Bernanke has started tapering.


"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."

A capital ratio does not diminish or eliminate the risk of insolvency. All that a capital ratio does is determine who partakes in that risk. Even if a bank was able to sell an infinite number of shares for a $1.00 each, there is still the possibility that those shares could become worthless.

The only way a bank (or any enterprise) avoids insolvency is to have assets that always have a higher future value than liabilities. The value of assets / liabilities can be market determined or can be legally determined.

Frank: "A capital ratio does not diminish or eliminate the risk of insolvency."

That makes no sense at all. Insolvency means your assets aren't worth enough for you to pay what you promised to pay. If your only promise is to pay a share of whatever your assets are worth, you cannot be insolvent.

Unless your reply has a very high quality/length ratio, let's just leave it there.



"Insolvency is the inability of a debtor to pay their debt. In many sources, the definition also includes the phrase or the state of having liabilities that exceed assets or some similar phrase."

I have an asset - a house for example. I have a liability - a mortgage. I can be insolvent (house worth less than mortgage) even while I am current in my payments on my mortgage (making my promises to pay).

Likewise, the market value of a banks assets may be worth less than the market value of a banks liabilities EVEN IF the bank is current on all payments.

Because we are talking about a bank that has no debt (only shares), the first definition of insolvency does not apply (inability to pay debts) but the second definition still does.

"If your only promise is to pay a share of whatever your assets are worth, you cannot be insolvent."

The value that the market is willing to pay for a bank's assets may be less than the value that holders of that bank's shareholders put on them.

Frank: that comment failed the ratio test badly. Stop now.

Frank's point is better made by noting that it's unrealistic for all liabilities to be in shares:

Assets = $100 loans
Liabilities = $150 regulatory fees; 100 shares
Share Value = $-0.5

Only BOC can insure that all its liabilities are in its own shares. (And for developing nations that might not even be true - given non-domestic payments/trade/etc).
How's the ratio?

Squeeky: That might be a point worth making. But it's not Frank's point.


“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.)”

I’m pretty sure the accounting people would say Bill Woolsey is correct. The capital ratio is capital to assets. Bank 1) has a capital ratio of 50%, not 100%. Bank 1) is not a 100% capital ratio example.

Let’s take that a step further.

There is 50% capital ratio/requirement for loans. All other assets have a 100% capital ratio/requirement. Start here.

A: $100 in reserves plus $200 computer loans
L: $200 in DD’s (fixed 1 to 1 convertible to currency)
E: $100

Pay back all the loans with no interest.

A: $100 in reserves plus $0 computer loans
L: $0 in DD’s
E: $100

Now the bank itself can only spend $100 for computers (not $200 that the loans allowed). Notice the $100 difference.

“2. The bank has $100 in loans, and $100 in chequable demand deposits, but those demand deposits are themselves shares in the bank.”

#1 For the bank 2) scenario, I don’t think the accounting can work that way.

A: $100 computer loans
L: $100 in DD’s
E: $0 in shares


A: $100 computer loans
L: $0 in DD’s
E: $100 in shares

I think you are double counting. I am not guaranteeing that.

And, “They do not have a fixed dollar redemption value”.

#2 I assume that you mean DD’s/shares are not 1 to 1 convertible to currency. If so, I’m not accepting that as MOE. Sell whatever and bring me currency.

Comment in spam?


Making banks insolvency-proof in your second sense is pretty much what’s advocated by Lawrence Kotlikoff, Positive Money and others. See respectively:



However, their system is better than yours for the following reason. Many people want to deposit $X somewhere and be 100% sure of getting $X back. Indeed, I think that’s a basic human right. Your system does not offer that, whereas a Kotlikoff / Positive Money system does. They do it by offering depositors a choice between two basic types of account. 1. 100% safe accounts where nothing is done with the relevant money (e.g. it could be deposited at the central bank), with depositors having instant access to their money (e.g. via checks). 2. Mutual funds, as per your suggestion. Access to money from mutual fund accounts is not instant, but like existing mutual funds, fund units can be sold, and cash obtained within a week or so. Banks would offer a range of funds for depositors to choose from: e.g. depositors could choose to put their money into safe mortgages, NINJA mortgages...etc etc.

Adam P,

You didn’t provide a link to Cochrane’s ideas on this subject (which are similar to Kotlikoff’s). There’s an article by Cochrane here:



Re your point that a bank-like institution suggested in Nick’s second option is not what most people think of as a bank, you’re quite right: Lawrence Kotlikoff is quite open about the fact that he wants to destroy banks as we currently understand the word and set up entirely new institutions which perform some of the functions of banks and not others.

Capital adequacy ratios use risk weighted assets.

Credit Exposure Type Percentage Risk Weighting

Cash 0
Short term claims on governments 0
Long term claims on governments (> 1 year) 10
Claims on banks 20
Claims on public sector entities 20
Residential mortgages 50
All other credit exposures 100

This makes government bonds very attractive, and in the Euro zone, bonds of all Euro members are treated the same. You can see where this might create a problem.

