MacroMania

John Cochrane has another fun and provocative post making his pitch for equity-financed banking. He makes a lot of great points. But I'm still left feeling a little uneasy. In particular, I wonder whether some of his sweeping claims have any firm theoretical backing. It could be I just haven't thought hard enough or long enough about it. In any case, in the spirit of promoting discussion, let me describe some of the things that bother me.

Actually, before I start, I should preface my concerns with a couple of observations. Policies directed toward stabilizing the banking sector target both the asset and liability side of bank balance sheets. The "narrow banking" proposal of 100% reserves, for example, is a policy designed to make bank assets safe. The "100% equity-financed banking" proposal on the other hand is a policy designed to render bank liabilities safe (run-proof). According to Cochrane, "...bank assets aren’t risky! A diversified, mostly marketable portfolio of loans and mortgage backed securities is far safer than the profit stream of any company." The problem evidently lies on the liability side. Moreover, the issue here is not simply one of ascertaining whether banks are "over-levered" (I'm willing to agree that they probably are). The issue is whether debt (fixed-value promises), especially demandable debt, has a role to play in the business of banking at all.
 
The main question I have is: where's the theory? In the benchmark neoclassical model, some version of the Modigliani-Miller theorem typically holds. The theorem states that under a very specific set of assumptions, the liability structure of a firm does not matter. We know that these assumptions (e.g., symmetric information) do not literally hold in reality. When information is asymmetric, debt can be superior way to fund assets relative to equity (see here and here, for example). Demandable debt may have socially desirable properties when liquidity demands are private information; see here. In a world where exchange media (including collateral assets) are valued, it could matter very much how the "pizza" is sliced into tranches designed to serve special uses.

What explains the widespread use of the debt contract and the prevalence of fractional reserve banking? The explanation is unlikely (in my view) to be "government distortions" or "greedy bankers." It seems to me that asymmetric information in financial markets is a pertinent real-world friction. Could it be that debt represents a sort of "second-best" solution to the problem of efficient (low-cost) financing in a world of asymmetric information? Might the same not be true of demandable debt? Implicitly, Cochrane must be thinking that these benefits are quantitatively small. Maybe so, but senior liability tranches do seem rather highly valued in the market place, especially as exchange media. Private monetary instruments have always been in the form of debt, not equity. Why has this been the case?

Cochrane begins his post with the statement "My premise is that, at its core, our financial crisis was a systemic run. The mechanism is familiar from Diamond and Dybvig."  The Diamond and Dybvig (1983) model can indeed be interpreted as a theory of bank sector fragility. But we should keep in mind it's also a theory that explains the benefits of an illiquid bank sector (a point stressed by Wallace, 1996). Moreover, it's also a theory that explains the desirability of demandable debt. We want demandable liabilities (according to this theory) because, well, imagine going to an ATM wanting to withdraw cash and then having the blasted thing make you fill out an insurance claim attempting to verify whether you do indeed have a pressing need for liquidity. (In fact, banks were known to do this during the banking panics of the 20th century.)

Now, I suspect that Cochrane may reply that while demandable debt in its traditional form once had a useful role to play, markets and communication technologies are now developed to the point that renders the demand deposit liability superfluous. Call me a hopeful skeptic. Cochrane claims that "unlevered bank equity would have 1/10 less the volatility it has today, so we're talking about 2% volatility on an annual basis." I'm not sure where he gets these numbers, though I do agree with him qualitatively. (On the other hand, how do we know that banks will not hold riskier assets if they are equity financed?)


In any case, just how much volatility is "too much" for depositors wanting transactions balances with a steady value to ensure that payment obligations can be met in all circumstances on a timely basis? Evidently, depositors value the fact that they can redeem their bank money at par for cash quite a bit. What Cochrane advocates is the replacement our present ATMs with one-armed bandits spitting out random returns whenever we want to redeem our bank equity shares for cash. That sounds like a lot of fun, but it may not be very practical. Perhaps the volatility of these returns will not be so great (how do we know?). Maybe we'll be able to withdraw only 98 cents on the dollar more often than not "by chance" (as the Gorton-Pennacchi insiders skim us outsiders while claiming "bad equity returns" as the culprit. Again, how do we know?)

I want to be clear here. I am not suggesting that Cochrane's proposals are a bad idea when all considerations are factored in. I'm just questioning whether it's the open-and-shut case he makes it out to be. If it is such a great idea, I wonder why banks have not offered the product on their own? (I am sure there is no shortage of explanations here, but still, it's worth having them spelled out.)
 
