CURBING THE MONEY MULTIPLIER: CAPITAL REQUIREMENTS VERSUS NARROW BANKING

CURBING THE MONEY MULTIPLIER: CAPITAL REQUIREMENTS VERSUS NARROW BANKING Abstract This article discusses financial regulation proposals based on capital and liquidity requirements and those that instead suggest a 100% reserve on bank deposits. The topic is developed by comparing the position of Alan Greenspan, a resolute supporter of capital requirements as the main regulator of the financial sector, with that of Mervyn King, who has recently proposed a sort of ‘moderate narrowness’ in banking as a solution. Ten years after Alan Greenspan’s The Age of Turbulence, Mervyn King’s The End of Alchemy offers the reader another valuable testimony of how a prominent central banker reads the emerging trends in the banking sector, and conceives the role that the central bank is called to play at the core of a modern financial system. These two books are very different in both style and contents, and complement each other well. While Greenspan gives ample space to autobiographical memories, this element is completely absent in King’s narrative. Greenspan focuses exclusively on the U.S. financial and banking system; King mainly looks at Britain and Europe. Greenspan masters the data, showing his celebrated practical knowledge of all the labyrinthine channels of the U.S. financial system. King uses data with less ease, although in his book there are numerous cultured references to hidden financial anecdotes from all over the world, from the beginning of the 17th century to recent times. Greenspan draws heavily on the crucial events of the 20th century (the Great Depression, World War II, the rise of communism), and numerous passages of The Age of Turbulence argue in favour of the superiority of the market economy over the planned economy. His book is imbued with politics (for example, there are many pages dedicated to Fabian socialism). This aspect is much less explicit in The End of Alchemy. Conversely, King’s book discusses monetary theory much more extensively, with Keynes at the centre of the discussion. In Greenspan’s book Keynes is rather in the shadows, since from his first approaches to economic studies ‘Keynes’s mathematical innovations and structural analyses were what fascinated me, not his ideas on economy policy’ (Greenspan, 2007, p. 30). Above all, the main difference between the two is determined by the fact that while Greenspan seems to consider financial crises as incidents that sooner or later occur, King believes that the finance and banking sector, as it stands today, is the most fragile and unstable feature of a modern capitalist system, to the point of threatening its own survival unless radical reforms are adopted. This difference of opinion does not depend merely on the fact that Greenspan’s book came before the economic and financial crisis. In a long essay published in 2010 entitled The Crisis, a sort of addendum to The age of turbulence, written in the aftermath of the financial unrest, the longest-serving chairman of the US central bank put forward straight the view that he knows of no form of economic organization based on a division of labour, from unfettered Laissez-Faire to oppressive central planning, that has succeded in achieving both maximum sustainable economic growth and permanent stability (Greenspan, 2010, pp. 217–18). This sentence is a condensed self-defense of his long years of service from the accusation of having favoured financial laxity, and therefore the crisis. Prolonged growth and financial stability are two goals that cannot be achieved at the same time. Financial means sustained a prolonged period of growth, he says in essence, and the financial crisis, however intense and virulent, must be assessed in the light of this, without too much alarmism. In his view, this does not justify an attitude of ‘business as usual’. However, the road ahead is not to get caught up in regulatory frenzies, but to increase regulatory capital, liquidity, and collateral requirements for banks and shadow banks. I. Regulatory capital requirements As a matter of fact, that of requiring adequate capital requirements is the direction that has been given to financial regulation over the last few years. According to Greenspan this is enough, since throughout the postwar years in the United States, with the exception of a limited number of bank bailouts (Continental Illinois in 1984, for example), private capital proved adequate to cover virtually all provisions for lending losses. As a consequence, there was never a definitive test of what then constituted conventional wisdom, namely, that an equity capital–to–assets ratio of 6 to 10% on average, the range that prevailed between 1946 and 2003, was adequate to support the U.S. banking system (Greenspan, 2010, p.218). Now, capital, liquidity, and collateral … address almost all of the financial regulatory structure shortcomings exposed by the onset of the crisis. In retrospect, there has to be a level of capital that would have prevented the failure of, for example, Bear Stearns and Lehman Brothers. (If not 10%, think 40%.) Moreover, generic capital has the regulatory advantage of not having to forecast which particular financial products are about to turn toxic. Certainly investors did not foresee the future of subprime securities or the myriad other broken products. Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning (Greenspan, 2010, p.220). What the crisis highlighted is not that adequate capital is incapable of guaranteeing the stability of the financial system, but that a ratio of equity capital-to-assets of 6%–10% is too low. But then, if it is too low, how much regulatory capital is currently needed? According to Greenspan, the answer has to be found by looking at how much capital is being required from financial institutions by their counterparties, since private market participants can require economic capital and balance sheet liquidity well in excess of the Basel requirements. To get a glimpse of this, Greenspan makes one of his back-of-the-envelope calculations with which it is claimed he has steered the US financial system for 20 years. As the financial crisis took hold, the average price of 5-year credit default swaps (CDSs) of the six major US banks rose from 17 basis points in early 2007 to 170 basis points just before the Lehman default on 15 September 2008. In response to the Lehman default, the 5-year CDSs average price rose to more than 400 basis points by 8 October. When the Troubled Asset Relief Program (TARP) was announced (14 October), the price fell to ~200 basis points. Now, since the TARP added ~2% points to the ratio of equity capital to assets, an overall additional 4% point rise (from 10% in mid-2007 to 14%) in that ratio would have reduced the price