Spanish banks, for instance held EUR235bn Spanish government bonds in August, equivalent to around 40% of the total stock.


Nick, three somewhat related comments:

1. This post is not a post about monetary policy. Let's examine the logical structure of the post. The key assumption is that central banks do not promise anything, i.e. central banks do not promise to achieve their policy goals. While the post is fine as it is, it would be a fallacy to argue that it has any consequences for monetary policy. Gustavo Adler, Pedro Castro, and Camilo E. Tovar have an IMF working paper "Does Central Bank Capital Matter for Monetary Policy?" that empirically examines central bank capital in a way that is relevant for monetary policy. Ulrich Bindseil, Andres Manzanares, Benedict Weller have a paper "The role of central bank capital revisited" that is more theoretical.

2. This post is about nominal solvency, but we should also care about the real solvency. 100% capital requirements protect against nominal solvency, but they do not protect us against adverse scenarios where the real capital of the financial system evaporates. It not obvious if a move to 100% capital requirements will reduce or increase the real risks.

3. While the real central banks have a capital buffer that protects their policy solvency and protects the real value of their monetary liabilities, bitcoin does not have such a buffer. And guess what - bitcoin is not used as a medium of account. Maybe the capital is what enables monetary liabilities to be used as a medium of account.

Nick: actually I think that banks already have something akin to #3 - that deposits are something akin to shares, or to be more precise that deposits are like bonds sold purchased from a bank. This is what basically happpened in Cyprus: it was not only shareholders but also people owning demand deposits that had to accept the "haircut". Similar thing happened in Iceland where it was decided that deposit insurance does not apply to foreigners who lost a lot of money.

Ralph: Kotlikoff's 1 sounds like 100% reserve banking.

I'm saying Kotilkoff's 2 could be implemented without the one week (or whatever) delay. You don't need to convert it into cash before writing a cheque.


1. The regulation of financial institutions that produce money can be thought of as monetary policy, in a broader sense.

2. I think that is a key problem with my proposal. Banks wouldn't go bust in a financial crisis, but the money supply would fall if the value of banks' assets fell. Bank shares would be less risky than they are now, since banks would have zero debt, but they would still fluctuate in value.

JV: Yep. When a bank goes bust, with no deposit insurance, bank deposits end up being like bank shares. But those deposits get frozen while everything gets worked out. Plus depositors weren't informed about the downside risk.

Nick, re (1) - the part of the post where central banks are discussed is not about monetary policy, but the part about commercial banks is.

Peter N: Yep. Looking down that list you posted reminds us how much of a joke those capital ratio regulations are. Plus, there's the whole mark-to-market vs book value question.


Re your second point (about risks run by banks), turning all bank creditors into loss absorbers ought to reduce risks run by banks. Reason is that if depositors stand to lose everything when a bank fails rather than depositors being bailed out by taxpayers, then depositor / loss absorbers will keep a keen eye on what banks do, and depositors will allocate their money to activities which suit the level of risk they want to run.

In contrast, where depositors want to run no risk at all, that option is available to them under the system advocated by Kotlikoff, Positive Money, etc (see by above comment).

But even if making all bank creditors loss absorbers DOESN’T reduce risks run by banks, the system still has advantages, as follows.

First taxpayers are absolved from any exposure, which in turn disposes of the TBTF subsidy (something that Dodd Frank and other regulators round the world have spectacularly failed to do).

Second, as Nick suggests, insolvency is impossible. And insolvency is a scenario where some entity owes $X to another entity which it cannot pay. And disposing of that possibility is an obvious plus.

Nick: yes, deposit protection is complicated but so is bankruptcy laws. In case of insolvency some creditors can have preferential claim on the remaining equity of a company, for instance in some countries it is social security debt, wages and some other classes of debt that are prioritized over regular loans/bonds or unpaid invoices for goods/services provided to insolvent company. So it is with a bank bankruptcy - especially too big to fail ones. Everybody can try to make claim on what is owed by the bank: from bank shareholders to bank employees or even owners who have their money deposited in bank on various types of accounts with various sums.

But all in all I think it is always good to think of a bank deposit as if it is a safe "colaterized debt obligation" where government shoulders some of the risk by absorbing the most risky "tranges" through deposit insurance. But there is no guarantee that this AAA type of security will not turn sour in a blink of an eye as people with their money in Cypriotic or Icelandic bank can attest.

Ralph: I think we are sort of on the same page here (for once!).

Getting rid of the risk of insolvent banks, and getting rid of TBTF, and bailouts, would be a big advantage.

I think we would see a spectrum of banks. At one extreme some people would want 100% reserve banks, and would get it. At the other extreme would be banks making lots of risky illiquid loans. And most would have a mix of assets, and be somewhere in between.

Take, for example, a Canadian bank, as it exists now, with its current assets.

Suppose we add together: the total market value of its shares, its bonds, and it's deposits. Call it V, for the total value of the bank. How volatile would V be? Not very. The shares are the most volatile component of that list, and those shares are a small proportion of the total.