There is one final thing I want to touch on before I sign off here. The main reason Cochrane preferes equity over debt is because equity is evidently "run-proof." I don't know, he may have his own special definition of "run." There are macroeconomic models of multiple equilibria (see Roger Farmer) where shareholders might be compelled to "run" on equity, driving its price lower, leading to all sorts of negative pecuniary externalities and self-fulfilling crises. Getting rid of debt will not necessarily get rid of financial crises.

Of course, getting rid of debt will get rid of bankruptcy. But I am sometimes led to question whether bankruptcy is quantitatively relevant for causing or exacerbating recessions. As Cochrane points out:

Our crisis and recession were not the result of specific business operations failing. Failure is failure to pay creditors, not a black hole where there once was a business. Operations keep going in bankruptcy. The ATMs did not go dark.

Absolutely. I can recall several times when an airline went bankrupt with no noticeable side-effects (passengers were treated terribly, but that was normal even outside of bankruptcy). Bruce Smith (2002) reports evidence suggesting that bank panics are not always associated with output losses. If so, then what's the big deal? As Cochrane explains, when equity takes a plunge, we all pull out our hair, but the firm is under no obligation to do anything on our behalf. But with debt--demandable debt in particular--we can demand--demand--our money back. And the firm has to ... has to what? I'm not really sure. The firm can just continue to operate as usual and restructure its debt, no? After all, bankruptcy is just a rearrangement of claims against a firm's assets (well, I suppose in some cases senior management gets the ax, but not always). In the old days, banks were permitted to temporarily suspend withdrawals without legal repercussion. As well, bank clearinghouses might issue currency substitutes in lieu of specie, etc.

These considerations lead me to wonder whether interventions on the asset side of bank balance sheets might not be a better way to promote a run-free banking system. Alternatively, as Cochrane suggests, we might consider opening up the central bank's balance sheet to the public. As I've mentioned before, the U.S. treasury does permit the public to hold online UST accounts at www.treasurydirect.gov. While the system is not set up for making payments, there is no reason why, in principle, it could not be. I'm not suggesting this as a panacea, of course. But I think the idea, or some variant of it, deserves serious consideration.

From L2R: Michael Casey (MIT Media Lab), David Andolfatto (FRB SL), Simon Johnson (MIT) and John Schindler (FSB)

I'm freshly returned from Consensus 2016: Making Blockchain Real where I participated in a panel on "Digital Cash for Central Bankers." Michael Casey did a stellar job in crafting the session. It was fun and informative to have Simon Johnson and John Schindler as co-panelists. As we didn't get booed off the stage, I think maybe the audience enjoyed what we had to say as well. (I left the session with almost a kilogram of business cards--odd that paper is still so widely used in this capacity. By the way, some of what I had to say can be found in my blog post here.)

Today's post is more about marketing the idea of blockchain. The word sounds intimidating to many people. That's probably because attempts to explain it often make use of a highly technical trade language that few people understand. My goal here is to think of ways to communicate the idea of blockchain in a manner that will make people feel like the concept is familiar to them. Indeed, I believe that the broad conceptual idea of blockchain should be familiar to us all.

Renowned Bitcoin expert Andreas Antonopoulos writes here:

It will take time for the idea of decentralized trust through computation to become a part of mainstream consciousness, and until then, the idea creates cognitive dissonance for those accustomed to centralized trust systems. With thousands of years of practical use, centralized systems of trust are accepted unconditionally and without much thought as the only model of trust.

It's an excellent article and I highly recommend you read it. What I want to do here is push back a little on the notion that decentralized trust systems should necessarily create cognitive dissonance. In particular, I should like to point out that we've had tens of thousands of years of experience with decentralized trust systems. Alright, so let's get started.

Consider the following scenario. You are attending a cocktail party with dozens of people present and you are asked by your hostess to deliver a short speech. Now suppose you utter something outrageous, e.g., "I think the Fed should buy the existing stock of bitcoin and store it as a foreign currency reserve!" The audience will stare at you, mouths agape (especially if you're a central banker, or a renowned Bitcoin enthusiast). You wake up the next day and regret your rash public remark. You wish you could take back what you said, but how? The only way this could be done is if you could somehow persuade the group to forget what you said. But just think about how difficult it would be to do that. Especially if the number of people in attendance was large.

What has just been demonstrated (I hope) is the power of a distributed database validated through a communal consensus algorithm. The database here is your silly statement above together with the time you made it (a timestamp). The information in this database is shared on a distributed network of brains (what you said and when you said it is imprinted forever in the memories of all who witnessed the event). The consensus algorithm here is "let's all agree to remember what was actually said (as opposed to some alternative, fabricated statement)."