of the CDSs to their initial levels. This is of course just an indication, as Greenspan himself does not fail to underline, but in any case it can provide a number: given the foregoing set of fragile assumptions and conclusions (and they are all we have), I would judge that regulatory equity capital requirements in the end will be seen to have risen from the 10% precrisis level (in terms of book value) to 13 or 14% by 2012, and liquidity and collateral requirements will toughen commensurately (Greenspan, 2010, p. 224). Having ascertained the ratio of equity capital to assets which offers reasonable guarantees to the counterparts of the financial system (i.e. how much guarantee capital is required by the market), Greenspan faces the problem (generally neglected by the economic literature on financial regulation) of the effects that an increase in regulatory equity capital can have on the banking system’s profitability. How much regulatory equity capital a banking system can tolerate without a significant number of banks being forced to raise their margin is something that can be singled out considering the remarkable stability of the ratio of bank net income to equity capital (π/C). With rare exceptions, since the end of the Civil War this ratio has moved within a range of between 5% and 15%. Over the same period, due to increasing competitive pressure on profit spreads, net income as percentage of assets (π/A) fell, while the ratio of equity capital to assets (C/A) also fell from ~50% to 6%–10% of the post-WWII decades. In other words, despite the fall in net profit as a percentage of assets, the net profit in terms of equity remained stable because of increasing leverage. In the years before the crisis, π/A averaged 1.2%. Taking π/C at the lower end of 5%, the inferred maximum average regulatory capital C/A is ~24%. Taking π/A at its average of 0.74% over the 1950–75 period, C/A = 15%, which is able to cover the 12–14% market-determined capital requirement that would induce banks to lend freely. A rate >14%, all else equal, would put the average rate of return on equity below the critical 5% level. Capital requirements are not sufficient to avoid the moral hazard posed by financial institutions which are too big to fail. According to Greenspan, the solution that has at least a reasonable chance of reversing the extraordinarily large ‘moral hazard’ that has arisen over the past year and more is to require banks and possibly all financial intermediaries to issue contingent capital bonds, that is, debt that is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures. However, should contingent capital bonds prove insufficient, we should allow large institutions to fail and, if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility, whereupon the regulator would be granted access to taxpayer funds for ‘debtor-in-possession financing’ of the failed institution. Its creditors (when equity is wholly wiped out) would be subject to statutorily defined principles of discounts from par (‘haircuts’), and the institution would then be required to split up into separate units, none of which should be of a size that is too big to fail. The whole process would be administered by a panel of judges expert in finance (Greenspan, 2010, pp.231–32). Greenspan then goes as far as accepting that large financial institutions can fail, but he thinks that their failures could be (strictly) managed. He is however unyielding about the role of the state as the regulator of the financial system: for him, its shape must in any case be determined by market forces without too many constraints. The more the division of labour develops, the greater the need for a dynamic financial system. Financial innovation is as essential as technical innovation. However, it is not possible to distinguish a priori between good innovations and harmful innovations. In Greenspan’s view, this is a terrain in which the state must not enter, or must enter as little as possible, both in terms of regulation of financial products and intermediaries, and in terms of acting as ‘systemic regulator’ of asset prices at large. The fact that the economy is on the path of financial instability is something that can only be ascertained with hindsight. And there is no possibility of changing this state of affairs, since the state knows about the future much less than the markets. His conclusion is that ‘Only adequate capital and collateral can resolve this dilemma’ and that ‘if capital is adequate, then by definition, no financial institution will default and serial contagion will be thwarted. Determining the proper level of risk-adjusted capital should be the central focus of reform going forward’ (Greenspan, 2010, p.244). II. More radical reforms Regulatory capital in the range 10%–15% and, more generally, collateral requirements with haircuts differentiated per asset class are the current consensus on financial regulation. What is King’s position about all this? The minimum amount of equity a bank must use to finance itself, known as its capital requirement, has been raised, and banks also have to hold a minimum level of liquid assets related to deposits and other short-term financing that could run from the bank within thirty days, known as the liquidity coverage ratio. Regulators are also conscious of the need to look outside the boundaries of the traditional banking sector…U.K. and U.S. have introduced legislation to separate, or ring-fence, basic bank operation from the more complex trading activities of investment banking. And most countries have either improved or introduced special bankruptcy arrangement – known as resolution mechanisms – to enable a bank in trouble to continue to provide essential services to its depositors while its finamces are being sorted out (King, 2016, pp.255–56). But, he asks, is this enough? He answers: I fear not, and for one simple reason. Radical uncertainty means that sentiment towards financial firms can change so quickly that regulations which appear too burdensome one moment seem too lenient the next…The experience of 2007-8 illustrates what can happen. Let’s ask the following question: how much equity finance does a bank need to issue in order to persuade potential creditors that it is safe for them to lend to the bank? Before the crisis, the answer was hardly any at all. Markets were content to lend large sums to banks at low interest rates, even though banks were highly leveraged. After 2008, the answer was a very large amount. Not even the new higher levels of capital mandated by regulators were sufficient to ensure that markets were happy to restore previous levels and pricing of funding (p. 257). To underline the point, King notes that in 2012 the Spanish bank Bankia, although reporting a risk-weighted capital ratio of more than 