Under my proposal, even if banks had exactly the same assets as Canadian banks have right now, the volatility of the price of bank deposits would be the same as the volatility of V.

Look at bitcoin. No runs, no TBTF, insolvency is impossible. But the fluctuations of real value are enormous.

Vaidas: But Bitcoin doesn't own any assets. Bitcoin is like Bank of Canada notes, if you froze the total quantity (roughly), and you didn't have any idea how big Canada was going to be, if everybody in the whole world would become Canadian, or if Canada would disappear next week.

The overnight loan market between banks would be replaced by a market in which banks trade each other's shares, rather like a forex market.

Nick: "I think we would see a spectrum of banks."
There are ETFs listed on Toronto stock exchange for that. ZFS is virtually a 100% reserve bank, riskier alternatives are lisited too.

"Under my proposal, even if banks had exactly the same assets as Canadian banks have right now, the volatility of the price of bank deposits would be the same as the volatility of V."
First we have to consider the liquidity of total V, which is much lower than liquidity of its deposits. We should substract a time-varying liquidity discount to get the value of V under your proposal.

George Selgin was thinking along similar lines to Nick’s “No.2” idea many years ago. In Selgin’s book “The Theory of Free Banking” (p.37) he says, “One way . . banks can prevent runs is . . . to link checkability to equity or mutual-fund type accounts . . . For a balance sheet without debt liabilities, insolvency is ruled out…” Selgin’s book is free online here:


Nick, bitcoin holds dotcom intangible assets, like Twitter or Facebook. To get a sense of volatility of V under your proposal, it makes sense to look at old economy, good example here:

But I'm afraid we will get the volatility of JNK instead of LQD.

The key issue - having different classes of liabilities increases the total liquidity of V. This effect is very strong.


"First taxpayers are absolved from any exposure, which in turn disposes of the TBTF subsidy (something that Dodd Frank and other regulators round the world have spectacularly failed to do)."

To eliminate too big to fail (TBTF) and taxpayer exposure, you must eliminate it from both the asset and liability side of a bank's balance sheet. Okay, so a bank issues shares which limits the risk to taxpayers of having to buy out the bank's creditors. The taxpayer is still at risk if the government should decide to assist a bank on its asset side (for instance swapping dodgy mortgages for government bonds).


If government gives a bank government bonds in exchange for the bank’s dodgy mortgages, then government is effectively rescuing bank shareholders / loss absorbers surely? I.e. I don’t see what there is for government do on the asset side.

You could argue that government, as part of its wider social responsibilities, has an obligation to help irresponsible mortgagors evicted from their houses by a bank. But that’s “social responsibility” stuff: it has nothing to do with banks. And certainly I don’t think taxpayers should rescue a bank (and it’s shareholders) where the bank has been badly run (any more than taxpayers should rescue restaurants or garages which have been badly run).

To restate Ralph's point another way: it eliminates one reason for government bailouts.


"If government gives a bank government bonds in exchange for the bank’s dodgy mortgages, then government is effectively rescuing bank shareholders / loss absorbers surely?"

Yes, most definitely. The point that I was making is that to eliminate too big to fail and tax payer bailouts, you must eliminate the risk free rate of return inherent in government bonds.

Government can invent any reason it likes for a bailout. What I am referring to is eliminating a method under which a bailout can be executed.

"But the Bank of Canada can never go insolvent. Because it has a 100% capital ratio."

I'm pretty sure the Bank of Canada has more assets than capital. That would mean it is not a 100% capital ratio example.

Well, here's how I understand it:

There are various capital ratios, and also a leverage ratio. The capital ratios use risk-weighted assets as the denominator, and some measure of capital as the numerator. The leverage ratio uses total exposures as the denominator. In these examples, the capital measure is uncomplicated because everything has been stripped down. It's all shareholders' equity, and Tier I capital = total capital.

For Bank I, if we assume all of the loans are residential mortgages (risk-weight = 50%), then the bank's risk-weighted assets are 50% x $200, or $100. It's total capital is $200. It's total exposures are $100 in deposits. So both the capital ratio and the leverage ratio are 100%.

But suppose we assume assume this bank has $100 in cash (including central bank deposit balances). The risk weight for cash is 0%. So the total capital is $200, while risk-weighted assets remain $100 and total exposure remains $100. So both the capital ratio and the leverage ratio are now 200%. But this bank faces no insolvency risk, because even if all of its loans fail, it still has enough cash to cover its exposures.

For the second type of bank Nick describes, one which has no real deposits at all, but instead offers checkable common equity shares that can be transferred from shareholder to shareholder within the bank, the bank as no liabilities at all. Common stock is not a liability of the bank. Upon dissolution, the common shareholder is entitled only to a proportional share of the residual value of the bank. In this case (assuming no cash assets), the capital ratio is 100% and the leverage ratio is infinite.

In my third paragraph, I put a dollar sign where a percentage symbol should be. The last sentence should read: "So both the capital ratio and the leverage ratio are 100%."

[I edited it. NR]

Dan: "Common stock is not a liability of the bank."