A database in this form is extremely secure. It will survive intact even if some brains holding the database are destroyed. The database can be communicated to other brains (who can confirm the validity of the statement by seeing how it squares with the memories of others). If one or more people tried to fabricate an alternative history, the attempt would almost surely fail (we cannot rule out the possibility entirely, however). If your remark instead lived only as an electronic recording in a central databank, the task of re-writing history would be much easier.

Now imagine living in a primitive village. Relevant elements of the database would include observations like: [1] John had his wound tended to by Bob at date t, [2] John killed a wild pig and shared it with the village at date t-1, etc. The database in this case can be organized in a sequence of time-dated blocks X(t) = {x(t), x(t-1),...}, where x(t) is the database (block) at date t, and X(t) is the "blockchain." So, the blockchain is just a communal databank recording some relevant aspects of villagers' activities. In village economies, this communal memory typically exists in a virtual state (written records are a much more modern invention).

Notice how the blockchain described above could serve a very useful economic purpose. In particular, note that the act of consumption (medical services) in [1], John is effectively using [2] as currency. At least, this is how things work in what anthropologists describe as "gift-giving societies." And if you think about it for a while, you'll notice that the same principle is at work in the various groups you interact with on a daily basis (your friends, your family, coworkers, etc.). Much, quite possibly most, economic exchange occurs via such localized trust networks.

The problem with this ancient blockchain technology is that it doesn't scale very well. There's only so much data we can fit in our brains.  So as populations grew and as people started forming large communities, a new type of record-keeping system was needed. The model that came to dominate is one in which databases are collected and maintained by trusted third parties. Much effort is expended in keeping these private databases secure (not always successfully). It is often difficult for these agencies to communicate and reconcile their databases (as in when you try to send money from your bank account to your friend's foreign bank account overseas).

And so enter the "new" technology, blockchain. I hope I have convinced you what is new here is not the principle of the blockchain. The new technological developments are: [1] bigger brains (increased capacity for data storage and processing via computers); [2] better communications (the Internet); and [3] computer-based algorithms to serve as communal consensus mechanisms (e.g., proof-of-work).

These innovations will permit a revolution in the truest sense of the word: we are traveling back to where we began--but with planet earth as our village.

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PS. Please let me know if this was helpful or how it could be improved. After writing this post, I came across this short video: Blockchain for Dummies. Some of the comments are critical of it, but I thought it communicated the idea in a nice way.

John Cochrane has a dream where the banking sector is financed entirely with equity. The dream is premised on the notion that debt-financed endeavors--especially those using short-term debt--are prone to runs. Run-prone structures can cause, or contribute to, financial crises. The possibility of crisis invites government regulation. Government regulation leads to regulatory arbitrage, much of which occurs in the shadows of the financial market. Which leads to more (now harder-to-monitor activities), leading to ... well, you get the picture. Why not just structure a regulatory framework that permits equity-financed banking ventures, like SoFi, to weave their (run free) magic? It's a good question. I'm not sure what the answer is. But I wonder if it's all as easy and straightforward as Cochrane makes it out to be.

I don't want to nitpick here but, I don't think I'd classify SoFi as a "bank" in the legal or economic sense. True, SoFi is acting as a financial intermediary. But insurance companies and pension funds are also financial intermediaries, and we do not think of them as banks. SoFi is more like a venture capital fund. It sounds like it's doing a wonderful job matching savers to borrowers. But matching savers to borrowers is not (the main) business of banking. Even a simple bond market matches savers to borrowers. We do not need banks to do that.

So what do banks do? We can get a grasp of their business model by comparing the structure of their balance sheets to other financial intermediaries. In many respects, the asset side of these balance sheets looks broadly similar: they consist of cash reserves, bonds (government and corporate) and other securities. Retail banks also hold personal and small business loans, which they typically originate as a part of their business. The differences on the liability side of financial intermediaries are much more striking. Pension funds issue time-dependent liabilities. Insurance companies issue state-contingent liabilities. Banks issue demandable liabilities. In all three cases, one wouldn't be so far off in forming the impression that financial intermediaries are fundamentally just "asset-transformers" (they transform a set of assets into structured liability products that people find useful).

Banks, in other words, are in the business of supplying a particular structured liability product: the demand deposit liability (DDL). It is Cochrane's worst nightmare. That's because the DDL is a "fixed-value promise." Specifically, a DDL promises redemption at (or close to) par for cash. But it's even worse than this because the promise is to redeem on demand (rendering the DDL a form of short-term debt). Worse still, the banking system does not possess enough cash in reserve to honor these short-term obligations in the event that all DDLs are presented for redemption at once (this is what it means to be a fractional reserve banking system). And as if things could not get any worse, they actually do. These bank-created DDL products -- they're used widely as payment instruments. That's right, banks are in the business of creating money (out of their assets).