10%—well above the regulatory minimum—was forced to recapitalise for 25 billion euros. It is precisely on this aspect that the positions of King and Greenspan diverge, to the point of becoming irreconcilable. Greenspan, faced with a case like that of Bankia, would probably have simply concluded that a ratio of 10% was not sufficient at that time (Bankia later merged with Banco Mare Nostrum and their post-merger risk-adjusted capital ratio is now in the 8%–8.5% range). Things are different for King. For him, no matter how much efforts can be made to design risk weights for bank assets, these assessments can only be based on past experience. But the need for banks to use equity to absorb losses is pressing precisely when past experience offers no help. For similar reasons, the rules that require banks to hold a minimum level of liquid assets to cope with an exceptionally high demand for repayment of debt and deposits, are useless. How to define a perfectly liquid asset? Before the crisis, everyone was convinced that public debt securities were perfectly liquid. During the crisis this certainty vanished. In addition, King notes, countries like Australia that have made little use of deficit spending and public debt, may not have sufficient public securities to meet the demand for liquid assets. In his opinion it must be admitted that in a world of radical uncertainty, only the central bank can create liquidity, and that this function must therefore be integrated with the lending of last resort. Where Greenspan would have suggested that we do not need anything but an adequate equity-assets ratio, King instead comes to the conclusion that there is urgency for ‘more radical reforms’. III. Some degree of narrowness Now, when ‘radical reforms’ come up in the context of financial regulation, the issue starts to gravitate around the idea of some form of ‘narrow banking’, namely, forcing banks to end fractional reserve, holding liquid assets to back 100% of their deposits. The list of proponents of the abolition of fractional reserve banking, King reminds us, is very long, including economists of the most various political attitudes (Irving Fisher, Henry Simons, Milton Friedman, James Tobin, Hyman Minsky, among others). Indeed, the idea has been presented in very different forms: its supporters go from those who opine that most of the financial sector can be deregulated and governed by free competition, to those who, at the opposite extreme, consider it essential to put the sector firmly under public control and therefore see in narrow banking the instrument to regulate, if not to ‘nationalise’, at least money management and the payment system. In general terms, a narrow bank issues demandable liabilities and invests in assets that have no nominal interest rate and credit risk. Specifically, there may be different degrees of narrowness, depending on the degree of risk of the securities backing liabilities. At one extreme, we find the 100% Reserve Bank Plan, where assets are made up of high potential money (central bank reserves) and liabilities are demandable deposits. At the other extreme, there is the Utility Bank Plan, where assets consist of low-risk money market instruments, retail and small businesses loans, and liabilities are deposits that have a claim on the money market instruments. In the middle, a variety of Mutual Funds, whose assets are treasury securities, commercial paper, repo and other similar instruments, and liabilities are equity with proportional claims on assets (Pennacchi, 2012). The 1933 Chicago Plan, which is considered the main reference of all the advocates of narrow banking, provided 100% coverage in central bank reserves of demandable deposits, allowing banks the normal lending activity funded with time deposits, equity capital, and the like. Friedman’s plan required any institution which accepts deposits payable on demand and transferable by check to have one dollar in high-powered money for every dollar in deposit liabilities. In fact, a very ‘monetarist suggestion’, since ‘shift between deposits and currency would have no effect on the total stock of money and banks could not alter the ratio of deposits to reserves’ (Friedman, 1959, p.69). For Friedman, as well as for Fisher before him, the question was not only that of making the creation of money a government function, but also that of keeping a proper volume and velocity of the circulation medium. Tobin’s idea, on the other hand, is that the Federal Reserve should offer the public not only Federal Reserve notes and coin, but also a ‘deposited currency’. It should therefore establish agencies located in banks or post offices, possibly managed by agents, who would carry out transactions cleared directly by the FED. Commercial banks that access deposit insurance should only invest in short and low risk securities. The riskiest long-term investments should be financed by equity and uninsured debt (Tobin, 1987). The ultimate aim of all these proposals is to separate banks that assure the working of the payment system, from banks that provide credit. Safe and liquid narrow banks will carry out payments services. Risky and illiquid wide banks will lend to the real economy, financing themselves with equity or long-term debts. As Irving Fisher put it, this means splitting each commercial bank into two departments, one—the checking department—a warehouse for money, and the other—the money lending department—virtually a savings bank or investment bank. This arrangement would let the Government take away from the banks all control over money, but leave the lending of money to bankers (Fisher, 1936). Once the checking department is separated from the money lending department, public authorities would no longer be forced to guarantee deposits or to bailout financial institutions in a run-free financial system. With full reserve banking, the credit market could be disciplined by competition, without this constituing a threat to the normal functioning of the payment system. Full reserve banking proposals date back centuries, having been born with fractional reserve banking. However, they have never been implemented. The fundamental reason why this has happened is not related to bankers’ vested interest. The credit market brings together lenders who want to invest in the short-term and at low risk, and borrowers who need long-term risky loans. The fractional reserve mechanism allows a ‘transformation’ of risk and maturities, matching borrowers and lenders with different preferences, and preventing these differences from leading to high lending rates. King is well aware of this. After introducing the reader to narrow banking, he immediately states: the complete separation of banks into two extreme types – narrow and wide – denies the chances to exploit potential