Well, yes and no. Whatever the accountants want to call it. But in an important sense, yes, it's not a liability in terms of risk of insolvency.

"In this case (assuming no cash assets), the capital ratio is 100% and the leverage ratio is infinite."

You lost me on the leverage ratio being infinite.

On the bitcoin issue, as I understand it, there is no dot-com company (or other kind of corporate or public entity) called "Bitcoin". Bitcoin is the name of an open source software system. Nobody owns it, and so there are therefore no assets or liabilities for Bitcoin as such. There are indeed Bitcoin exchanges that are enterprises possessing assets and liabilities - the hardware they use for example. The exchanges are not Bitcoin; they are organized platforms for the exchange of bitcoins. Other firms could be set up for the provision of Bitcoin-related services, and so they would have assets and liabilities as well. There are also Bitcoin wallets containing bitcoins, and the bitcoins contained therein are the property of the owner of the wallet.

The number of bitcoins in a bitcoin wallet can be augmented or diminished via exchange. These numbers can also be augmented by employing the software to "mine" additional bitcoins.

The bitcoins in a Bitcoin wallet are not the liabilities of any corporate or public entity. Nor are they any kind of tangible commodity that has a value going beyond their market exchange value. Their value is pure exchange value, and consists entirely in whatever it is others are presently willing to exchange for bitcoins.

Nick: "You lost me on the leverage ratio being infinite."

I have this wrong I think, Nick. I was taking the leverage ratio to be the ratio of assets to liabilities. So if liabilities = $0, the leverage ratio would be infinite. But after a further look, it appears the regulatory leverage ratio is the ratio of Tier I capital to total (non-risk-weighted) assets. So if total assets = $200, liabilities = $0 and capital thus = $200, the leverage ratio would be 1.

Dan: that sounds better on the leverage.

(I think you mistakenly posted your previous comment here. If you want to copy and paste it onto the Bitcoin post, go ahead, and I will unpublish it here.)

Dan Kervick said: "It's all shareholders' equity, and Tier I capital = total capital.

For Bank I, if we assume all of the loans are residential mortgages (risk-weight = 50%), then the bank's risk-weighted assets are 50% x $200, or $100. It's total capital is $200. It's total exposures are $100 in deposits. So both the capital ratio and the leverage ratio are 100%."

Shouldn't that be "Its total capital is $100."?


Sorry I've missed so much of the discussion but I have a serious question:

Where do you get the idea that a bank with 100% capital can't become insolvent?

Seems to me it can.

@Too Much Fed,

Yep... Sorry.

Adam P: Well, turns out there's an ambiguity in "100%", because it's 100% *of what?*

A bank (or any firm) with 100% equity and 0% debt cannot become insolvent. It doesn't owe anybody anything.

I'm thinking capital =100% of assets, so no liabilities.

However, seems to me a money market fund getting run is a money market fund becoming insolvent.

Both are cases where those holding claims sell off the assets and wind up the concern.

I'm late to this, and I haven't read all the comments, so if anyone else has already said this I'm sorry.

Re option #2: if deposits are equity shares in the bank, what you have is a mutual. Not a mutual fund, but a mutual BANK - like a UK building society. Strictly, a bank funded entirely with equity in this manner cannot become insolvent, since it has no debt on which to default. But unless the asset base was very safe and stable, it could be prone to runs, because depositors' money is seriously at risk. Originally, in the UK building society model, this risk was mitigated by limiting building society lending to low-LTV prime residential mortgages. But those restrictions were progressively lifted, and building societies gradually took on riskier lending - subprime, commercial property and commercial lending. Consequently some of them failed in the aftermath of Lehman as their asset values collapsed, and depositor shareholders would have lost their money had the UK government not passed emergency legislation to allow these building societies to be taken over by other institutions (building societies, banks and in one case a private equity company). One building society was even nationalized to prevent it failing. At the present time, depositor shareholders rank junior to unsecured bondholders in UK building societies: legislation is proposed to change this so they rank pari passu with unsecured bondholders, which would give them the same seniority as depositors in conventional banks, but it has not yet been enacted.

So a bank in which depositors are shareholders may not technically be able to become insolvent, but it definitely can fail. And I would suggest that its funding might actually be more unstable than a conventional bank in which depositors ranked senior to shareholders.

Adam: closed end funds can't really have a run. The shareholders might decide to wind them up though.

Frances C: I thought this post would be more up your street!

The way I'm thinking of it, depositors, as shareholders, would be both first and last in line. They are the only people in the line. (OK, I expect there's the electricity bill, and wages for the staff). Can there be a run on shares/deposits? If there were, and nobody wanted to buy, and the price of shares/deposits fell to $0, then if the bank still had some assets, anyone could make a killing by buying those shares/deposits.


With equity ownership it is a little more complicated. Would all bank equity holders be voting shareholders capable of electing / firing board of director and steering committee members? Equity ownership does grant a degree of control over the fortunes of the company that is legally protected. And so, when you opine shareholders are "owed" nothing, that seems a bit of overreach. True, they are no legally protected in the same way that bondholders are (through bankruptcy law), that does not mean they are totally without legal recourse.

