Tag: Chicago Plan

Resolution of First Republic Bank

JPMorgan Chase’s purchase of First Republic Bank appears to be a standard purchase and assumption resolution of a failing bank. The Federal Deposit Insurance Corporation (FDIC) has organized hundreds of such bank resolutions there by painlessly purging bad banks for the banking system. The only mistake in my view was selling it to the country’s largest bank.

Purchase and assumption resolutions involve the simultaneous purchase of a failing bank’s good assets and the assumption of its deposit liabilities by a good bank and putting what’s left into bankruptcy (wiping out its shareholders and some or all of its corporate debt). Its the risk of loss to shareholders that provides the market scrutiny of bank risk taking. “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution And Ways to Overcome Them”

Money (currency and demand deposits) should not be at risk of a bank failure. Depositors should not need to evaluate the safety and soundness of the bank they chose to hold their money in. So the FDIC insures deposits up to $250,000. But all deposits in the last three banks to fail were made whole whether insured or not and there is talk that all deposits should be explicitly (rather than just implicitly) insured. Central Bank Digital Currency (CBDCs) would provide such total protection to those holding it (retail CBDCs would be issued/administered by commercial banks and fully backed by an equivalent amount at the central bank).

Public “runs” on banks in order to move vulnerable deposits to cash or a safer bank, result from the fact that banks can fund long term loans with callable deposits. They can lend your deposit to someone buying a house with a 30-year mortgage. This works as long as banks keep enough cash or quickly liquidated assets on hand to cover any deposit withdrawals their depositors might want to make. An alternative to deposit insurance for all deposits is to isolate demand deposits from bank lendable resources by requiring that they be 100% back at the central bank (as with CBDCs) and not available to cover any losses on other bank activities.

It is time to take so called narrow banking (or The Chicago Plan) seriously. CBDCs are the natural vehicle for this restructuring of our money and credit systems.  “Protecting bank deposits”

Protecting bank deposits

Following the collapse of Silicon Valley Bank last week there has been considerable discussion about whether and how the regulatory regime might be strengthened (or actually more effectively implemented) to prevent such collapses (yet again) in the future. Raising deposit insurance coverage to 100% of all deposits is being suggested (and was provided ad hoc to SVB and Signature Bank this week). Econ 101: SVB and bank runs – Warren’s space (wcoats.blog)

Insuring all deposits and adopting the Chicago Plan represent two very different approaches to removing all risk of loss to depositors and thus any incentive to run from a bank. In the search for regulatory or market checks on excessive bank risk taking or poor management, the expectation that depositors would carefully monitor the behavior and condition of their banks was never realistic. Thus, removing any financial incentive for such due diligence by raising deposit insurance to cover all deposits would have little to no impact on bank behavior. Such scrutiny by bank shareholders and managers is much more realist and thus important. US bank bankruptcy procedures do not spare shareholders, who in the case of SVB have lost everything. However, more might be done to impose losses on managers of insolvent banks.

Following the bankruptcy of SVB considerable attention has rightly focused on the speed with which facts or rumors of a bank’s weakening financial condition can spread over the Internet. What might have taken weeks as depositors began to line up outside their banks to withdraw their deposits while the funds lasted, now takes minutes, dramatically accelerating the speed with which a bank must try to liquidate enough of its assets to fund the withdrawals.

Full deposit insurance and the Chicago Plan of 100% reserve banking (deposits at the central bank, which are always safe and instantly available) eliminate any incentive for bank runs. But the difference between them deserves more attention. The full deposit insurance approach puts the cost of bailing out the depositors of a failed bank on the rest of the banking system (on the “good” banks) who finance the insurance fund.  The cost of the Chicago Plan, if indeed it is a cost at all rather than a benefit, is the need for banks to fund their credit operations with equity or long-term debt, rather than with potentially volatile deposits. We should move to the Chicago Plan and fully separate money from credit.

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Econ 101: SVB and bank runs

What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.

It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).

The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.

The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)?  “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”

Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset.  When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).

The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.

The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years.  See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”

Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits.  Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.  

The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?

Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”

When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available.  The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”

Econ 101: Retail Central Bank Digital Currency (CBDC)

The history of money is long and fascinating. Even the currency most frequently used in the United States has a rich history. Money makes possible the specialization and trade upon which our great wealth depends. Through its long history of development and evolution, money has serviced two key functions. It provides the standard unit for pricing traded goods and services so that their values can be meaningfully compared (it’s the unit of account) and it is the common asset in which payments are made (it’s the medium of exchange or payment).

