Tuesday, June 2, 2015

Bank at the Fed

"Segregated Balance Accounts" is a nice new paper by Rodney Garratt, Antoine Martin, James McAndrews, and Ed Nosal.

Currently, large depositors, especially companies, have a problem. If they put money in banks, deposit insurance is limited. So, they use money market funds, overnight repo, and other very short-term overnight debt instead to park cash. If you've got $10 million in cash, these are safer than banks. But they're prone to runs, which cause little financial hiccups like fall 2008.

But there is a way to have completely run-free interest-paying money, not needing any taxpayer guarantee: Let people and companies invest in interest-paying reserves at the Fed. Or, allow narrow deposit-taking: deposits channeled 100% to reserves at the Fed.

(I'm being persnickety about language. I don't like the words "narrow banking." I like "narrow deposit-taking" and "equity-financed banking," to be clear that banking can stay as big as it wants.)

That's essentially what Segregated Balance Accounts are. A big depositor gives money to a bank, the bank invests it in reserves. If the bank goes under, the depositor immediately gets the reserves, which just need to be transferred to another bank. This gets around the pesky limitation that the Fed is not supposed to take deposits from people and institutions that aren't legally banks.

...the funds deposited in an SBA would be fully segregated from the other assets of the bank and, in particular, from the bank's Master Account. In addition, only the lender of the funds could initiate a transfer out of an SBA; consequently, the borrowing bank could not use the reserves that fund an SBA for any purpose other than paying back the lender. ...The bank receives the IOER rate for all balances held in an SBA. The interest rate that the bank pays the lender of the funds deposited in an SBA would be negotiated between the bank and the lender
The reverse repo program achieves the same thing, but many at the Fed seem to regard it with suspicion.

Why is this such a good idea? First, from my perspective, it opens the door to narrow banking; to government provided run-proof electronic money.

Second, emphasized in the paper, SBAs could help "pass through" interest rate rises. Suppose the Fed wants interest rates to be 5%  It starts paying banks 5% on reserves.  Banks will probably start demanding 5% or more on loans, since they can get 5% from the Fed. But banks may not compete on deposits, merrily taking our money at 0% and investing at 5%.  Large institutional investors, who can invest in money market funds, aren't going to sit still for that however, so they SBA accounts should very quickly reflect interest on reserves. In turn, that will put upward pressure on short-term commercial paper, Treasury, and other markets, and provide competition for deposits.

I learned an interesting legality. Are the SBA accounts really run free, exempt from bankruptcy proceedings? Not totally
Under the FDI Act, and subject to certain exceptions that are not applicable here, creditors of a DI [Depository Institution] that is in FDIC receivership are prohibited from exercising their right or power to terminate, accelerate, or declare a default under any contract with the DI, or to obtain possession or control of any property of the DI, without the consent of the receiver during the 90-day period beginning on the date of the appointment of the receiver. For purposes of this paper, it is assumed that the FDIC would act quickly to permit lenders to gain access to SBAs that collateralize their loans. However, this treatment has not been approved by the FDIC, and the decision by the FDIC on treatment of an SBA account in resolution could affect the willingness of firms to participate in these accounts.
That's all putting it mildly. It could also affect the willingness of firms not to run at the first hint of trouble, which is the whole point. Evidently, the FDIC needs to carve exemption from bankruptcy in stone.

A few quibbles
The near elimination of credit risk, which is the hallmark of SBAs, would level the playing field so that all banks could borrow in the overnight money market on equal footing..
Well, not really. Sure, they can borrow on equal footing so long as they put the results right in to the Fed. They cannot borrow for other purposes, like to lend it out to you and me, on equal footing.

The paper also echoes the worry that firms might run to these programs in a crisis
One concern is that SBA take-up could be too large. .. in times of intense stress, which may be characterized by a flight to quality, flows into SBAs could produce a scarcity of reserves that banks use to meet reserve requirements and could also cause (temporary) dislocations in funding markets for nonbank entities.  
I beat up on this view in discussing the overnight RRP program here, so I won't make the same points again. It still makes no sense to me. Flows into SBAs have to come from somewhere; and we're $3 trillion dollars away from required reserves anyway. And will be even further away once this program goes in.

