Since retiring from the Federal Reserve in mid-2016, our friend Jamie McAndrews has been very busy. Unlike most of us, he is putting his ideas into action: in 2015, he and a number of his colleagues, proposed the creation of segregated balance accounts (SBAs). As they write, “SBAs are accounts that a bank or depository institution (DI) could establish at its Federal Reserve Bank using funds borrowed from a lender.” Their proposal is that a bank would offer a special account that it is fully collateralized by a deposit at the Federal Reserve. Furthermore, the SBA deposits would be remunerated at the interest rate the Fed pays on excess reserves (the IOER), minus a small fee for the bank.
We have no expertise whatsoever in determining whether the Fed has legal grounds for denying TNB a Master Account—the subject of the court case in the opening quote. But we do have concerns about SBAs and narrow banks: we worry that they would shrink the supply of credit to the private sector and aggravate financial instability during periods of banking stress. Compared to what may be large costs, we suspect that the benefits would be small…. Read More
On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.
Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.
It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why…. Read More
In 2012, the ECB faced down a mortal threat to the euro: fears of redenomination (the re-introduction of domestic currencies) were feeding a run away from banks in the geographic periphery of the euro area and into German banks. Since President Mario Draghi spoke in London that July, the ECB has done things that once seemed unimaginable, helping to support the euro and secure price stability.
So far, it has been enough. But can the ECB really do “whatever it takes”? Ultimately, monetary stability requires political support. Without fiscal cooperation, no central bank can maintain the value of its currency. In a monetary union, stability also requires a modicum of cooperation among governments.
Recent developments in France have revived concerns about redenomination risk and the future of the euro.... Read More
Professor Mervyn King, our friend, NYU Stern colleague and the former Governor of the Bank of England, has written a wonderfully insightful and thought-provoking new book, The End of Alchemy. His goal is not just to explain the sources of the 2007-09 crisis, but to provide a template for financial reform that would reduce the frequency and severity of future crises. In the end, Professor King proposes a radical structural change intended to make banking safe while preserving the intermediation function that is critical to modern economies.
The alchemy to which Professor King refers in his book’s title is banks’ traditional function of transforming high-risk, illiquid and long-maturity assets into low-risk, liquid and short-term liabilities. But, in the presence of limited liability for the banks’ owners and the government safety net (in the form of deposit insurance and the lender of last resort that remove both solvency and liquidity risk for the depositors), banks’ incentive is to transform too much. Holding assets that are overly risky, insufficiently liquid and too long-term makes banks fragile and run-prone, providing fodder for systemic crises.... Read More
The global financial crisis started in 2007 when European banks came under increasing strain. If forced to specify the crisis kickoff, we would pick Thursday, August 9, the day that BNP Paribas halted redemptions from three investment funds because it couldn’t value their holdings of U.S. mortgages. Responding to the ensuing market scramble for liquidity, the ECB injected €95 billion that day into the European banking system and the Federal Reserve put $24 billion in theirs. Today, with the benefit of hindsight, these numbers appear quaint, but then they seemed enormous... Read More
The SEC has finally acted. On July 23, the SEC issued 859 pages of new rules for the operation of some money market funds. (You can find a mercifully short description here.) To summarize our reaction: we are underwhelmed! It is hard to see how the new rules will reduce systemic risk in any meaningful way... Read More
Observers of the euro-area financial crisis typically focus on the yield spreads on peripheral government long-term bonds (compared to German yields) as the “fever thermometer” of the crisis. On that basis (see chart below), the crisis looks like it is over: after peaking in 2012, spreads rapidly receded following European Central Bank (ECB) President Mario Draghi’s promise to do “whatever it takes” to save the euro. Indeed, in Ireland, Italy, and Spain, yields themselves have now sunk to the lowest levels since the euro was created in 1999... Read More
Following the collapse of Lehman in 2008, a run on U.S. prime money market mutual funds (MMMFs) was halted only when the U.S. Treasury provided a blanket guarantee. (Prime MMMFs typically invest in corporate debt, including the debt of intermediaries.) Shortly thereafter, the Federal Reserve added emergency machinery (the “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to encourage depositories to acquire illiquid assets from MMMFs... Read More
Every financial crisis leads to a new call to restrict the activities of banks. One frequent response is to call for “narrow banks.” That is, change the legal and regulatory framework in a way that severely limits the assets that traditional deposit-taking banks can hold. One approach would require that all liabilities that are demandable at par be held in the form of deposits at the central bank. That is, accounts that can be withdrawn without notice and have fixed net asset value would face a 100% reserve requirement. The Depression-era “Chicago Plan” had this approach in mind. Read More