Why Have Fractional Reserve Banking?

1. Why Have Fractional Reserve Banking? Rajnish Mehra Arizona State University Edward C. Prescott Arizona State University 14 August 2014

2. Definition of a Commercial Bank • A bank is an institution which BOTH • Accepts demand deposits from the public • Originates loans *Definition is the one in the 1971 U.S. Banking Act of 1971* From Raghuram G. Rajan, “Do We Still Need Commercial Banks?”

3. The definition rules out: • Money market funds as they do not originate loans • Finance companies as they do not offer demand deposits * From Raghuram G. Rajan, “Do we Still Need Commercial Banks?”

4. Two Economic Reasons For Commercial Banks In the Past Are: • They economized on resources allocated to digging gold out of the ground when there was a gold standard • There typically was not enough US government debt to serve as reserves for all demand deposits – now there is

5. A Bogus Argument for Fractional Reserves • Save on costly equity financing • Admati, DeMarzo, Hellwig and Pfleiderer demolishes that argument in, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Requirements: Why Bank Equity is not Expensive” (2011) • It comes down to the Modigliani-Miller Theorem • Value cannot be created by shuffling balance sheets

6. “There is a pervasive sense in discussions of bank capital regulation that ‘equity is expensive’ and that higher equity requirements, while beneficial, also entail a significant cost. The arguments we examine, which represent those most often made in this context, are fallacious, irrelevant, or very weak.” Admati, DeMarzo, Hellwig, and Pfleiderer (2011)

7. Transactions are not Part of Theory of Value • With valuation theory, the primitives include the commodity space • Households and firms can exchange each commodity for value and value for each commodity • Households face a value (budget) constraint • An agent selecting the commodity vector in a technology set picks the one that maximizes value

8. What is Value? • Relative prices are determined in the theory of value • Irving Fisher hypothesize that MV = PT, the quantity theory, where one unit of M is one unit of value for determining P • Meltzer estimated the M1 demand function, M = v(i) Y, where i is the nominal interest rate

9. Lucas developed micro foundations for this money demand function • Lucas and Nicolini(2013) make a case that the demand for money theory for transactions is still alive • Cooley and Hansen (1991,JME) established that with this transaction based theory of money, the consequences of monetary policy for output and employment are small

10. Do Banks Perform a Socially ValuableMaturity Transformation Function? Data source: Flow of Funds for end of 2012 • Demand deposits small relative to total business sector borrowing • Checkable deposits 0.08 GNPs (L104, line 10) • Time and savings deposits 0.57 GNPs (L105, line 12)

11. Business borrowing, 2.30 GNPs ! • This includes household businesses (home mortgages) • Bigger number if car loans treated like home mortgages • Non-collateralized loans (credit cards) are small

12. PROPOSAL:Abolish Fractional Reserve Banking • Replace commercial banks with transaction banks • A sister trust corporation to a transaction bank would remain • It would set up and monitor trust that are used to make business and other loans

13. The people evaluating loan applications at a bank and trust company would continue to do what they have been doing though they would all be employees of the trust companies • There is no loss of information relative to a system with commercial banks

14. Transaction Banks • Transaction Banks would have 100% reserve, on which they receive tax-free interest. Any interest they pay demand depositors is tax free • Reserves are a type of Federal Government debt that only the Fed can hold (R) • The other government debt is privately held (D) • Fed can increase R by issuing reserves to buy some D • D automatically becomes R when held by the Fed • The composition of government debt changes accordingly

15. With this System • No too-big-to-fail problem • No possibility of a bank run • No need for costly commercial bank regulation and deposit insurance • Resource costs of deposit insurance is at least 50 basis point a year per dollar of deposits • Currently small banks are going out of business because of big regulation costs

16. What About Financing Businesses? • The value of US businesses is about 3.5 GNPs • Currently half financed by debt and half by equity • In 1960 three-quarters funded by equity • Fact:Currently very little of businesses are financed by commercial banks accepting demand deposits and making loans to businesses

17. Types of Businesses in NIPA • Corporations, with value about 1.5 GNPs (L213 Line 23) • Unincorporated businesses, with value about 0.5 GNPs (B103 Line 33) • Household businesses value about 1.5 GNPs (B.100 Line 2) • Add 1 GNP of government debt yields household net worth, 4.5 GNPs • Net asset position of Rest of the World is near zero for most countries including the U.S.