economic benefits from allowing financial intermediaries to explore and develop different ways of linking savers, with the preference for safety and liquidity, and borrowers, with a desire to borrow flexibly and over long period. Constraining financial intermediation would mean that the cost of financing investment in plant and equipment, houses and other real assets would be higher (p.264). Thus, at the heart of a book whose title is ‘The end of Alchemy’, the reader finds the idea that the credit system actually needs some ‘alchemy’. To the extent that long-term loans are financed by equity, ‘the risk from unexpected events is then focused on the prices of assets held directly by households and businesses and on the solvency of wide banks’ (p.265). This also brings into play the returns that must be offered to underwriters to encourage them to take on these risks. Moreover, the question arises of the central banker’s intervention in times of crisis, which should necessarily take on the task of supporting the prices of these securities—an outcome that King, like Greenspan, firmly believes should be avoided. It must also be taken into account that debt, even though in the post-crisis period regarded as the culprit of all financial ills, plays a fundamental and irreplaceable role. For small businesses, or for excessively complex ones, King notes, the lender does not have the ability to monitor the borrower’s behaviour. He can monitor instead the value of the collateral. Now, although wide banks cannot create money in the form of deposits, they can still borrow short and lend long. In both cases they use collateral. They lend to households and businesses against real assets, and they borrow against financial securities created for the purpose, which give the impression to purchases of bank debt of being liquid and safe but ultimately are backed by the long-term loans and other assets of the bank. A large quantity of paper claims on underlying assets has been constructed to satisfy the demand for collateral. In this way, even wide banks create a degree of alchemy’ (p.267). In fact, wide banks have been at the centre of the 2008 run. The ‘provision of catastrophic insurance’ is something that unfortunately we cannot be dispensed with, thanks to some more or less intense degree of narrowness. How to offer this insurance without replicating the adverse incentives that played such an important role in determining the crisis? IV. Mervyn King’s proposal To give an answer to this question, King proposes for central banks the role of ‘Pawnbroker for all seasons’. The lending of last resort is an ill-conceived measure because the only way to offer liquidity in times of crisis is to absorb collateral of dubious value, with inadequate haircuts and without penalty rates. The Bagheot rule (lending freely, to solvent firms, against good collateral at a penalty rate) has to be systematically disregarded during financial turmoils. Now, instead of acting post-crisis as a lender of last resort committed to mop up almost every bad loan, the central bank could ex-ante declare its willing to lend—always, not just in times of crisis—the liquidity needed. The basis of this proposal is the idea that banks must always be able to repay all short-term deposits. In contrast to narrow banking, this 100% coverage is guaranteed by the central bank lending against collateral. Banks submit to the central bank all their assets eligible as collateral. To each of them is applied a haircut based on their degree of liquidity (for example, the haircut would be 0% for reserves held at the central bank). The sum of all these pre-positioned assets will provide banks with the maximum amount of liquidity that the central bank is willing to provide at all times. Total demand deposits and short-term unsecured loans must be lower than the amount the bank was entitled to borrow from the central bank. To clarify the point, let us consider a numerical example offered by King. A bank with total assets (and liabilities) equal to $100 million, has $10 million in central bank reserves, $40 million in liquid assets, and $50 million in long term loans to businesses. A haircut of 10% on liquid assets and of 50% on illiquid loans will give Effective Liquid Assets (ELA) for $10 + $36 + $50 = $71 million. The bank cannot finance itself with more than $71 million of deposits and short term debt. If the bank had $50 million deposits, $35 million of short-term debt, $10 million of long term debt, and $5 of equity, its Effective Liquid Liabilities (ELL) will be $85 million and thus they must be reduced progressively to $71 million, in order to satisfy the rule ELL<ELA. King’s proposal is halfway between narrow banking and capital and liquidity requirements. Compared to the latter it would seem to impose more restrictive rules, even though a more precise assessment in this regard depends crucially on the haircuts that the central bank would apply. From this point of view, between King and Greenspan there is much more common ground than the reference to ‘more radical reforms’ would lead us to think. It would have been useful to elaborate more precise quantitative indications, in order to clarify the extent to which the constraints proposed by King are different from the combination of capital and liquidity requirements advocated by Greenspan, and today imposed on banks. Compared to the first, it would present the defect of still allowing the banks to create money, since nothing would prevent a bank from granting, for example, $10 million new mortgage loans, creating $10 million deposits (and providing that, assuming a haircut of 10%, $1 million deposits are transformed into long-term loans). From this point of view, King’s proposal appears to be much less radical than the general tone of the book would suggest. Perhaps, a more adequate title would have been ‘Why can't we end alchemy?’ References Fisher , I. ( 1936 ). ‘100% Money and the Public Debt’ . Economic Forum, 3 April–June, 406 – 420 . Friedman , M. ( 1959 ). A Program for Monetary Stability . New York : Fordham University Press . Greenspan , A. ( 2007 ). The Age of Turbulence. Adventures in a New World . New York : The Penguin Press . Greenspan , A. ( 2010 ). The Crisis . Brookings Pap Econ Act , 201 – 246 . Pennacchi , G. ( 2012 ). Narrow Banking . Annu Rev Financ Econ , 4 , 141 – 159 . Google Scholar CrossRef Search ADS Tobin , J. ( 1987 ). A Case for Preserving Regulatory Distinctions . Challenge , 30 , 10 – 17 . Google Scholar CrossRef Search ADS © The Author(s) 2018. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/about_us/legal/notices) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Contributions to Political Economy Oxford University Press

CURBING THE MONEY MULTIPLIER: CAPITAL REQUIREMENTS VERSUS NARROW BANKING