Medium of Payment–Money

When you hire the neighborhood boy to mow your lawn, you probably first agree on a price (the number of dollars) This is the unit of account function of money, which is indispensable for the functioning of markets.  You could agree to trade with the neighborhood boy a nice lunch with lemonade in exchange for his mowing your lawn. But paying him $15 in Federal Reserve Notes has the advantage that he can exchange it for your lunch, or he can buy his lunch at Wendy’s or anything else of his choice.

Obviously, markets can’t really function if each item or service is priced in a different money unit (dollars, Euro, rubles, bitcoin, etc.). The Continental Congress of the United States authorized the issuance of a new currency, the US dollar, on July 6, 1785. Following the ratification of the Constitution of the United States, the new Congress established the United States dollar as the official currency of the United States in the Coinage Act of 1792. The Act also established the United States Mint, which produced and circulated coins with a fix amount of gold or silver (later only gold). “History of the United States dollar”  

As the result of the changing relative price of silver for gold, the bimetal gold/silver standard was replaced with the single metal standard of gold. The dollar was redefined in 1900 as “twenty-five and eight-tenths grains of gold nine-tenths fine,… and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard.” Fast forwarding through WWI and WWII and the creation of the Bretton Woods Institutions and the failure of the US to adhere to the requirements of the gold standard, the US “closed its gold window” and proceeded with varying degrees of success to manage the supply of its currency so as to preserve its purchasing power.

Over this long history many private actors (banks) created dollars. There are in fact thousands of private producers of dollars (Chase dollars, B of A dollars, etc.) Glossing over the details, it was a one currency system–the US dollar–because each bank’s currency could be redeemed for gold at  fix price or, after the creation of our central bank in 1913, for a deposit at a Federal Reserve Bank. This is obvious when you pay with Federal Reserve Notes, which are direct obligations of our central bank. Originally each note was identified by the Federal Reserve Bank that issued it–there were twelve of them–but even that distinction has been eliminated. Few people even noticed the difference. But most of our dollar money supply (M1: Federal Reserve Notes in circulation plus demand deposits at banks) is privately produced by banks and exists in digital form as accounting records with each of our banks.

Means of Payment

Our money–US dollars (or Euros or bitcoin)–is quite distinct from the various ways in which you can pay it–payment technologies. Cash payments–the transfer of Federal Reserve Notes from me to you–are hand delivered. But most payments are made by digitally transferring an amount of dollars from my bank account to yours. Such digital payments have the obvious advantage of enabling you to pay someone across town, across the country or even across the world (if they accept your currency) plus the safety of keeping your money in the bank pending such payments.  It’s not recommended that you send cash in the mail. The key insight is to understand how my dollar balance in my bank gets to your account at your bank and why your bank is willing to accept it. The quick answer is that your bank will not generally accept a claim on my bank but will record my payment because it receives an increase in its deposits at a Federal Reserve Bank of that amount.

In the old days I wrote a check that authorized my bank (after the check was deposited by you at your bank, which sent it to my bank) to debit my balance with the indicated amount and to transfer that amount from its balance at the Fed to your bank’s account at the Fed. SWIFT performs this payment instruction/authorization function for cross border payments (i.e., those involving two central banks). Today I issue this instruction directly to my bank electronically on the internet or my smart phone. The “dollars” are one currency no matter who creates and issues them because whoever receives them can redeem them for balances at the central bank (or in the old days for gold).

Visa, Master Card and American Express credit cards provide payments on my behalf by lending me the money before I actually make the payment from my bank account to the credit provider at the end of the month. The loan to me involved in such payments, increases the cost of this type of payment.

The execution of the interbank portion of my payments have become increasingly efficient over time but can still take several days because the Federal Reserve Banks do not operate in the evening or on weekends. When our central bank launches FedNow next year it will allow the continuous processing of payments between banks 24/7.

The front end of the payment process, i.e., my initiation of a payment to you, for example, has also benefited from software improvements. Unlike bitcoin, Ethereum, or Ripple, which are currencies, Zelle, Venmo, PayPal, etc. are payment technologies rather than money. They are means for paying US dollars (or other currencies) from me to you. Venmo, for example can be thought of as the payment service part of a bank. It can hold money for you and can transfer it to others (who must also have a Venmo account) but Venmo cannot make loans with your money. Thus, people without bank accounts can use Venmo as if it were a bank account.

