Brad Setser

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An unlimited guarantee requires unlimited access to financing …

by Brad Setser
October 13, 2008

Over the weekend, the countries of the G-7 indicated that they would do “whatever it takes” to prevent another Lehman-style bankruptcy. They pledged to “use all available tools to support systemically important financial institutions and prevent their failure. ”

Many European banks need access to short-term dollar financing to support their dollar assets, as we discovered after Lehman default’s led to a run on money market funds. Today, the Fed and the major European central banks made sure that any European bank that needs dollars will get dollars:

“The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.”

Emphasis added.

Any word, when over-used, loses its impact — but this really is unprecedented.

The US and the major European central banks have effectively agreed to lend without limit to make good on their pledge to avoid a systemic bank failure. All major financial institutions in the G-10 ultimately now have access — through their national central bank — to the Fed. This isn’t quite a global lender of last resort (in dollars) but it is close. Banks are different than countries, so the analogy is imprecise — but back when emerging economies had trouble rolling over their short-term dollar debts during the crises of 97-98, the G-7 never pledged to lend “any amount” needed.

Lending to countries through institutions like the IMF isn’t collateralized — but it also was never unconditional. The G-7’s guarantee of liquidity doesn’t seem to be linked to steps the banks could take to help themselves — like suspending dividend payments on their common stock.

The nature of the global response to the current crisis is beginning to emerge.

Step 1 is to guarantee against failure — or at least the kind of failure that leads to losses for unsecured creditors. If such guarantees are credible — and money market funds stop losing funds, so they have money to lend — that should guarantee that any systemically important institution can borrow the funds it needs to repay its maturing short-term debts, no matter how troubled its balance sheet. Short-term bank debt would be as good as short-term Treasury debt.

A necessary component to this guarantee though is a real effort to recapitalize the financial system, so that the banks will eventually be able to borrow on the strength of their own balance sheets — not on the strength of the government’s guarantee.

France, Germany, and the UK have now pledged a sum substantially larger than the United States’ TARP to backstop their banks — and they have indicated their willingness to take large equity stakes in their respective bank systems. France has pledged a sum of up to 2% its GDP. The UK has already committed 37 billion pounds ($64 billion), or 2.5% of its GDP. Germany has indicated that it willing to use 3.2% of its GDP to buy equity in its banks. Comparable US equity injections from the US government would imply a commitment of between $300 and $500b.

That seems to me to provide a baseline from evaluating the scale of the equity investments the TARP may need to make. The IMF has estimated that the major banks need roughly $700b in new equity capital.

The US government still seems to worry that overly punitive terms would discourage “healthy” institutions from seeking a government equity injection. I understand the need to be reassuring — and to make it clear that the injection of government funds is considered to be reassuring rather than evidence of hidden problems.

At the same time, I would hope that the executives of America’s banks gathering at the Treasury this afternoon recognize that a lack of confidence in the quality of their balance sheets pushed the global financial system to the edge of collapse. Lehman’s default revealed that few large financial institutions can currently borrow without at least an implicit government guarantee. The market isn’t sure about the valuations they have given to their illiquid and opaque assets — and thus isn’t convinced about their solvency in rapidly slowing global economy. No bank executive wants to dilute existing equity investors. But absent unprecedented government intervention first to provide the banks with emergency financing and now to guarantee their liabilities, many banks would have already had to shut their doors.

I am open to be being persuaded otherwise, but I would think that any institution that is now borrowing heavily from the Fed should be expected to receive an equity injection from the government if it cannot quickly raise substantial sums from true sources of risk capital — and by that I mean sources of capital that are investing in the banks without any expectation that the government will protect new equity investment from future losses.

Absent a major equity infusion, it is hard to see how the banking system can be weaned off the need to rely on the government’s implicit — if not explicit — guarantee to borrow. Think of it this way: all the concerns traditionally raised about Fanny and Freddy — privately owned companies borrowing in the market on the back of a government guarantee rather than than the strength of their own balance sheets — now apply to the “private” financial system.

It looks like the G-7’s actions have kept the financial system from falling off the precipice. But a world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

UPDATE: The Treasury has indicated that it will inject $250 billion in the banking system — in a way that in effect leaves the banks no choice but to accept the Treasury’s offer to buy preferred stock. That addresses one of my concerns, namely that the government wouldn’t use the leverage associated with its de facto guarantee of bank liabilities to force the banks to accept actions that are good for the system as a whole even if they are bad for current shareholders. But as Felix Salmon notes, it isn’t clear how much preferred equity the government will get in exchange for its capital and the government is buying non-voting stakes — leaving it to the Fed and other regulators to assure that the capacity to raise funds on the back of the government’s guarantee isn’t abused. And as Yves Smith notes, the government seems to have opted to support all the remaining large players in the system. That helps to explain the stock market rally — but it also potentially leaves some difficult questions unresolved.

104 Comments

  • Posted by flow5

    The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate, (or via the federal funds “bracket racket”, or thru a series of temporary “pegs”, or via a Taylor-like rule).

    We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    The effect of tying open market policy to a fed Funds bracket is to supply additional (and excessive legal reserves) to the banking system when loan demand increases.