Contributions to Political Economy , Volume Advance Article (1) – May 10, 2018

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Abstract

Abstract This article discusses financial regulation proposals based on capital and liquidity requirements and those that instead suggest a 100% reserve on bank deposits. The topic is developed by comparing the position of Alan Greenspan, a resolute supporter of capital requirements as the main regulator of the financial sector, with that of Mervyn King, who has recently proposed a sort of ‘moderate narrowness’ in banking as a solution. Ten years after Alan Greenspan’s The Age of Turbulence, Mervyn King’s The End of Alchemy offers the reader another valuable testimony of how a prominent central banker reads the emerging trends in the banking sector, and conceives the role that the central bank is called to play at the core of a modern financial system. These two books are very different in both style and contents, and complement each other well. While Greenspan gives ample space to autobiographical memories, this element is completely absent in King’s narrative. Greenspan focuses exclusively on the U.S. financial and banking system; King mainly looks at Britain and Europe. Greenspan masters the data, showing his celebrated practical knowledge of all the labyrinthine channels of the U.S. financial system. King uses data with less ease, although in his book there are numerous cultured references to hidden financial anecdotes from all over the world, from the beginning of the 17th century to recent times. Greenspan draws heavily on the crucial events of the 20th century (the Great Depression, World War II, the rise of communism), and numerous passages of The Age of Turbulence argue in favour of the superiority of the market economy over the planned economy. His book is imbued with politics (for example, there are many pages dedicated to Fabian socialism). This aspect is much less explicit in The End of Alchemy. Conversely, King’s book discusses monetary theory much more extensively, with Keynes at the centre of the discussion. In Greenspan’s book Keynes is rather in the shadows, since from his first approaches to economic studies ‘Keynes’s mathematical innovations and structural analyses were what fascinated me, not his ideas on economy policy’ (Greenspan, 2007, p. 30). Above all, the main difference between the two is determined by the fact that while Greenspan seems to consider financial crises as incidents that sooner or later occur, King believes that the finance and banking sector, as it stands today, is the most fragile and unstable feature of a modern capitalist system, to the point of threatening its own survival unless radical reforms are adopted. This difference of opinion does not depend merely on the fact that Greenspan’s book came before the economic and financial crisis. In a long essay published in 2010 entitled The Crisis, a sort of addendum to The age of turbulence, written in the aftermath of the financial unrest, the longest-serving chairman of the US central bank put forward straight the view that he knows of no form of economic organization based on a division of labour, from unfettered Laissez-Faire to oppressive central planning, that has succeded in achieving both maximum sustainable economic growth and permanent stability (Greenspan, 2010, pp. 217–18). This sentence is a condensed self-defense of his long years of service from the accusation of having favoured financial laxity, and therefore the crisis. Prolonged growth and financial stability are two goals that cannot be achieved at the same time. Financial means sustained a prolonged period of growth, he says in essence, and the financial crisis, however intense and virulent, must be assessed in the light of this, without too much alarmism. In his view, this does not justify an attitude of ‘business as usual’. However, the road ahead is not to get caught up in regulatory frenzies, but to increase regulatory capital, liquidity, and collateral requirements for banks and shadow banks. I. Regulatory capital requirements As a matter of fact, that of requiring adequate capital requirements is the direction that has been given to financial regulation over the last few years. According to Greenspan this is enough, since throughout the postwar years in the United States, with the exception of a limited number of bank bailouts (Continental Illinois in 1984, for example), private capital proved adequate to cover virtually all provisions for lending losses. As a consequence, there was never a definitive test of what then constituted conventional wisdom, namely, that an equity capital–to–assets ratio of 6 to 10% on average, the range that prevailed between 1946 and 2003, was adequate to support the U.S. banking system (Greenspan, 2010, p.218). Now, capital, liquidity, and collateral … address almost all of the financial regulatory structure shortcomings exposed by the onset of the crisis. In retrospect, there has to be a level of capital that would have prevented the failure of, for example, Bear Stearns and Lehman Brothers. (If not 10%, think 40%.) Moreover, generic capital has the regulatory advantage of not having to forecast which particular financial products are about to turn toxic. Certainly investors did not foresee the future of subprime securities or the myriad other broken products. Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning (Greenspan, 2010, p.220). What the crisis highlighted is not that adequate capital is incapable of guaranteeing the stability of the financial system, but that a ratio of equity capital-to-assets of 6%–10% is too low. But then, if it is too low, how much regulatory capital is currently needed? According to Greenspan, the answer has to be found by looking at how much capital is being required from financial institutions by their counterparties, since private market participants can require economic capital and balance sheet liquidity well in excess of the Basel requirements. To get a glimpse of this, Greenspan makes one of his back-of-the-envelope calculations with which it is claimed he has steered the US financial system for 20 years. As the financial crisis took hold, the average price of 5-year credit default swaps (CDSs) of the six major US banks rose from 17 basis points in early 2007 to 170 basis points just before the Lehman default on 15 September 2008. In response to the Lehman default, the 5-year CDSs average price rose to more than 400 basis points by 8 October. When the Troubled Asset Relief Program (TARP) was announced (14 October), the price fell to ~200 basis points. Now, since the TARP added ~2% points to the ratio of equity capital to assets, an overall additional 4% point rise (from 10% in mid-2007 to 14%) in that ratio would have reduced the price of the