The Federal Reserve and other central banks are investigating whether they should also provide the service to the public of paying dollars with so called Central Bank Digital Currency (CBDC). The Federal Reserve defines a CBDC “as a digital liability of the Federal Reserve that is widely available to the general public.” “Money and payments–Fed report”  CBDCs would be a direct claim on the central bank like Federal Reserve notes (cash) but would be held and transferred digitally like your bank deposits. If the Fed goes forward with introducing CBDCs, they would almost certainly be what are called retail CBDCs. Rather than opening accounts at the Fed directly, we would each do so through a bank. We would sign up with and deal with a bank to hold the Fed’s CBDCs. The Fed has no existing capacity to deal directly with each of us in the way that our banks do. The balance of this note will explore how such CBDC would compare with, say, Venmo balances and payments and whether they are worth the trouble.

All digital money is recorded on electronic ledgers, either distributed as with a block chain used by bitcoin, or centrally maintained as with our bank accounts. As block chains are slow and expensive to verify, they would not be used for CBDCs. Just in case you didn’t know, when you walk into your bank and deposit cash, they don’t put it in the value for you. They record the value of the cash you delivered in our account with the bank, and they return the cash to the Fed for a credit to your bank’s Fed account or invest or lend it to someone else (after having converted it into a balance in their Fed account). It is both useful and interesting (to us economists at least) to walk through how my deposit at my bank is transferred to you (your account at your bank).

Taking Venmo as the example of existing digital payment technology, your deposit of dollars to your Venmo account would be digitally transferred from your bank account to your account on Venmo’s ledger. Your bank would transfer the same amount to Venmo’s deposit account with its bank (in the name of PayPal, which owns Venmo) in the usual interbank transfer manner. All (double entry) financial ledgers have a liability side (your deposit with the bank — what the bank owes you) and an asset side (the cash you deposited or the balance in your bank’s fed account for the money you had transferred to it). The ledger shows what the bank owes (liabilities) and the assets it holds with which to pay out what it owes (assets).

All digital money, whether your bank deposit or Venmo or bitcoin, must provide for an on ramp into and off ramp out of the digital system, i.e., for the process of paying cash in to acquire the digital money and of drawing it out as cash. Interestingly, Kenya has had a version of Venmo payments for several decades already. Kenya’s M-Pesa The ownership and use of cell phones (not necessarily smart phones) is very widespread in Kenya, while bank accounts are far more limited. Thus, people paid for phone airtime by the hour by paying cash to street venders selling such service. This became the on ramp for the unbanked to fund their M-Pesa mobile money accounts.

If you have money in your Venmo account (a positive balance), you can issue a payment instruction via your Venmo wallet directly to the friend you are paying. You can also instruct Venmo to take that the money simultaneously from your bank account. You can do all of this on your smart phone while waiting for your drink at a local bar. If your friend doesn’t have a Venmo account, Venmo will instruct her on how to set up one in order to receive your payment. If you give Venmo a day or two to complete the payment, it is free. If you want it delivered immediately (within a few minutes) there is a small fee. When the payment is complete, your balance at Venmo (or your bank) will have been reduced by the amount of the payment and your friend’s balance with Venmo will have been increased by the same amount. She can leave the money there or move it to her bank account (on her cell phone) if she has one. The money will “exist” as an accounting record somewhere. These “dollars” are accepted from wherever they come (from whoever produced them) because they are claims on, or are converted into deposits at, a Federal Reserve Bank.

How would this compare with a payment with central bank digital currency (CBDC)? While the Federal Reserve has not indicated the details of a possible CBDC, it would probably work something like this. I would ask my bank to sell me CBDCs by debiting my checking account by the indicated amount. These would be added to (credited to) my CBDC account at my bank.  My bank would transfer that amount from its general account at its Federal Reserve Bank to a segregated CBDC account at the Fed. My cell phone wallet would record (by accessing my CBDC account at my bank) this amount, and my bank would back it 100% with its CBDC account at the Fed.

Why does this matter? It matters because if my bank fails (goes into bankruptcy), the amount in the bank’s CBDC reserves at the Fed would be excluded from the bankruptcy process. They are exclusively and fully available to back my CBDC holdings. When I pay CBDC to my friend, her bank will receive them without regard for the condition of my bank.

Some of you will recognize this as the equivalent of the so-called Chicago Plan. The Chicago Plan required banks to back all checking account deposits 100% with central bank reserves. Our bank deposits today are largely backed by bank loans and investments plus a small deposit with the central bank. Such CBDC deposits would be totally free of default risk. While all CBDCs would exist on the books of the Federal Reserve, ownership by individuals would be reflected on the books of their respective banks and in their CBDC wallets.