    The Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

    This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.

    There are only 3 interest rates that the Fed can directly control in the short-run; the discount rate charged to bank borrowers & the primary credit rate for both the PDCF & ABCP. The effect of Fed operations on all other interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    As any monetarist knows, the money supply can never be controlled by any attempt to control the cost of credit.

    The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is free/gratis legal reserves.

  • Posted by flow5

    “explanations about how it’s impossible to monetize debt”

    Just raise reserve ratios. Reserve requirements have been as high as 91.1 (in 1941).

  • Posted by Cedric Regula

    Blissex:

    No servo guys I know would ever design a servo system like that.

    Besides, the first prototype would blow up in the first five minutes of bench testing, and we get in trouble for that.

  • Posted by RebelEconomist

    To be clear, I am not disputing that banks lend first and then acquire reserves. Nor I am disputing that the Fed can control interest rates if they are willing to lose money in the process – even I can control interest rates for a microsecond if I am willing to lose money.

    The key problem, which Warren Mosler’s article, which I see was originally written in 1994, glosses over, is the elasticity of banks’ demand for reserves. He seems to argue that reserves demand is inelastic because of reserves requirements, but other countries do not always have reserve requirements and are still supposed to control interest rates using similar techniques. Anyway, this idea clearly needs to be reconsidered in the light of recent events. For example, he says “added reserves in excess of required reserves drive the funds rate to zero”. See the first chart in http://www.econbrowser.com/archives/2008/10/balance_sheet_o.html.

  • Posted by STF

    Rebel economist writes: The key problem, which Warren Mosler’s article, which I see was originally written in 1994, glosses over, is the elasticity of banks’ demand for reserves. He seems to argue that reserves demand is inelastic because of reserves requirements, but other countries do not always have reserve requirements and are still supposed to control interest rates using similar techniques.

    Good questions.

    Mosler’s point does not rely on reserve requirements. He’s well aware of, say, Canada’s lack of reserve requirements and zero overnight balances. There’s no inconsistency there with his paradigm, though full explanation would require a bit of space here. Essentially, the Fed already credits reserve accounts at a penalty rate WHENEVER banks go into overdraft or miss on reserve requirements–the point is that the Fed’s operations (or any other central bank’s) are necessarily about the price of reserves, not the quantity, since the Fed (or any other central bank) is the monopoly supplier of net balances.

    The Fed has a particularly strange way of setting the target rate, but the far simpler method is to set the rate paid on reserve balances and the penalty rate very close (if not equal) to the target rate, and the rate would not deviate from this corridor.

    Under current circumstances, setting the both rates equal to the target (as Mosler and Charles Goodhart have proposed) would again make obvious the Fed’s ability to hit the target rate. Mosler further proposes that the Fed to lend unsecured to member banks at the target rate, since their assets are already signed off on by regulators and the Treasury is already on the hook, and pay the target rate to bank reserve accounts, all to help reduce counterparty risk in interbank markets.

  • Posted by RebelEconomist

    STF,

    You glossed over what was meant to be my main point, which is that the demand for reserves appears not to be inelastic. As far as I can see (this is something that I am trying to work out myself), if the demand for reserves is not inelastic, the Fed has no special power to control interest rates. As I said above, I can believe that the Fed or any other institution with deep pockets can control interest rates, simply by becoming one side of the market (which is I think what Goodhart is effectively suggesting), but that is not a sustainable situation (assuming, in the Fed’s case, that inflation is kept under control). It seems to me that what we are seeing now is exactly that. In an attempt to hold interest rates down at a time when the natural price of loanable funds is higher due to risk, the Fed is tending towards becoming one side of the entire money market.

  • Posted by flow5

    Reserves are not a tax. The tax is inflation.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time/savings deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) — somewhere in the banking system.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System, etc., etc.

    Thus, it’s not possible to compare the non-banks to the commercial banks when talking about “funding” or the supply of loan-funds. The commercial banks (as a system of banks) pay for something that they already have (interest bearing deposits). The (CBs & intermediaries) modus operandi is diametrically opposed.

    The member CBs could continue to lend if the public ceased to save altogether.

  • Posted by flow5

    “Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

    “These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

    A commercial bank only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities. Reserve ratios were at 84% in 1942.

    Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) — somewhere in the banking system.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System.

    Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.

    From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

    That is, CB time/savings deposits, unlike savings-investment accounts in the “thrifts”, bear a direct, virtually one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    Consequently, the effect of allowing member CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase long-term interest rates, increase the proportion, and the total costs of CB TDs.

    Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

    However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.

    In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the “thrifts” with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

    Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

    In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

    The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

    Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

    Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

    From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

    Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity or turnover of existing money. Here investment equals savings (and velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money (bank credit & the money stock).

    The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

    It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

    How does the FED follow a “tight” money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business — gradually (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, are demand/transaction deposits – directly or indirectly through currency or their undivided profits accounts. Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

    Dr. Leland James Pritchard (MS, statistics – Syracuse, Ph.D, Economics – Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

    “The Economics of the Commercial Bank Savings-Investment Process in the United States” — “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
    “Profit or Loss from Time Deposit Banking” — Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

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