18. Theory of Value and the D-D Environment • The D-D model is probably the most important paper in banking. It has fostered so much important research

19. Does the Diamond-Dybvig Model Establish a Reason forFractional Reserve Banking? • We make a distinction between the D-D environment and their banking mechanism. The latter is a particular mechanism • One of the equilibria to their mechanism supports the anonymous social optimum for their particular environment

20. Essence of D-D Environment • A long term investment that has a high return and is costly to liquidate • A preference shock that results in some people wanting consumption in period 1. It is called a liquidity shock • Preference shocks are private information • All people identical ex-ante • Social welfare is their ex-ante expected utility

21. Mechanism Design Problem • There are environments for which the good D-D equilibrium allocation is optimal • BUT, there are D-D type environments for which this equilibrium is not the optimal allocation • How can this be? ANSWER…

22. In the private information economies with one ex ante type, if there are shocks to preferences the optimum can have non-degenerate lotteries • Happens when they are useful in differentiating the ex post types • See Prescott and Townsend (1984, IER) and Cole (1989, IER) for an example. • Bottom line: Fact that it is a good mechanism in some environment does not mean it should be set up

23. Diamond-Dybvig Environments • We distinguish between the environment and the banking mechanism they employ • The D-D environments can be represented as economies using the Prescott-Townsend extension of the theory of value to environments with private information • Equilibrium exists, is optimal and generically unique • Is the use of this theory appropriate for D-D environments?

24. Banking is not a Mechanism Design Problem as Argued by Wallace (1996) • Can’t justify setting up the D-D banking arrangement because it’s good equilibrium supports the anonymous Pareto optimum for the D-D environment • Modifying the preference ordering, but not the technologies, in a way that preserves liquidity demand in period 1, the good D-D equilibrium is not optimal • This is accomplished by selecting preferences such that the valuation equilibrium has consumption lotteries which are non degenerate

25. Runs are a Characteristic of the Optimal Arrangement for Some Environments • Tri Vi Dang, Gary Gorton, and BengtHolmstrom(2010) have an example where banking crises are a propriety of the optimal mechanism in “Financial Crises and the Optimality of Debt for Liquidity Provision” • This implies banking crises are not prima facie evidence of market failure

26. This is a good use of mechanism design theory • Establishes some observation does not establish a market failure CONCLUSION….

27. Mechanism Design Theory is of Little Use in Designing a Financial System

28. Properties of a Good System • Should be nearly optimal • Borrowing lending system is optimal if people can privately save at the market rate (Cole and Kocherlakota, 2001) • Hansen and Imrohoroglu (1992) show the simple borrowing and lending arrangement is nearly as good as the costless AD allocation of unemployment risk • The proposed transaction bank system is a borrowing and lending arrangement • Given the high cost of insurance, only big idiosyncratic loses should be insured

29. A Good System Permits Innovation • Our financial system has been improving • Bid-ask spreads down – assets very liquid • Fees for managing assets down • Cost of diversifying down – index funds • Brokerage fees down – ETF’s zero at Vanguard • There will be new products and arrangement • Some will fail • Others will make the system better

30. The proposed transaction banking system has these properties

31. A Possible Problem • Private agents may create substitute for this interest bearing currency to make transactions. • This is commonly called shadow banking • Money market funds and similar institutions will carry out transactions if interest on government debt higher than interest on reserves. Is there a solution?

32. A Possible Solution • Put a 100% tax on net interest income of limited liability businesses • This would make borrowing from one group and lending at a higher interest rate to another unprofitable • Maybe I am overlooking something and smart people will figure out a way to get around it • If a way occurs to you, please let me know • We want to be confident that a system will work before implementing it

33. With this System How will Businesses be Financed? • Answer: By mutual organizations • Equity financing is a mutual arrangement • Households pooling money and lending to business and to state and local governments is a mutual arrangement • There are mutual funds and trusts that hold mortgages • Insurance and pensions funds have a mutual element • Maybe banning limited liability insurance businesses would be a good thing

34. Mutual Arrangements is the Way to Finance Businesses • Most currently is financed mutually • Let’s look at US capital accounts and private sector net worth accounts • My unit is GNP, which equals Gross National Income

35. How are U.S. Businesses Financed? • Following statistics come from McGrattan and Prescott (2010) published paper. All data and computer programs are available on Minneapolis Federal Reserve Bank website.

36. U.S. Fixed Asset TablesAverages Relative to GNP, 1999-2008

37. U.S. Capital StocksRelative to GNP, 1999-2008

38. Private Sector Balance SheetAverages for 1999-2008 Relative to GNP

39. Question: Why Net Worth Less than K? • K is 5.77 GNPS • Private sector net worth less government debt is 3.78 GNPs • What about the 2 GNPs difference?

40. Question: Why Net Worth Less than K? • K is 5.77 GNPS • Private sector net worth less government debt is3.78 GNPs • What about the 2 GNPs difference? Answer: The nature of the tax code.

41. Answer: The Nature of the Tax Code • The cost of intangible capital to a business is half it costs because intangible capital investment are expensed and not capitalized • Effectively the government pays half the cost and gets half the return. Thus it is half owner.

42. Concluding Remark • We need financial reform • The new system should be simple and transparent to mitigate the time-inconsistency problem • This helps insulate the transaction system political manipulation • We should rely even more on mutual arrangements for the financing of businesses