Like the Chicago Plan, CBDCs have the potential to reduce the money multiplier (the ratio of broad money to base money–the Federal Reserve’s monetary liabilities). A shift from demand deposits to CBDC deposits at banks would reduce the funds available to banks for lending by increasing the reserves they must hold at the Fed. This could be easily compensated for by increasing base money (Federal Reserve monetary liabilities). Sudden shifts to the safer CBDCs in reaction to financial shocks, like traditional bank runs, would require central bank intervention. The Fed has also indicated that it would want any digital replacement of its currency notes to provide as much user privacy as possible (like cash) consistent with “affording the transparency necessary to deter criminal activity.”

How would this compare with a Venmo payment. From our perspective (the perspective of the payer and payee) a Venmo or CBDC payment would be executed in the same or very similar way. The difference is that the CBDC balances would be totally risk free (being relatively direct claims on the central bank) while the Venmo balances would be exposed to the risk of the failure of the bank in which Venmo keeps its assets that back our Venmo balances. It is not obvious that this is a big enough difference to make it worth undertaking.

A proposal for the Fed’s balance sheet

By Warren Coats[1]

To save financial institutions from the collapse that threatened them after the bankruptcy of Lehman Brothers in September 2008, the Federal Reserve purchased government securities and Mortgage Backed Securities (MBS) sufficient to increase the size of its asset holdings from $0.9 trillion to $4.5 trillion by the end of 2014.  These large open market purchases were not meant to increase the money supply, the traditional purpose of such operations, which after a sharp drop followed by a sharp increase in the growth rate of broad money (M2) has grown at its historical average rate of around 6% per year. Rather they were to support the market prices of government debt and hard to price MBS in the face of market panic (at least initially).

The Fed accomplished this trick (large increase in the Fed’s asset holding with only modest increases in the money supply) by paying banks to keep the proceeds of their sales of securities to the Fed in deposits with the Fed, so called “reserves,” in excess of what is required, so called “excess reserves.”  Beginning in October 2008, the Fed began to pay interest on bank required and excess reserves deposited with Federal Reserve banks.  This kept broad money from growing in response to the huge increases in base money (the counterpart of the securities purchased by the Fed) and became the primary tool of monetary policy.

The Fed is now pondering what to do about its abnormally large balance sheet.  A year ago it announced its intention to gradually reduce the size of its asset portfolio in order to return to its traditional policy tools—regulating the growth in bank money and credit by targeting the overnight interbank lending rate (the Fed funds rate) via open market operations.  After having suspended the open market purchases that had inflated its balance sheet in recent years (QEs 1, 2, and 3), in October 2017 the Fed stopped replacing the maturing securities it held to the extend of about $20 billion per month.  As a result its asset holdings dropped about $150 billion in the nine months since then and by the end of June 2018 stood at $4,315 billion.  Its current intention is to reduce its asset holdings to $3 trillion by the end of 2022.

The reduction in the Fed’s holdings of these securities (Treasuries and MBSs) is an increase in the market’s holdings of them, other things equal.  But other things are not expected to be equal.  Our profligate government is expected to run a one trillion dollar deficit in 2019, adding that amount of government debt to the market on top of the Fed’s additions.  The Congressional Budget Office projects a worsening federal deficit every year over the next ten of its official forecast, worsening even as a percent of GDP. This will put pressure on the Fed to rain in or suspend its program to return its asset holdings to more traditional levels.

There is a better way to handle this difficult situation.  Bank reserves with the Fed are currently about $2 trillion (the rest of the Fed’s monetary liabilities is Currency in Circulation of $1.7 trillion) and banks’ checkable deposits are about the same amount (of which demand deposits are $1.5 trillion).  Requiring 100% reserve backing of checkable deposits was recommended in the 1930s by a group of University of Chicago economists as a way to protect our payment system from the loan default problems being experienced by many banks at the time.  This so called Chicago Plan would remove any risks to checkable deposits, a key part of our payment system, and thus eliminate the need for deposit insurance for such deposits.  Required reserves would continue to earn interest as they do now, but excess reserves would not.  But in addition to strengthening our payment system, adopting the Chicago Plan today would convert existing excess reserves into required reserves and end the debate over whether to further shrink the Fed’s balance sheet.