I'm working on a more interesting reply, but a clarifying question first:

What exactly is the liability associated with the shares in your example? Here are some possibilities I infer:

a) The shares allow investors to demand, on the drop of a dime, their proportional share in the bank's assets in the form of cash $. This is sort of like traditional demand deposits, in that traditional demand deposits are promises to pay a fixed dollar redemption value (as you say) on the drop of a dime. The difference here - a big difference - is that the bank only has to pay out a percent of its assets in cash, which can vary in value.

b) The shares give shareholders first dibs on assets in the case of a liquidation. The shares can also be represented electronically or given as paper certificates. The only thing shareholders can demand on the drop of a dime, outside of liquidation, is electronic to paper conversion or paper to electronic conversion of their shares.

The difference matters for the accounting, and thus properly identifying the balance sheet metrics we care about, as I see it (and probably also affect the bank's cost of capital or debt). For a), if investors invest $100 into the bank, then I think the balance sheet of the bank would look like:

Assets: $100 cash; Liabilities: $100 cash (investors can ask for whatever the value of its assets are at anytime); Equity: $0 (equity is simply a plug: it's value is equal to assets - liabilities). If the bank invests the $100, then the asset turns into the dollar value of the investment, and the liability adjusts with it as its value changes. This is because the bank is only ever liable for the value of its assets.

For b), if investors invest $100 into the bank, then I think the balance sheet of the bank would look like:

Assets: $100 cash; Liabilities: $0 cash; Equity: $100.

The liability to give investors paper versions of their shares exists, but it's not denominated as a $ liability. Perhaps you could put the # of shares as a liability and the negative of that as equity (like if the central bank handed over dollars to the private sector in return for nothing), but it wouldn't be dollar denominated. It'd be like a separate balance sheet with a separate unit of account.

Alternatively, maybe you'd prefer to keep the # of shares off the balance sheet of the bank (because they aren't really liabilities - the conversion feature isn't compelling enough to identify them as liabilities), but put it on the balance sheet of investors as assets and equity. Again, though, this would be in a share # denominated balance sheet, not $ denominated.

In any case, if the bank invests the $100, then the asset turns into the $ fair market value of the investment, and $ equity adjusts with it as its value changes. The bank has no liabilities outside of liquidation. Only if it goes bankrupt does it owe shareholders the value of its assets.

I'm not a total expert on accounting. The whole share # denominated thing was my own machination. But this is what I'd guess as being coherent accounting-wise.

BTW, I felt like you were more talking about b), but wasn't sure. If it is b), and banks never fund themselves except through share issuance, what would ever make the bank forced to be liquidated, unless by covenant? If it were never to be liquidated, then it's certainly not clear that the shares should have any $ denominated value. If they for some reason did, then you're in Bitcoin world: why would a share, which has no inherent conversion ratio to $, be exchangeable for dollars?

If the shares said the bank would liquidate by some date (or that it would pay dividends in $ every now and then), then it would be more plausible that the shares would have a $ denominated value. If that were the case, you would start to make book entries for dividend related or liquidation related liabilities, I believe.


It depends on the terms of the deposit shares. If we assume they look like ordinary deposit accounts (as they do in most building societies) then whether or not they can "run" is determined by lock-in. Time deposits can't run - only demand deposits run. A bank funded entirely by demand deposits is not much more stable than one funded entirely by wholesale funding, so banks prefer to have a good proportion of time deposits in the funding mix. In which case the shareholding would never fall to zero, but time depositors could end up benefiting from a demand deposit run even if asset values collapsed significantly.

You're right about overheads, though. Staff wages, supplier bills, legal costs and taxes all have to be settled before depositor shareholders can receive anything. So they aren't first in line. They can only be last in line. I'm sure you can imagine the tabloid headlines: "FAT CATS WALK AWAY WITH MILLIONS WHILE GRANNIES LOSE OUT". That would go down really well in the corridors of power.

The reason I was mostly confused on what you were talking about is because you said the accounts were chequable and you could write a cheque for $ cash. But is what you meant that you only can write a check for S shares (the bank will give you S paper certificates representing shares or transfer them somewhere else, assuming they're accepted wherever that is), and perhaps you would calculate how much S you want based on their fair market value in terms of $? If so, if the shares are worth 0 in terms of $ (see previous comment), it won't be possible to do this. You can't transfer $20 worth of S when all S is worth $0. That's why I think it's better to state the general case: they're chequable in terms of S, and maybe S has FMV in terms of $. (And then obviously, even if S are worth $, they may not be accepted as medium of exchange.)

Right, Frances asks my question. What are the specific terms of the shares? Is it a), b), or something else? If it's b), when are shares allowed to get liquidated, if ever?



and the next day's headline


"Your memory is good. Mine is failing."

Nah, that post was a particular favorite of mine, so it stuck in my head.

