Deposit insurance

To Form a More Perfect Union

On 31 May 2018, Vítor Constâncio completes 18 years on the Governing Council of the European Central Bank (ECB)—8 as Vice President and 10 as Governor of the Bank of Portugal before that. Ahead of his departure, Vice President Constâncio delivered a valedictory address setting out his views on what needs to be done to make European Monetary Union (EMU) (and what people on the continent refer to as the “European Project”) robust.

Before we get to his proposals, we should emphasize that we continue to view political shifts as the biggest challenge facing EMU (see our earlier posts here and here). The rise of populism in recent euro-area member elections is not conducive to the risk-sharing needed to sustain EMU over the long run. Without democratic support, investor fears of redenomination risk—associated with widening bond yield spreads and, possibly, runs on the banking systems of some national jurisdictions—will continue to resurface whenever political risks spike or local economic fortunes ebb. This latent vulnerability—resembling that of a fixed-exchange rate regime with free movement of capital—diminishes the prospect for strong and stable economic growth in the region as a whole.

Turning to the need for change, the current framework has three significant shortcomings…

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Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

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Fintech, Central Banking and Digital Currency

How will financial innovation alter the role of central banks? As the structure of banking and finance changes, what will happen to the mechanisms and frameworks for setting monetary and financial policy? Over the past several decades, with the development of inflation targeting, central banks have delivered price stability. And, improved prudential policies are making the financial system more resilient. Will fintech—ranging from the use of electronic platforms to algorithm-driven transactions that supplant the traditional provision and implementation of financial services—change any of this?

This is a very broad topic, some of which we have written about in previous posts. This post considers an innovation suggested by Barrdear and Kumhof at the Bank of England: that central banks should offer universal, unlimited access to deposit accounts. What would this “central bank digital currency” mean for the financial system? Does it make sense for central banks to compete with commercial banks in providing deposit accounts?

We doubt it. It is not an accident that—at virtually every central bank—only commercial banks today have interest-bearing deposits. Changing this would pose a risk of destabilizing the financial system....

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Walmart and Banking: It's Time to Reconsider

Guest post by Professor Lawrence J. White, NYU Stern School of Business

Overshadowed by the media attention to the proposed repeal of Obamacare, the House Financial Services Committee recently approved substantial changes in financial regulation. The House of Representatives may soon consider the proposed bill—the Financial CHOICE Act—which would make major changes in the Dodd-Frank Act.

However, when financial regulation is being discussed, there is a large elephant that isn’t in the room, but really should be: Walmart. Starting in the mid-1990s, Walmart made two separate efforts to enter banking in the United States, but was repelled both times. After its second effort was rebuffed in 2007, Walmart gave up this effort in the United States (but has since entered banking in Canada and in Mexico).

One question to ask might be, “Why should Walmart be allowed to enter banking?” But a more relevant question would be, “Why shouldn’t Walmart be allowed to enter banking?” ….

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Making Banking Safe

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....

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After Greece: Saving EMU

Euro-area leaders announced yet another agreement with Greece this morning. However, the survival of the euro area has never been about the fate of Greece. Instead, it is whether the Europeans will implement the reforms necessary to keep the euro area together. If they do, the common currency will endure. If they don’t, then the euro may not survive the next big adverse shock...

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How securitization really works

In the winter of 1997, musician David Bowie issued $55 million worth of bonds backed by royalty revenue from 287 songs he had written and recorded before 1990. The bonds had a 10-year maturity, a Moody’s A3 rating, and a 7.9% interest rate (at the time, the 10-year Treasury yield was around 6.5%, so the spread was relatively modest). “Bowie bonds” were no accident: by the late 1990s, the U.S. financial system had evolved to the point where virtually any payment stream could be securitized.

The success of U.S. securitization – as an alternative to bank finance – is a key factor behind the current push of euro-area authorities to increase securitization...
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Reverse Repo Risks

Since the collapse of Lehman Brothers in September 2008, the Federal Reserve has stabilized the financial system and put the economy back on a path to sustainable growth. This task involved creating a colossal balance sheet, which now stands at $4.37 trillion, more than four times the pre-Lehman level ($940 billion). As textbooks (like ours) teach, along with this increase in Fed assets has come an increase in reserve liabilities (which represent deposits by banks at the Fed). Today, banks’ excess reserves (that is, the extra reserves beyond those that banks must hold at the Fed) are at $2.56 trillion, compared to virtually zero prior to the crisis.

Getting the money and banking system back to normal requires doing something to manage these excess reserves ...
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Form vs. Function: Regulating Money Market Funds

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...
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Narrow Banks Won't Stop Bank Runs

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.
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