CDSs to their initial levels. This is of course just an indication, as Greenspan himself does not fail to underline, but in any case it can provide a number: given the foregoing set of fragile assumptions and conclusions (and they are all we have), I would judge that regulatory equity capital requirements in the end will be seen to have risen from the 10% precrisis level (in terms of book value) to 13 or 14% by 2012, and liquidity and collateral requirements will toughen commensurately (Greenspan, 2010, p. 224). Having ascertained the ratio of equity capital to assets which offers reasonable guarantees to the counterparts of the financial system (i.e. how much guarantee capital is required by the market), Greenspan faces the problem (generally neglected by the economic literature on financial regulation) of the effects that an increase in regulatory equity capital can have on the banking system’s profitability. How much regulatory equity capital a banking system can tolerate without a significant number of banks being forced to raise their margin is something that can be singled out considering the remarkable stability of the ratio of bank net income to equity capital (π/C). With rare exceptions, since the end of the Civil War this ratio has moved within a range of between 5% and 15%. Over the same period, due to increasing competitive pressure on profit spreads, net income as percentage of assets (π/A) fell, while the ratio of equity capital to assets (C/A) also fell from ~50% to 6%–10% of the post-WWII decades. In other words, despite the fall in net profit as a percentage of assets, the net profit in terms of equity remained stable because of increasing leverage. In the years before the crisis, π/A averaged 1.2%. Taking π/C at the lower end of 5%, the inferred maximum average regulatory capital C/A is ~24%. Taking π/A at its average of 0.74% over the 1950–75 period, C/A = 15%, which is able to cover the 12–14% market-determined capital requirement that would induce banks to lend freely. A rate >14%, all else equal, would put the average rate of return on equity below the critical 5% level. Capital requirements are not sufficient to avoid the moral hazard posed by financial institutions which are too big to fail. According to Greenspan, the solution that has at least a reasonable chance of reversing the extraordinarily large ‘moral hazard’ that has arisen over the past year and more is to require banks and possibly all financial intermediaries to issue contingent capital bonds, that is, debt that is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures. However, should contingent capital bonds prove insufficient, we should allow large institutions to fail and, if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility, whereupon the regulator would be granted access to taxpayer funds for ‘debtor-in-possession financing’ of the failed institution. Its creditors (when equity is wholly wiped out) would be subject to statutorily defined principles of discounts from par (‘haircuts’), and the institution would then be required to split up into separate units, none of which should be of a size that is too big to fail. The whole process would be administered by a panel of judges expert in finance (Greenspan, 2010, pp.231–32). Greenspan then goes as far as accepting that large financial institutions can fail, but he thinks that their failures could be (strictly) managed. He is however unyielding about the role of the state as the regulator of the financial system: for him, its shape must in any case be determined by market forces without too many constraints. The more the division of labour develops, the greater the need for a dynamic financial system. Financial innovation is as essential as technical innovation. However, it is not possible to distinguish a priori between good innovations and harmful innovations. In Greenspan’s view, this is a terrain in which the state must not enter, or must enter as little as possible, both in terms of regulation of financial products and intermediaries, and in terms of acting as ‘systemic regulator’ of asset prices at large. The fact that the economy is on the path of financial instability is something that can only be ascertained with hindsight. And there is no possibility of changing this state of affairs, since the state knows about the future much less than the markets. His conclusion is that ‘Only adequate capital and collateral can resolve this dilemma’ and that ‘if capital is adequate, then by definition, no financial institution will default and serial contagion will be thwarted. Determining the proper level of risk-adjusted capital should be the central focus of reform going forward’ (Greenspan, 2010, p.244). II. More radical reforms Regulatory capital in the range 10%–15% and, more generally, collateral requirements with haircuts differentiated per asset class are the current consensus on financial regulation. What is King’s position about all this? The minimum amount of equity a bank must use to finance itself, known as its capital requirement, has been raised, and banks also have to hold a minimum level of liquid assets related to deposits and other short-term financing that could run from the bank within thirty days, known as the liquidity coverage ratio. Regulators are also conscious of the need to look outside the boundaries of the traditional banking sector…U.K. and U.S. have introduced legislation to separate, or ring-fence, basic bank operation from the more complex trading activities of investment banking. And most countries have either improved or introduced special bankruptcy arrangement – known as resolution mechanisms – to enable a bank in trouble to continue to provide essential services to its depositors while its finamces are being sorted out (King, 2016, pp.255–56). But, he asks, is this enough? He answers: I fear not, and for one simple reason. Radical uncertainty means that sentiment towards financial firms can change so quickly that regulations which appear too burdensome one moment seem too lenient the next…The experience of 2007-8 illustrates what can happen. Let’s ask the following question: how much equity finance does a bank need to issue in order to persuade potential creditors that it is safe for them to lend to the bank? Before the crisis, the answer was hardly any at all. Markets were content to lend large sums to banks at low interest rates, even though banks were highly leveraged. After 2008, the answer was a very large amount. Not even the new higher levels of capital mandated by regulators were sufficient to ensure that markets were happy to restore previous levels and pricing of funding (p. 257). To underline the point, King notes that in 2012 the Spanish bank Bankia, although reporting a risk-weighted capital ratio of more than 10%—well