Adopting the Chicago Plan would prevent banks from on lending our checkable deposits.  At the moment they are not doing that anyway. This raises the question of where banks would get the funds (our savings) to on lend in their financial intermediary role?  In an extreme version of the Chicago Plan (100% required reserves against all deposits and deposit like bank liabilities) all bank lending would be finance by equity rather than debt.  Savers would hold claims on the value of a portfolio of loans as they now do with mutual fund investments and as in some Islamic banking instruments.  Equity rather than debt financed bank intermediation is a more stable structure as a result of shifting the risk of loses (loan defaults) from banks to the ultimate public investors.  The Federal Deposit Insurance Company would stop insuring 100% reserved deposits and its bank resolution functions would be moved to the Office of the Comptroller of the Currency (OCC) in the U.S. Department of the Treasury.

For purposes of requiring a 100% reserve and dropping deposit insurance, a more pragmatic boundary between all deposit liabilities and checkable deposits might include savings deposits (which can generally be shifted into checkable deposits almost automatically) and time deposits with a maturity of less than six months (or maybe three months).  This would add almost $10 trillion dollars to required reserves and would need to be phased in gradually.  The Fed would need to buy an equivalent amount of government securities in order to finance the increase in required reserves without contracting the money supply or bank credit.

It is very desirable to separate our payment system (checkable deposits of one definition or another) from the necessarily risky lending by banks and other financial institutions and make our money (currency and deposits) risk free.  Doing so would allow banks to take whatever risks with investor funds those investors are willing to finance.  This would enable a significant reduction in the government’s regulations of these activities.  “Changing Direction on Bank Regulation” Cayman Financial Review April 2015

[1]Dr. Coats retired from the International Monetary Fund in 2003 and is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.

Free Banking in the Digital Age?

By Warren Coats[1]

Introduction

A number of central banks are considering issuing digital currency either in place of the paper currency they now issue or in parallel with it.  The advantages of central bank digital currency (CBDC) over paper currency for the issuer is the much lower cost of supplying and maintaining the currency (printing, storing, transporting, safekeeping and replacing old and damaged notes). For the users, there are the benefits of much greater speed and lower cost of making payments of currency across distances.  The use of paper currency (cash) in economies with proliferating electronic means of payment (Visa, PayPal, Zella, popmoney, etc.) has been and will continue to fall.  In addition, digital currencies can and do extend digital payment services to the unbanked.  This note explores some of the policy issues raised by CBDC, by which I mean digital claims on the currency issued by the official monetary authority, whether directly or indirectly.

Payment with digital currency involves transferring ownership of a claim on the issuer without needing to or providing any information about the payer, in particular without providing information about the payer’s bank account if she has one.  In this respect it mirrors the payment of traditional paper currency.  A primary issue for a central bank when considering issuing a digital currency is whether it should be offered wholesale or retail, i.e., offered only to banks and maybe other financial firms, or offered to the general public.  If a central bank offered CBDC directly to the general public it would transform and greatly expand the role of the central bank and could potentially end the role of commercial banks in the payment system.

Offering CBDC only to banks and other financial firms would offer little that is not already available via central banks’ acceptance of deposits from these entities, which of course are digital.  In fact the distinction between digital currency and traditional deposits is not always clear or important.[2]  Currently Fedwire settles payments between account holders, including government agencies, in domestic and foreign banks licensed in the U.S.  It does not settle USD payments between accounts in non-resident banks and resident banks.  Such payments could occur with CHIPS (Clearing House Interbank Payments System) correspondent banks, but could also potentially be made by the transfer of a central bank digital currency.

If a digital currency is issued to the general public by banks in the two-tier fashion of today’s bank money, in which banks maintain deposits of national money with their central bank to secure the deposits of national money held by banks for the general public, there is an issue of what assets banks should hold or be required to hold against their deposit or currency liabilities to the public.  Digital currency issued to the public by the central bank would have no default risk, whereas digital currency issued by banks or other entities, being a liability of the issuing bank, would have default risks.

It is also possible to permit non-banks to issue digital currency as has been done very successfully in Kenya by a phone company.[3]  Over half of Kenya’s population participates in this so-called mobile phone money service. Public acceptance of a digital currency requires that its claim on central bank money is credible.  Safaricom, the issuer of Kenya’s digital currency, M-Pesa, backs the deposits of participants 100% with Kenyan shilling deposits with banks.  While M-Pesa balances are generally paid from one person or firm to another, they can be withdrawn via an agent at their face value in shilling currency issued by the central bank at any time.

