Thursday, 14 January 2010

Will banking be more stable? Is that a good thing?

In an intriguing example of pricing an externality, Barack Obama has announced a plan to tax American banks based on their reliance on the wholesale finance markets.

On a related subject, Nick Rowe has a neat analysis of finance as magic - the magic of borrowing short and lending long, sharing risk and creating liquidity.

To make this magic work in a more stable fashion, it's understandable that governments would want to encourage banks to move from wholesale to deposit finance. Assuming it works, what are the effects of this move likely to be?
  1. The coordination game between multiple owners of capital will work better, for two reasons. First, because no individual will have as much power as they do now. Second, because the more finance is provided by millions of depositors (instead of a few hundred managers of wholesale capital) the more statistically predictable their behaviour is likely to be. Even when there are herd changes in depositor behaviour, the movement of a larger, more granular, herd is more predictable than the movement of a small group.
  2. The amount of capital available in the economy is likely, in the short term, to shrink. Wholesale funding is a quick and efficient way for banks to lever up their reserves by lending to (and depositing with) each other through the money multiplier effect. If there is less wholesale funding, then money will be multiplied through the slower process of retail lending and deposits. The lower efficiency means the total multiplier will ultimately be lower. Slower transmission means more stability, but also less growth in the money supply.
  3. Central banks are therefore likely to pursue a looser monetary policy than they otherwise would. Thus, interest rates will be kept lower for longer and/or QE-like programs will continue. This effect will be further strengthened by the fiscal tightening that the $120 billion tax represents (because central banks, in the long run, act to neutralise the effects of fiscal policy).
  4. Non-bank providers of credit should gain an advantage. In theory, there's no reason why an unregulated (or less regulated) institution shouldn't issue its own promissory notes which can be used as capital. While these notes, because their issuer is uninsured, would presumably trade at a discount to bank money, there may be times when they have an advantage. Imagine Microsoft issues vouchers for future purchases of Windows or Microsoft Office; these might either be sold for cash or traded for other resources, and could help to finance the development of the next versions of those products. There is a paradox here: Microsoft might have the financial strength not to require such unconventional means of finance; while a smaller company which does need it, might have to issue its paper at such a large discount that it would become uneconomic. The instruments may end up being more equity-like than money-like. But there could well be points on the risk/return curve where this makes sense.
  5. Investment banking in general will become more expensive relative to retail banking. Perhaps this will nudge the US slightly closer to the European model, where large retail banks provide a higher proportion of corporate finance.
  6. If finance does become more stable, in the long term this should make investment decisions more predictable and increase the net present value of financial assets. It's possible that this would lead to a repeat of the last ten years: stability leads to asset price rises, leading to more leverage, and maybe some other currently unforeseen pressure will create the potential for another crisis. But that could also be true of anything that increases economic growth. It's probably not worth sacrificing growth for a vague idea of risk reduction.
  7. If countries outside the US don't impose such a tax, London may end up attracting more wholesale finance - quite the reverse of the exodus many people have feared.
Generally I think a flexible finance market with many forms of different capital is a good thing. But there's nothing wrong with riskier forms of money being priced a little more highly. As economic theory would predict, putting a price on a service that's currently being provided for free will encourage people to consume the right amount of it.
    Two dangers that I see. One is that it may be possible to find loopholes in the definition of "wholesale finance". The simplest definition is that it should cover any liability which is not already covered by the deposit insurance scheme. But would that then include retail deposits that are over the deposit insurance limit? If so, would that actually act as a disincentive for some deposit-taking? An more sophisticated mechanism would be to use statistical models of the volatility or riskiness of each source of finance; but that opens up all sorts of model risks of the kind we've seen with agency-based credit rating.

    The second is that the price may not be right. It seems that goal is specifically to raise $120 billion, on the basis that that was the cost of the last bailout. But there's no reason to assume that that is the correct price of the government's implicit guarantee. Maybe the next bailout will cost more - or less - than the last one. In which case wholesale capital will be under- or over-priced respectively. Still, it's probably better than not pricing it at all.

    Update: Greg Mankiw agrees.

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