above the regulatory minimum—was forced to recapitalise for 25 billion euros. It is precisely on this aspect that the positions of King and Greenspan diverge, to the point of becoming irreconcilable. Greenspan, faced with a case like that of Bankia, would probably have simply concluded that a ratio of 10% was not sufficient at that time (Bankia later merged with Banco Mare Nostrum and their post-merger risk-adjusted capital ratio is now in the 8%–8.5% range). Things are different for King. For him, no matter how much efforts can be made to design risk weights for bank assets, these assessments can only be based on past experience. But the need for banks to use equity to absorb losses is pressing precisely when past experience offers no help. For similar reasons, the rules that require banks to hold a minimum level of liquid assets to cope with an exceptionally high demand for repayment of debt and deposits, are useless. How to define a perfectly liquid asset? Before the crisis, everyone was convinced that public debt securities were perfectly liquid. During the crisis this certainty vanished. In addition, King notes, countries like Australia that have made little use of deficit spending and public debt, may not have sufficient public securities to meet the demand for liquid assets. In his opinion it must be admitted that in a world of radical uncertainty, only the central bank can create liquidity, and that this function must therefore be integrated with the lending of last resort. Where Greenspan would have suggested that we do not need anything but an adequate equity-assets ratio, King instead comes to the conclusion that there is urgency for ‘more radical reforms’. III. Some degree of narrowness Now, when ‘radical reforms’ come up in the context of financial regulation, the issue starts to gravitate around the idea of some form of ‘narrow banking’, namely, forcing banks to end fractional reserve, holding liquid assets to back 100% of their deposits. The list of proponents of the abolition of fractional reserve banking, King reminds us, is very long, including economists of the most various political attitudes (Irving Fisher, Henry Simons, Milton Friedman, James Tobin, Hyman Minsky, among others). Indeed, the idea has been presented in very different forms: its supporters go from those who opine that most of the financial sector can be deregulated and governed by free competition, to those who, at the opposite extreme, consider it essential to put the sector firmly under public control and therefore see in narrow banking the instrument to regulate, if not to ‘nationalise’, at least money management and the payment system. In general terms, a narrow bank issues demandable liabilities and invests in assets that have no nominal interest rate and credit risk. Specifically, there may be different degrees of narrowness, depending on the degree of risk of the securities backing liabilities. At one extreme, we find the 100% Reserve Bank Plan, where assets are made up of high potential money (central bank reserves) and liabilities are demandable deposits. At the other extreme, there is the Utility Bank Plan, where assets consist of low-risk money market instruments, retail and small businesses loans, and liabilities are deposits that have a claim on the money market instruments. In the middle, a variety of Mutual Funds, whose assets are treasury securities, commercial paper, repo and other similar instruments, and liabilities are equity with proportional claims on assets (Pennacchi, 2012). The 1933 Chicago Plan, which is considered the main reference of all the advocates of narrow banking, provided 100% coverage in central bank reserves of demandable deposits, allowing banks the normal lending activity funded with time deposits, equity capital, and the like. Friedman’s plan required any institution which accepts deposits payable on demand and transferable by check to have one dollar in high-powered money for every dollar in deposit liabilities. In fact, a very ‘monetarist suggestion’, since ‘shift between deposits and currency would have no effect on the total stock of money and banks could not alter the ratio of deposits to reserves’ (Friedman, 1959, p.69). For Friedman, as well as for Fisher before him, the question was not only that of making the creation of money a government function, but also that of keeping a proper volume and velocity of the circulation medium. Tobin’s idea, on the other hand, is that the Federal Reserve should offer the public not only Federal Reserve notes and coin, but also a ‘deposited currency’. It should therefore establish agencies located in banks or post offices, possibly managed by agents, who would carry out transactions cleared directly by the FED. Commercial banks that access deposit insurance should only invest in short and low risk securities. The riskiest long-term investments should be financed by equity and uninsured debt (Tobin, 1987). The ultimate aim of all these proposals is to separate banks that assure the working of the payment system, from banks that provide credit. Safe and liquid narrow banks will carry out payments services. Risky and illiquid wide banks will lend to the real economy, financing themselves with equity or long-term debts. As Irving Fisher put it, this means splitting each commercial bank into two departments, one—the checking department—a warehouse for money, and the other—the money lending department—virtually a savings bank or investment bank. This arrangement would let the Government take away from the banks all control over money, but leave the lending of money to bankers (Fisher, 1936). Once the checking department is separated from the money lending department, public authorities would no longer be forced to guarantee deposits or to bailout financial institutions in a run-free financial system. With full reserve banking, the credit market could be disciplined by competition, without this constituing a threat to the normal functioning of the payment system. Full reserve banking proposals date back centuries, having been born with fractional reserve banking. However, they have never been implemented. The fundamental reason why this has happened is not related to bankers’ vested interest. The credit market brings together lenders who want to invest in the short-term and at low risk, and borrowers who need long-term risky loans. The fractional reserve mechanism allows a ‘transformation’ of risk and maturities, matching borrowers and lenders with different preferences, and preventing these differences from leading to high lending rates. King is well aware of this. After introducing the reader to narrow banking, he immediately states: the complete separation of banks into two extreme types – narrow and wide – denies the chances to exploit potential economic