Before I go on, I want to say something about the manner in which "deposits" is used in discussions of banking. It is sometimes said that "banks take deposits." But what does this mean? Even a Las Vegas slot machine takes deposits (and issues a very unattractive state-contingent liability in exchange, I might add). Well, yes, I can make a deposit of cash at my local bank. And my employer "deposits" my paycheck in my bank account (in reality, just a debit-credit operation on a ledger). But this is probably not the best way to think about "deposits." I sometimes like to say that banks don't take deposits--they create deposit liabilities. Related to this notion, the banking system does not "lend out cash." The banking system funds its assets (including loan creation/acquisitions) by creating DDLs. (At the individual level, banks need to acquire cash to fund their operations only to the extent they want or need to meet some reserve requirement). Cash finds its way into circulation whenever the owners of DDLs exercise the redemption option embedded in the DDL contract. Alright, with this out of the way, let me continue.

It's not been easy to discover the fundamental economic (or social) rationale for banks (defined here as intermediaries that fund their assets, including their loans, through DDLs). Economists have struggled to understand debt, never mind demandable debt. Probably the best theory of bank debt we have is still the Diamond and Dybvig (1983) model. Like any model of debt, certain "financial market frictions" need to be present; else, the Modigliani-Miller theorem holds, in which case we should all be living in Cochrane's dream world (assuming no bad government fairy, of course).

The root frictions appear to be what economists label "private information" and "limited commitment." Among other things, limited commitment renders all sorts of assets, like our human capital, illiquid. In a frictionless world, there is no reason why I shouldn't be able to buy my Starbuck's latte by peeling off a slice of my house or my future earnings. It just doesn't work. That's what banks are for. They measure the value of my house, my future earnings, and they create DDLs that are backed by their assessed value of the collateral I have to offer. They would be performing an equivalent service by acting as licensing agents whose job is to verify the quality of the promises I issue (imagine an Andolfatto-IOU stamped as "BoA approved.") What's not entirely clear is why banks couldn't just get me the money I need by the way SoFi does--by first acquiring state-created money from willing lenders?

To put things another way, if banks are primarily in the business of payment services, why are they not limited to that business? Why are banks permitted to create money? (Why should banks help render my illiquid assets liquid?) Why not make banks hold 100% cash reserves? And then let the financial market handle matching lenders with borrowers, a la SoFi? This is the line taken by those who favor "narrow banking" proposals (see, e.g., Musgrave, 2014).

I have yet to digest all the arguments made by Musgrave and others. But they make enough sense to be taken seriously (so I plan to continue reading). I have a lot of questions. I am not bought into Cochrane's claim that equity is a run-proof security. The equity traded on junior exchanges, for example, does not appear run-proof (one can "run" to your stock broker and scream "sell, sell, sell!" just as easily as you can "run" to your bank to ask for your money). Moreover, there's a lot of evidence to suggest that equity makes lousy money. Gorton and Pennacchi, 1990 claim this is the case because equity is "informationally sensitive," and (senior tranches of) debt is not. Like it or not, most contracts are drawn up in nominal terms. In such a world, it would be terribly inconvenient, I think, to have floating NAV MMMF shares used as an exchange medium. People seem to like fixed-exchange rate systems (which is what DDLs are, after all).

What I would really like to see is how their claims stack up in a formal model. After all, the Diamond and Dybvig model does suggest the possibility of a trade-off. Maturity transformation enhances risk-sharing (when conventional markets are absent or too costly to operate), but potentially exposes the bank sector to self-fulfilling bank runs. A narrow banking regime kills risk-sharing but enhances financial stability. So in some jurisdictions, the switch to narrow banking might be worth making (although, there may be other ways to enhance the stability of fractional reserve banks, like central bank lender-of-last resort facilities, etc.).

I suspect that narrow banks might work relatively well in low-inflation environments, but possibly not so well in high-inflation regimes. The reason is because high inflation imposes a big tax on cash reserves (unless they pay interest, I guess). In such an environment, fractional reserve banks may be preferred as a way to escape the inflation tax by offering a higher rate of return on their DDLs. (Of course, it would be better to encourage a low-inflation regime, but that's not always possible).

So, these are just a few of the thoughts that came to mind after reading about Cochrane's dream. It's an interesting debate and I look forward to reading a lot more about it.

Annual Inflation Rate