A study issued by the Bank of International Settlements explores issues raised by central bank digital currency (CBDC) more generally.[4]

Background

A review of the free banking era in the U.S. (1837 – 1913) provides a useful framework in which to analyze the options and implications of digital national currencies.  Banks in that period could issue their own U.S. dollar denominated banknotes.  Because banks lend some of the money deposited with them – so-called fractional reserve banking – issuing their own currency when their depositors wished to withdraw cash, was stabilizing as explained below.  The issue of whether CBDC should use block chain (DLT) or centrally administered ledgers will not be considered here as DLT is too expensive and inefficient to take seriously as an option at this time.[5] Project Jasper of the Bank of Canada concluded that: “the versions of distributed ledger currently available may not provide an overall net benefit when compared with existing centralized systems for interbank payments.  Core wholesale payment systems function quite efficiently.”[6]

The report does not exclude the possibility that future versions might overcome existing defects and have net advantages for some applications.

The feature of so called free banking that is relevant here was the ability of commercial banks to issue their own currency (banknotes).  These banknotes did not represent private currencies in the way bitcoin does.  In the case of the United States, all bank issued currency was denominated in US dollars and redeemable for gold (or silver) at its fixed price for the dollar.  Historicallybanknotes were originally created by goldsmiths in post Medieval England – first as warehouse receipts to depositors of cash – and then as a form of lending as an alternative to having the borrower’s account credited.  For an interesting account see the article by Benjamin Geva.[7]

Banks generate most of their income by lending at interest or investing the money deposited with them by the public.  As a result, not all of the money deposited is available to pay out to the depositors should they all want their money back (as cash or by transfer to another bank) at the same time (a so-called bank run).  Only a modest amount of depositors’ money (it is actually the bank’s money once it is deposited) is available in the bank in the form of cash or deposits at the central bank.  These so called reserves must be, and virtually always are, sufficient to satisfy the cyclical (monthly and seasonally) variations in the public’s preferences for cash over deposits.  This system is referred to as fractional reserve banking because the amount of bank “reserves” are less than the amount of their deposit liabilities.  The difference in the amount of deposits and of reserves consists of bank loans and investments in less liquid assets.

In today’s banking systems all banknotes (cash) are issued by a central bank.  Thus when a deposit is withdrawn for cash, the bank’s assets (cash) and deposit liabilities both fall by the same amount.  If a bank does not hold sufficient cash or deposits with the central bank to satisfy these periodic demands, the bank is said to be illiquid.  When banks were able to issue their own currencies (Citibank dollars and Chase dollars) only the mix of bank liabilities changed (from deposits to cash) with no change in their assets.  Their total liabilities and assets remained the same.  This was a very desirable feature of note issuing banks and eliminated the risk of illiquidity from cash withdrawals.  These banks might still suffer illiquidity from deposit transfers/payments to entities with deposits in other banks.

In the free banking era when the public came to doubt the solvency of their bank (loan and investment losses that exceeded a bank’s capital—i.e., when the value of a bank’s assets falls below the value of its deposit and other liabilities) it was pointless to withdraw deposits as the bank’s own banknotes because the bank did not have sufficient assets to redeem them.  Bank runs in such cases would take the form of converting deposit or cash claims on the bank into claims on another, hopefully sounder, bank.  Those who failed to do so before the insolvent bank was closed and liquidated would lose part of their claim, i.e. they would be forced to absorb their share of the bank’s asset shortfall (its negative capital).

Thus a ten dollar bill issued by Citibank and one issued by Chase, being claims on two different banks, could have different values (even if redeemable in theory for the same amount of gold) if the public lost confidence in the solvency of one or the other. Merchants needed to pay attention to whose banknotes they were accepting.

When you pay someone by transferring some of your bank balance to the payee’s bank account (e.g. by writing a check), your bank and the receiving bank must both participate in the same clearinghouse (or have an account with a correspondent bank that participates) enabling their obligations with each other to be settled in central bank money.[8]  This role is now generally performed by each country’s central bank and the deposits that banks keep there are called reserve deposits.  In some countries a minimum amount is required (a reserve requirement) and in others it is fully voluntary but needs to be sufficient for net payments between banks.

While this fractional reserve system worked well most of the time, banks were occasionally hit with unusually large or panic withdrawals that they were not able to satisfy even when they were fully solvent (had positive capital).  A key function of the central banks being established all over the world a century or more ago was to provide temporary liquidity to such illiquid but solvent banks (though it is difficult to evaluate the solvency of a bank in real time—i.e. the soundness of their loans and investments).  Thus central banks were so-called Lenders of Last Resort.