benefits from allowing financial intermediaries to explore and develop different ways of linking savers, with the preference for safety and liquidity, and borrowers, with a desire to borrow flexibly and over long period. Constraining financial intermediation would mean that the cost of financing investment in plant and equipment, houses and other real assets would be higher (p.264). Thus, at the heart of a book whose title is ‘The end of Alchemy’, the reader finds the idea that the credit system actually needs some ‘alchemy’. To the extent that long-term loans are financed by equity, ‘the risk from unexpected events is then focused on the prices of assets held directly by households and businesses and on the solvency of wide banks’ (p.265). This also brings into play the returns that must be offered to underwriters to encourage them to take on these risks. Moreover, the question arises of the central banker’s intervention in times of crisis, which should necessarily take on the task of supporting the prices of these securities—an outcome that King, like Greenspan, firmly believes should be avoided. It must also be taken into account that debt, even though in the post-crisis period regarded as the culprit of all financial ills, plays a fundamental and irreplaceable role. For small businesses, or for excessively complex ones, King notes, the lender does not have the ability to monitor the borrower’s behaviour. He can monitor instead the value of the collateral. Now, although wide banks cannot create money in the form of deposits, they can still borrow short and lend long. In both cases they use collateral. They lend to households and businesses against real assets, and they borrow against financial securities created for the purpose, which give the impression to purchases of bank debt of being liquid and safe but ultimately are backed by the long-term loans and other assets of the bank. A large quantity of paper claims on underlying assets has been constructed to satisfy the demand for collateral. In this way, even wide banks create a degree of alchemy’ (p.267). In fact, wide banks have been at the centre of the 2008 run. The ‘provision of catastrophic insurance’ is something that unfortunately we cannot be dispensed with, thanks to some more or less intense degree of narrowness. How to offer this insurance without replicating the adverse incentives that played such an important role in determining the crisis? IV. Mervyn King’s proposal To give an answer to this question, King proposes for central banks the role of ‘Pawnbroker for all seasons’. The lending of last resort is an ill-conceived measure because the only way to offer liquidity in times of crisis is to absorb collateral of dubious value, with inadequate haircuts and without penalty rates. The Bagheot rule (lending freely, to solvent firms, against good collateral at a penalty rate) has to be systematically disregarded during financial turmoils. Now, instead of acting post-crisis as a lender of last resort committed to mop up almost every bad loan, the central bank could ex-ante declare its willing to lend—always, not just in times of crisis—the liquidity needed. The basis of this proposal is the idea that banks must always be able to repay all short-term deposits. In contrast to narrow banking, this 100% coverage is guaranteed by the central bank lending against collateral. Banks submit to the central bank all their assets eligible as collateral. To each of them is applied a haircut based on their degree of liquidity (for example, the haircut would be 0% for reserves held at the central bank). The sum of all these pre-positioned assets will provide banks with the maximum amount of liquidity that the central bank is willing to provide at all times. Total demand deposits and short-term unsecured loans must be lower than the amount the bank was entitled to borrow from the central bank. To clarify the point, let us consider a numerical example offered by King. A bank with total assets (and liabilities) equal to $100 million, has $10 million in central bank reserves, $40 million in liquid assets, and $50 million in long term loans to businesses. A haircut of 10% on liquid assets and of 50% on illiquid loans will give Effective Liquid Assets (ELA) for $10 + $36 + $50 = $71 million. The bank cannot finance itself with more than $71 million of deposits and short term debt. If the bank had $50 million deposits, $35 million of short-term debt, $10 million of long term debt, and $5 of equity, its Effective Liquid Liabilities (ELL) will be $85 million and thus they must be reduced progressively to $71 million, in order to satisfy the rule ELL<ELA. King’s proposal is halfway between narrow banking and capital and liquidity requirements. Compared to the latter it would seem to impose more restrictive rules, even though a more precise assessment in this regard depends crucially on the haircuts that the central bank would apply. From this point of view, between King and Greenspan there is much more common ground than the reference to ‘more radical reforms’ would lead us to think. It would have been useful to elaborate more precise quantitative indications, in order to clarify the extent to which the constraints proposed by King are different from the combination of capital and liquidity requirements advocated by Greenspan, and today imposed on banks. Compared to the first, it would present the defect of still allowing the banks to create money, since nothing would prevent a bank from granting, for example, $10 million new mortgage loans, creating $10 million deposits (and providing that, assuming a haircut of 10%, $1 million deposits are transformed into long-term loans). From this point of view, King’s proposal appears to be much less radical than the general tone of the book would suggest. Perhaps, a more adequate title would have been ‘Why can't we end alchemy?’ References Fisher , I. ( 1936 ). ‘100% Money and the Public Debt’ . Economic Forum, 3 April–June, 406 – 420 . Friedman , M. ( 1959 ). A Program for Monetary Stability . New York : Fordham University Press . Greenspan , A. ( 2007 ). The Age of Turbulence. Adventures in a New World . New York : The Penguin Press . Greenspan , A. ( 2010 ). The Crisis . Brookings Pap Econ Act , 201 – 246 . Pennacchi , G. ( 2012 ). Narrow Banking . Annu Rev Financ Econ , 4 , 141 – 159 . Google Scholar CrossRef Search ADS Tobin , J. ( 1987 ). A Case for Preserving Regulatory Distinctions . Challenge , 30 , 10 – 17 . Google Scholar CrossRef Search ADS © The Author(s) 2018. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/about_us/legal/notices)

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Contributions to Political EconomyOxford University Press

Published: May 10, 2018

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