Update: In fact, when you dig in to the paper, it pretty much concludes that these "financial stability" arguments are not important. From p 18
Recently, market observers and policy makers have expressed concerns that uncapped ON RRPs could exacerbate flight-to-quality flows, by providing a risk-free alternative to bank deposits, thereby causing a removal of much needed liquidity from the financial system.  For these reasons, an aggregate cap on the amount that can be invested at the ON RRP facility has been imposed and an auction pricing mechanism has been introduced to ration ON RRPs in the event that bids exceed
the aggregate cap. 
A similar concern could arise with SBAs. During a crisis, SBAs might be seen by lenders as an attractive near risk-free investment. However, a "surge" into SBAs i.e., an increased supply of funds by lenders for SBA collateral arrangements, would be accommodated by counterbalancing price movements.... an increase in the federal funds rate, as usable reserve become scarce. Further, because SBAs are supplied competitively, their rate would not adjust, since the rate is "competitively tied" to the IOER rate. The result would be an increase in the spread between the federal funds rate and the rate paid on SBA balances, which would help to arrest the surge and mitigate potential dislocations in funding markets. 
Additional factors could limit the ability of investors to suddenly place large sums of money into loans secured by SBAs. ...
I think there are deeper conceptual problems with the whole argument that offering SBAs, ON RRPs, or floating-rate Treasuries contributes to a run by offering a safe alternative, but in the end we are agreeing just for slightly different reasons.

Reserves for all! Via money funds and overnight RRP, or via narrow deposits at banks. Or, via fixed-value floating-rate Treasuries. Let the run-proof financial system begin to emerge.

Now, if the Fed would only say "and, by the way, any bank that puts all of its deposits in SBAs, and finances all of its lending with equity capital, will be exempt from all the Dodd-Frank regulation and stress tests, because it is obviously completely un-systemic."

17 comments:

  1. What if the fed itself provided electronic depository accounts? They would be risk free, therefore the pmt system would be safe in a systemic crisis. Private banks would have to pay interest to issue deposits and therefore bank credit would be more regulated.

    ReplyDelete
    Replies
    1. That would be simpler. But the Fed is not legally allowed to take deposits except from member banks. And imagine what banks would think of that proposal! They're going to earn a nice spread taking your money and investing it at the Fed.

      Delete
    2. The financial sector would get smaller if banks didn't make so many easy profits leading to more real GDP growth and stability too.

      Delete
    3. Isn't the Fed paying .25%? Even with non-interest paying large deposits, a .25% profit (minus costs) seems rather small.

      Of course, I started out during the high interest rates of the late 1970s. Compared to those returns, I almost laughed at a banker talking about our "high rate CDs" paying something like .75%.

      Delete
  2. There's nothing all that new here.

    First, individuals and corporations should have direct access to open and manage Fed bank accounts. Why not? That really would be run free.

    Second, we don't need to innovate anything here. Rather, we need to undo the innovations of 19th century banking: non-segregated accounts, the ability for the bank to invest risk-free deposits in risky investments, and government backing for the whole scheme.

    Risk free deposits should be held in risk-free assets (ie: cash in a safe). Risky investments can be made with money intended to be put at risk. There's nothing novel about that, and that's been the standard in every non-bank financial institution for almost a hundred years.

    ReplyDelete
  3. Does this not all assume that Repurchase Agreements ("Repos") and Reverse Repurchase Agreements ("Reverse Repos") are always completed, i.e. it the seller never fails to repurchase? However the history of Repo "fails" is long enough to suggest otherwise. In 2008 it was enough of a problem that the Treasury Market Practices Group (TMPG) developed a "dynamics fails charge"[1] in May of 2009 to incentivize "timely settlement by providing that a buyer of Treasury securities can claim monetary compensation from a seller if the seller fails to deliver on a timely basis". The TMPG was supported by the Federal Reserve Bank in this matter[2].

    It might be the case that the risk is not being eliminated, simply being relocated.

    [1] http://bit.ly/1syyVyR
    [2] http://nyfed.org/1syyUej

    ReplyDelete
  4. Dr. Cochrane,


    Does this not all assume that Repurchase Agreements ("Repos") and Reverse Repurchase Agreements ("Reverse Repos") are always completed, i.e. it the seller never fails to repurchase? However the history of Repo "fails" is long enough to suggest otherwise. In 2008 it was enough of a problem that the Treasury Market Practices Group (TMPG) developed a "dynamics fails charge"[1] in May of 2009 to incentivize "timely settlement by providing that a buyer of Treasury securities can claim monetary compensation from a seller if the seller fails to deliver on a timely basis". The TMPG was supported by the Federal Reserve Bank in this matter[2].