Checks are liabilities that always trade at their face value. In the days of free banking, where bank monies were the media of exchange, money had to be traded at a discount, since counterparty risk was priced into it. This made commerce extremely awkward, as people needed to consult a continuously updated discount table before accepting money, and holding bank money meant accepting counterparty risk, though there was no market risk, since it was redeemable at the bank at its face value in gold (as long as the bank was solvent).

This was gradually replaced by a system of checkable deposits deposits and clearinghouses. The advantage of this was that checks could normally trade at face value, which decreased trade friction enormously. Any system where the conversion rate from the medium of exchange to the medium of account fluctuates in the short term is inherently inefficient.

Deposit insurance is merely the government taking on the role of the clearinghouse as guarantor. There are markets which still have their own clearinghouses, and there is usually not much difference between the two systems. For commodities' futures, for instance, there is the ICCH.

The market has clearly spoken in favor of clearinghouse systems. It is neither practical nor economically efficient to have depositors bear the risk of banks. The annual report of a bank like Bank of America in spite of being over 300 pages, still doesn't give an accurate representation of the bank's finances.

Look at the failure of Lehman. If they could fool sophisticated investors until close to the end, what can you reasonably expect from depositors? Banks would have to go back to private clearinghouses, and the government would, in effect, have to guarantee their operation, because the consequences of a clearinghouse failure would be catastrophic cf. the panic of 1907.


I don’t agree with your claim that runs are likely where a bank is funded entirely by shareholders or other types of loss absorber. As George Selgin explains in his book (see above) and as Diamond and Dybvig explain in sundry papers, its conventional DEPOSITORS who run, and they do it when they suspect they might lose everything (which they do when a bank becomes insolvent).

In contrast, when a bank (or indeed any other type of firm) does badly, the value of shares (or mutual fund holdings) drifts downwards. But it never collapses to zero: at least I know of no instance of a bank’s assets collapsing to zero. If that ever happens, it’s extremely rare. And if it does happen, who cares? Shareholders / mutual fund investors are wiped out.


Re your first option (i.e. “a”) that more or less the system advocated by Lawrence Kotlikoff, Positive Money and others, which in turn is much the same as Nick’s No.2 option in the above post. (See my comments above for links to LK & PM’s relevant literature.)

The only bit of Nick’s proposal I disagree with is his claim (in one of the comments above) that depositor / mutual fund investors can get their cash out IMMEDIATELY. In contrast, I think (as do Kotlikoff and Positive Money) that if an investor decides to cash in their chips at midday on 1st Jan, then what they get is what those chips actually sell for at midday, 1st Jan. Thus there is an inevitable delay (perhaps only a day or two) between a depositor / mutual fund investor’s decision to cash in, and the actual receipt of cash.

In contrast, under Kotlikoff and Positive Money’s systems, anyone wanting GENUINE INSTANT ACCESS to a given sum of cash has to put that money into a full reserve / 100% safe account (where the money is not loaned on and thus earns no interest).

Frances and ATR: I'm basically with Ralph, except for the delay thing.

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.

The market for bank shares would be much thicker than it currently is, because people would be buying and selling them the whole time whenever they bought and sold anything else by cheque. So bank shares would be very liquid. If the bank shares still weren't liquid enough, banks themselves could buy and sell their own shares, acting as market makers.

Banks would need to keep currency reserves, of course, just like they do today. And they could borrow from the central bank, against a haircut on good collateral, just like today.


"And they could borrow from the central bank, against a haircut on good collateral, just like today."

Would that put the central bank in a position of secured creditor ahead of share holders? If so, how does that change too big to fail?

Frank: this is a liquidity operation. A repo. If the worst happens, and those assets the central bank bought turn out to be worthless, the central bank has lost what it paid for them. Just like the electricity company has lost the electricity it sold the bank.

*Try* to see the big picture.


I thought I was seeing the big picture - end too big to fail. I mean that is the whole point of 100% capital ratios isn't it?

"...the central bank has lost what it paid for them..."

If this happens, the central bank does not just throw up its hands and say oh well. In the U. S., the central bank is given very strict limitations on what it can buy / lend money against by the federal government. And so, there are legal ramifications for the central bank if they fail due diligence or are misled by a bank.

Unless of course you are talking about expanding the federal reserve's ability to buy any asset at whatever face value the bank says it is worth.

Frank: the BIG picture is this: instead of being owed fixed dollar amounts, the bank's depositors are only owed their share of the value of the bank's assets. Just like any shareholder. Unless the value of the bank's total assets falls to zero, the bank is not bust. Unlike a bank with only 10% capital, where a 10% drop in the value of its assets means it is bust.

Stop now.


I got all that. What you haven't explained is why the central bank is still needed - if a bank is allowed to fail then certainly it should be allowed to fail from a lack of liquidity.

Ah, okay. I agree that if that's all the bank literally did, it could not become insolvent (unable to pay its debt). It seems you've identified two ways to structurally avoid insolvency. One way is how the central bank does: being able to create what's needed to settle its liabilities (cash or reserves). The way your novel bank avoids it is by making sure the value of its liabilities are only ever equal the value of its assets, on a continuous basis. I know you drew a parallel between them, but they are different in my opinion.