In 1933, in the midst of America’s Great Depression, a group of University of Chicago economists proposed, among other things, that banks be required to hold reserves (cash and deposits with the Federal Reserve) of at least 100% of their demand deposit liabilities (checking accounts).  This is often called “The Chicago Plan.”  If banks’ demand deposit liabilities and their reserve assets are segregated from the rest of their balance sheet it removed any default risk to the public of holding demand deposits at any bank.  Instead of the Chicago Plan, the U.S. Congress enacted deposit insurance to reduce the risk of bank runs.

To review:banknotes issued by banks in the free banking era eliminated the risk of a bank becoming illiquid when its depositors withdrew cash, but imposed on the public the need to judge the solvency of the note-issuing bank before accepting its currency.  The risk of losses on demand deposits remained.  While that risk could have been eliminated with a 100% reserve requirement (The Chicago Plan), it was eliminated for smaller deposits by deposit insurance.

Central banks around the world now have a monopoly on issuing legal tender currency.  This eliminates the default risk of accepting such currency but reintroduces a liquidity risk for banks that promise to convert customer deposits into (central bank issued) cash on demand.  This risk is substantially reduced by central banks’ lender of last resort function.

Structuring Digital Currency

The above considerations can help us evaluate options for central banks wishing to issue digital currencies.  So-called “digital currencies” can take different forms.  “Digital coins” are the closest digital counterpart to paper currency.  Both have unique serial numbers for each unit.  “Tokens” or “claim check centralized digital currency” pass from one owner to another P2P via block chain or central registry and can be redeemed for central bank base money at any time.  “Deposits” function the same as tokens without pretending that they are not deposits.  The distinctions between these are primarily technical and may be of little if any relevance to users.  Thus I will use “digital currency” to refer to any and all of them.

Our two-tiered system for supplying money to the public (central banks issue base money that is their own liability and commercial banks create deposit money fractionally backed by central bank base money) has the very considerable benefit of outsourcing the competitive creation and management of money to many banks.  Banks develop and service their own relationships with their customers from tens of thousands of offices around the country (speaking now of the U.S.).  However, this money creating and payment function performed by banks is also comingled with their lending activity intermediating between savers and borrowers. There are synergies as well as risks from providing both services under one roof.[9]

Should central bank digital currency be provided retail or wholesale?  A central bank could issue its digital currency to anyone who signed up (registered, i.e. opened an account directly with the central bank). As all uses of this digital currency would be between participants in the system, transfer would be simple and instantaneous.  It would be essentially the same as logging into your current bank account and transferring money to another depositor in the same bank.

In addition to the above advantages of speed and simplicity, this central bank retail approach carries the burden of an enormous expansion of central bank staff to interface with the general public in establishing and managing this new digital currency. Equally troublesome is the likelihood, if not certainty of a “digital run” from bank deposits to the central bank’s digital currency.  This would be a permanent shift from banks to the central bank, which would force banks to liquidate a significant share of their assets in order to finance the outflow of their demand deposits into the central bank’s payment system.  The transition would need to be carefully managed. The magnitude of the digital run could be limited by limiting the size of CBDC payments.  This could leave most business payments with the banking system.

There are advantages to a single, monopoly provider of digital currency because payments would take the form of transfers between accounts/participants within the same system (in effect intra-bank).  But there would be the usual disadvantages of monopolies as well (e.g. sluggish technical innovation).[10]  Central banks generally have a monopoly in printing paper currency, but their sale to the public is done by competitive commercial banks.

Central banks could leave the provision of digital cash to banks and other qualifying financial firms.  This would parallel the two-tier system now in place with central bank base money and commercial bank broad money (deposits of the public).  Digital currency would be supplied only by banks, as was the case during the free banking era when individual banks supplied their own currency notes.  Thus there would be many digital dollars (Citibank digital currency, Chase digital currency, etc.).  As with free banking banknotes, each digital currency would be the liability of the issuing bank.  The risk of default for each bank’s digital currency could be eliminated by requiring 100% reserves with the central bank against any digital currency issued and segregating these assets and liabilities from the rest of bank balance sheets. It would also be possible for commercial banks to sell and administer central bank digital currency on behalf of the central bank.  Adoption of a full Chicago Plan (100% reserves for both currency and demand deposits and legal segregation from the rest of the bank’s activities) would fully protect all payment system assets (money) from bank failures. Policies would also be needed with regard to close substitutes for demand deposits such as time and savings deposits.[11] Alternatively the risk could be limited via the equivalent of deposit insurance.