    It might be the case that the risk is not being eliminated, simply being relocated.


    [1] http://bit.ly/1syyVyR
    [2] http://nyfed.org/1syyUej

    ReplyDelete
  5. Right now a depository institution could, if it wanted to, hold 100 percent reserves at a Federal Reserve Bank as its only assets. If it did so, and everyone knew it was doing so, I imagine it could dispense with deposit insurance and all the regulations that come with it. Why don't we see anyone doing this?

    ReplyDelete
    Replies
    1. After deducting the bank's operating costs the deposit would need to have a negative interest rate. This already applies for wholesale accounts at many major banks i.e. zero interest plus account keeping fees even though the assets funded are higher yielding than Fed Reserves. These depositors have not yet found an alternative but they are probably looking.

      Delete
    2. Jeff,

      "Why don't we see anyone doing this?" I think we do, or at least we will very shortly. I think there are money market mutual funds that invest just in base money and short term government debt. But if they don't exist, they soon will because the SEC is imposing a new rule as follows. If a MMMF wants to promise depositors they'll get $X back for every $X deposited, they'll have to invest just in base money and short term government debt. In contrast, if an MMMF invests in anything more risky, it cannot make the above promise: it has to let the value of "deposits" float, just like the value of stakes in normal mutual funds float.

      Delete
  6. John,

    "Banks will probably start demanding 5% or more on loans, since they can get 5% from the Fed."

    Presuming interest on reserves is really interest paid on U. S. government debt they won't be getting 5% from the Fed, they will be getting 5% from the U. S. Treasury with the central bank acting as a go between.

    In the other case (Fed is printing up 5% interest payments) banks won't make loans at all, they will simply take the 5% from the Fed and call it a day.

    ReplyDelete
  7. John,

    "But there is a way to have completely run-free interest-paying money, not needing any taxpayer guarantee: Let people and companies invest in interest-paying reserves at the Fed."

    As currently constructed, interest on reserves paid by the central bank is simply interest paid by the federal government on federal debt owned by the central bank - Fed acts as a pass through mechanism.

    The taxpayer guarantee is already there - the taxpayer is making the interest payments on debt owned by the central bank.

    WTH?

    ReplyDelete
  8. Very interesting ideas.

    I do wonder about the concept that in free markets one is entitled to returns on savings, but also entitled to losses.

    This Cochrane-Fed deposit program essentially eliminates losses on savings. It creates an entitled group called savers.

    Maybe that is good, but is it free market?

    ReplyDelete
    Replies
    1. Ben,

      It is not one person that is entitled to returns on savings under John's model, it is all parties. And so "entitled" is a bad description in this case, since entitlement implies a privilege given to a subgroup of individuals. In John's system, all individuals can obtain the same return on savings.

      Also, as I understand it, the return is of the nominal variety (not inflation adjusted) - see John's recent post on the positive correlation between inflation and nominal interest rates (aka Neo-Fisherism). From a strict monetarist point of view, if the money supply growth rate is simply the interest rate that the Fed prints to pay on reserves, then the returns being risk free, the inflation rate is likely to rise in lockstep with the interest rate.

      Delete
    2. Bejamin,

      For a century or two in most countries, the central bank has issued a form of money (dollar bills and coins in the US). As soon as the CB does that, it becomes possible for anyone to hoard those bills under their mattress. To that extent a form of saving where “losses” are “eliminated” has existed for a long time.

      As to whether it should be possible to earn interest on those savings, I suggest not: why should those who choose not to hoard pay taxes so as to fund interest to people with metaphorical wads of dollar bills under their mattress? I can’t see the excuse for it. Milton Friedman and Warren Mosler oppose/d the payment of any interest on government liabilities. I.e. they argued that the only liability issued by the state should be base money on which no interest is earned.

      Delete
  9. John,

    Given that people are now permitted to have online accounts with the U.S. treasury ( http://www.treasurydirect.gov/ ), I wonder how amenable the treasury might be to this idea? Why can't the treasury be a payment processor as well?

    ReplyDelete
  10. Allowing segregated reserves creates ambiguity in the role and legal status of reserves. A company with a large holding of cash could just buy Treasuries. If they do not have the economies of scale to justify that and want some protection - spread the money around several different banks.

    ReplyDelete

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.