If my accounting is correct, though, neither case is a "100% capital ratio" as is traditionally defined and measured, to my knowledge. In your novel bank case, assets would always be equal to liabilities and equity would be zero, so there'd be no capital to speak of. I guess this depends on the generally accepted accounting practice, but I'd consider your shares to be on-demand liabilities just like traditional demand deposits, except they adjust in value with assets. Thus, no equity.

I know Frank's bugging you, but technically once the bank starts borrowing funds elsewhere, it starts owing fixed dollar amounts and its total liabilities will no longer always be equal to its total assets (until the debt is settled). In fact, equity goes negative. This violates your banking principle.

Say the bank starts with $100 shares:

Assets: $100 investment
Liabilities: $100 shares
Equity: $0

Then say it borrows $20 from the central bank. The shares are always equal to total assets, so equity goes negative here:

Assets: $100 investment, $20 cash
Liabilities: $120 shares, $20 central bank borrowing
Equity: -$20

It uses the $20 to pay a shareholder looking to get out:

Assets: $100 investment
Liabilities: $100 shares, $20 central bank borrowing
Equity: -$20

The only way we get back to the original assets = liabilities situation is to get rid of that borrowing by liquidating the investment:

Assets: $80 investment
Liabilities: $80 shares
Equity: $0

ATR: Frank is always bugging me. He always seems to miss the point and lay out some stupid red herring, which I then have to track down, wasting my time, and throwing off the comment thread.

Sure. If the bank has an unpaid electricity bill, equal to 1% of its assets, and if all its assets fall in value by more than 99%, the bank is insolvent. But depositors would never choose to use a bank whose share price was that volatile. It's peanuts, compared to the likelihood a regular bank would go bust.

ATR: "I guess this depends on the generally accepted accounting practice, but I'd consider your shares to be on-demand liabilities just like traditional demand deposits, except they adjust in value with assets. Thus, no equity."

You may well be right according to GAAP. But that would only show that GAAP is useless, and should be ignored. The deposits-as-shares are equity. They are liabilities, or not, in exactly the same sense as shares in any company. Forget the book value of those shares. It's just an accounting irrelevancy. The shares are worth what the stock market says they are worth.

Since you were looking for something in between an open and closed ended fund, maybe an exchange traded fund (ETF) would be a good analogy for your bank? With ETFs, shares can be continuously sold and redeemed for net asset value (NAV – which you can calculate from book value, I believe) but also traded on a market exchange where the market value of the shares could depart from NAV. Differences would be the types of assets the bank invests in (as you mentioned), and I think ETFs also place floors on the size of new share issuances and redemptions, but otherwise it seems kind of similar.

We definitely agree on the implications for solvency. I could definitely be wrong about the accounting. If we cared about that, we could probably find the right answer by looking at mutual funds. I just wanted to nail it down since you brought in balance sheet metrics such as capital ratio, and that's all based off of accounting. It also helps one be explicit about what exactly the company is on the hook for, in my opinion.

"They are liabilities, or not, in exactly the same sense as shares in any company."

I wasn’t thinking of closed end mutual funds, much less ETFs, and I'm not aware of stock that allows investors to take their shares to the company and ask for cash in return whenever they want. That’s why I dissociated this with the typical ‘share’ associated with exchange-traded equities.

ATR: ETFs would be a good analogy. Except ETFs usually only hold assets that are themselves traded, while banks also hold things like loans to individuals that are very illiquid and not usually traded, so there is no easily observed market value for the assets the bank holds.

"I'm not aware of stock that allows investors to take their shares to the company and ask for cash in return whenever they want."

Suppose you own shares in a brokerage company, and you also use that same company as your broker. If you tell the company you want to cash out your shares, it sells them for you. It won't normally buy those shares back itself, though it could perhaps do so.

Ralph, Nick,

It's ridiculous to suggest that share deposits wouldn't run. If that's what Selgin said, he doesn't know what he's talking about (but I suspect it ISN'T what he is talking about). Depositor shareholders do not see themselves as different from any other sort of depositor. They do not consider their money to be "at risk", and although they may understand that they "own" the bank, they don't expect to share in any losses. So if they view the bank as risky, they will pull their funds just as any normal depositor would - and indeed as institutional shareholders would. Redefining people's deposits as shares isn't going to change their expectation that their money is safe. For that, you have to explicitly tell them that their money is at risk, and provide a safe alternative (as Ralph is suggesting, actually). And then accept that your banks are going to be pretty thinly capitalised, because they can't offer the service that most depositors expect, namely a safe place to put money.

Heh, clever, but a stretch.

Okay, onto more interesting questions:

"But depositors would never choose to use a bank whose share price was that volatile."

Speaking of that, would these banks be able to replace the banking industry as we know it today, and/or would our economy be as healthy?

The business models of banks as I understand them rely on a mix of about ~10% equity and ~90% debt (ball park). The return on bank assets are small compared to non-financial corporations. So in order to generate sufficient returns for equity investors, banks use a lot of debt. Banks can afford this debt because they can find it for cheap: deposits and money market borrowing.