Non Central Bank Digital Currency

Digital currencies issued by commercial banks would eliminate the risk of “digital runs” on bank deposits to the central bank’s digital currency flagged by the BIS in its report cited above.  Non-national digital currencies (or deposits) fixed in value to a foreign currency, to SDRs, or to gold, for example, issued by an entity playing the role of a central bank for that currency (e.g. the BIS) would also minimize the risk of a “digital run” from bank deposits in national currencies.  Such digital currencies could also adopt a traditional two-tier model by which commercial banks issue the digital currency to the retail public. In all cases of multiple, individual bank issued digital currencies, arrangements would be needed (as now) to settle payments from holders of digital currency issue by one bank to holders of digital currency issued by a different bank.  The transfer of deposits from one issuing bank to another on the books of a common institution (the traditional central bank) is the most likely mechanism for settling such payments as is now the case for deposit payments.

In the digital world the distinction between a digital deposit and a digital currency is notional. Both are liabilities of and claims on the bank or other entity that issued them.  Distinctions blur.  In addition, digital currency need not necessarily be issued by a deposit-taking bank. M-Pesa is the digital mobile phone currency version of the Kenyan shilling issued by a trust operated by the Kenyan mobile phone operator Safaricom.[12]  The trust is not licensed as a bank as it does not lend any of the money deposited with it.  One hundred percent of the money deposited with M-Pesa is placed with commercial banks. If these deposits were with the central bank, they would be risk free—an example of the Chicago Plan.

Conclusion

My conclusion from the above considerations is that digital currency should be issued by banks or by entities adhering to the Chicago Plan if and when they prove superior to existing electronic means of payment.  Commercial bank digital currency liabilities should be insured or should adhere to the Chicago Plan segregated from the rest of the bank and thus from any losses the bank’s other activities might suffer.  If bank demand deposits were also 100% reserved, bank digital currency would feature the same stability benefit as was enjoyed in the free banking era by bank note issuing banks without the default risk of that era.  Such digital currency can extend the benefits of digital payments to the non-banked as it has in Kenya and a growing number of other countries.  It is a model also well suited to the issue of global, non-national currencies such as market SDRs or gold backed currency.

[1]Dr. Coats is retired from the International Monetary Fund, where he was Assistant Director of the Monetary and Capital Markets Department.

[2]Michael D. Bordo and Andrew T. Levin, “Central Bank Digital Currency  and the Future of Monetary Policy” Economics Working Paper 17104, Hoover Institution, August 2017. https://www.hoover.org/sites/default/files/research/docs/17104-bordo-levin_updated.pdf

[3]Warren Coats, “The Technology of Money”Cayman Financial Review,January 18, 2012.

[4]“Central Bank Digital Currency,” Bank for International Settlements, March, 2018. https://www.bis.org/cpmi/publ/d174.pdf.

[5]Warren Coats, “Bitcoin, Cybercurrencies, and Blockchain” March 12, 2018. https://wcoats.blog/2018/03/12/bitcoin-cybercurrencies-and-blockchain/

[6]Project Jasper: Are Distributed Wholesale Payment Systems Feasible Yet?Bank Of Canada, Financial System Review, June 2017.  https://www.bankofcanada.ca/wp-content/uploads/2017/05/fsr-june-2017-chapman.pdf

[7]Benjamin Geva, “Banking In The Digital Age – Who is Afraid of Payment Disintermediation?”  EBI Working Paper Series, 2018 No 23, March 23, 2018.  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3153760

[8]In the “good ol days” representatives of all local banks would meet in a room and exchange the physical checks that their customers had written to each other and settling the net differences between each bank via a common correspondent bank.

[9]Warren Coats, “Changing direction on bank regulation”Cayman Financial Review, April 2015.

[10]For an elaboration see Geva, op.cit.

[11]Warren Coats, “The Money Problem-Rethinking Financial Regulation” by Morgan Ricks, Cayman Financial Review April 26, 2017.

[12]op. cit. Coats, 2012

The Cayman Financial Review

I have three articles in the latest issue of the quarterly Cayman Financial Review, on whose editorial board I serve. The first is the Letter from the Editorial Board, which explores my thoughts on restoring more market discipline of bank risk taking rather than piling on more government regulations: http://www.compasscayman.com/cfr/2015/04/22/Changing-direction-on-bank-regulation/ The second is the second installment of The Kabul Bank Scandal series, http://www.compasscayman.com/cfr/2015/04/22/The-Kabulbank-Scandal–Part-II/   And the third is my review of Martin Wolf’s new book, “Shifts and Shocks.”   http://www.compasscayman.com/cfr/2015/04/22/%E2%80%9CThe-Shifts-and-the-Shocks%E2%80%9D-by-Martin-Wolf/ If any of these topics interest you please click on its link.