With your banks, you're saying everything is now essentially funded with equity. But I take it that banks as we know them today couldn't just fund themselves with equity. They wouldn't be able to generate sufficient returns to attract the same amount of funding. Would this limit the size of these new banks, and thus the amount of loans they could fund relative to traditional banks? By limiting the amount of loans, would our economy not be as healthy?

This is complicated.

I think Perry Mehrling thinks about this kind of stuff. How finance is moving from traditional banking to shadow banking, which includes entities like mutual funds.


"They do not consider their money to be at risk, and although they may understand that they own the bank, they don't expect to share in any losses."

They might understand that they are expected to share in losses if they are also given the ability to change management in the event of losses - ie, their shares (deposits) are voting shares.

Frances: I'm not 100% sure, but I think you might be totally missing it. (Apologies if I'm wrong.)

"Depositor shareholders do not see themselves as different from any other sort of depositor."

These ones would know immediately they are different. Because if they "deposit" $100 in their chequing account, they would see its value fluctuate hourly, according to the stock price.

"It's ridiculous to suggest that share deposits wouldn't run."

OK, suppose they do run. Everybody tries to sell their share deposits at the same time. The bank shrugs its shoulders. The market price of shares drops to $0. So speculators buy the shares, because they know the bank's assets are worth more than $0 per share.

ATR: "This is complicated."

Yep. Equity finance is normally more expensive than debt finance, which is more expensive than deposit finance. But if shares were deposits:

1. They would be very liquid, because they are media of exchange

2. They would be much safer than current shares, because the bank would have no debt.

So banks' average funding costs might be higher or lower than at present. It's not obvious.


How do you reasonably conduct commerce in such a situation? How is check clearing be handled? I write a check to buy some good from a company 1,000 miles from where I live. Check takes 3-5 days to clear my bank. In the meantime the value of my shares (deposits) are no longer sufficient to cover the balance of the check.


Then you basically don't have a bank that is usable by ordinary people, who by and large are risk averse. They don't want to see the value of their deposits fluctuating hourly, and they don't want to run the risk of losses. They want to know that what they put in they can always get out again. The conflict between what depositors want (safety) and what borrowers want (risk finance) is the biggest problem in banking.

If you force ordinary people to take that sort of risk in deposit accounts, they won't use them. They will stuff mattresses. This would be even more likely if you make it difficult for them to take money out when there is risk - that they can only do so by selling their shares, possibly for considerably less than they bought them for. Why on earth would risk-averse people put their money into such a bank, when they could put it into a money market mutual fund which at least guarantees that they get their money back, or buy government bonds which are 100% guaranteed and are highly liquid? And if they wanted to take risk with their money, they would do better to put it into a managed investment fund which at least is run by professional fund managers rather than bank treasurers who simply regard their money as a source of funding.

I've gone through the logic of 100% capital funding many times before. It founders on the problem that most of the people who put money in banks are risk-averse. You can't prevent banks from failing by forcing losses on to people who neither want nor can afford to take those losses. They simply won't use the banks.

But we know that investors initially looked at the banking business opportunity and observed what the return would be if banks were 100% equity financed. They decided that wasn't good enough. So they demanded a ton of leverage. So I'm not sure your point number 2 is that compelling, at least on its own.

Is your reasoning for point 1 that because businesses accept traditional demand deposits, which are liabilities of commercial banks, they also accept these shares, which look like demand deposits? That's not certain. Businesses ultimately want the cash, but they know that deposits are 1 to 1 with cash always, thanks to the central bank and government backstopping those markets. So they take the deposits.

But businesses can't know what the shares are truly worth until they're a) sold into the secondary market or b) they ask the company for their proportional NAV, which is only known when the company finally sells its assets into the secondary market. Unless the central bank and government started back-stopping capital markets, like they have traditionally done for money markets, you probably have more liquidity risk here, and so costs will probably be higher.

Frances and ATR: remember the Modigliani Miller Theorem. The cost of financing is independant of debt/equity ratios. The MM is false, of course, because it ignores liquidity and bankruptcy. But by eliminating bankruptcy, and by making bank shares as liquid as deposits, that suggests that financing costs should fall.

There would always be 100% reserve banks for the pathalogically risk-averse.

Why should the taxpayer have to subsidise someone's desire for absolute safety+liquidity in a chequing account?

Isn't it also false because of taxes? We're not getting rid of those, though.

Liquidity is the key issue here.

"Why should the taxpayer have to subsidise someone's desire for absolute safety+liquidity in a chequing account?"

Isn't this essentially what we've decided is the best thing to do since Bagehot? Governments/central banks ensure there is enough liquidity in money markets so that deposits stay 1 to 1 with cash. This gives people the confidence to transact with them at low cost, greasing the wheels of the economy.

I think I could make the analogy that for your shares to be treated just like deposits, you'd need the government/central bank to back stop capital markets as well. But maybe that's a good way to go.

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