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What Do Banks Do? What Should They Do?

Some time back there was a bit of a kerfluffle when Paul Krugman argued that one shouldn’t bother with Minsky if one wants to understand banking. He went on to present the typical, and fatally flawed, textbook view. See here: http://www.economonitor.com/lrwray/2012/04/02/krugman-versus-minsky-who-should-you-bank-on-when-it-comes-to-banking/, and here: http://www.economonitor.com/lrwray/2013/08/28/krugman-rediscovers-the-wheel-commercial-banks-as-creators-of-money/, for my responses.

A new issue of Accounting, Economics and Law has published a series of articles on Minsky and banking: http://www.degruyter.com/view/j/ael.2013.3.issue-3/issue-files/ael.2013.3.issue-3.xml. In addition to my contribution, you can find some nice pieces by Thorvald Moe, Yuri Bondi, and Robert Boyer.

According to Minsky, “A capitalist economy can be described by a set of interrelated balance sheets and income statements”. The assets on a balance sheet are either financial or real, held to yield income or to be sold or pledged. The liabilities represent a prior commitment to make payments on demand, on a specified date, or when some contingency occurs. Assets and liabilities are denominated in the money of account, and the excess of the value of assets over the value of liabilities is counted as nominal net worth. All economic units – households, firms, financial institutions, governments – take positions in assets by issuing liabilities, with margins of safety maintained for protection. One margin of safety is the excess of income expected to be generated by ownership of assets over the payment commitments entailed in the liabilities. Another is net worth – for a given expected income stream, the greater the value of assets relative to liabilities, the greater the margin of safety. And still another is the liquidity of the position: if assets can be sold quickly or pledged as collateral in a loan, the margin of safety is bigger. Of course, in the aggregate all financial assets and liabilities net to zero, with only real assets representing aggregate net worth. These three types of margins of safety are individually important, and are complements not substitutes.

If the time duration of assets exceeds that of liabilities for any unit, then positions must be continually refinanced. This requires “the normal functioning of various markets, including dependable fall-back markets in case the usual refinancing channels break down or become ‘too’ expensive”. If disruption occurs, economic units that require continual access to refinancing will try to “make position” by “selling out position” – selling assets to meet cash commitments. Since financial assets and liabilities net to zero, the dynamic of a generalized sell-off is to drive asset prices towards zero, what Irving Fisher called a debt deflation process. (To some extent, this can be called a liquidity problem – but it is really more than that. I’ll return to this later.) Specialist financial institutions can try to protect markets by standing ready to purchase or lend against assets, preventing prices from falling. However, they will be overwhelmed by a contagion, thus, will close up shop and refuse to provide finance. For this reason, central bank interventions are required to protect at least some financial institutions by temporarily providing finance through lender of last resort facilities. As the creator of the high-powered money, only the government – central bank plus treasury – can purchase or lend against assets without limit, providing an infinitely elastic supply of high-powered money.

These are general statements applicable to all kinds of economic units. This is what Minsky meant when he said that any unit can be analysed as if it were a “bank,” taking positions by issuing debt. This should not be carried too far – obviously, there are big differences between a household and a bank! Financial institutions are “special” in that they operate with very high leverage ratios: for every dollar of assets they might issue 95 cents of liabilities; their positions in assets really are “financed” positions. Further, some kinds of financial institutions specialize in taking positions in longer term financial assets while issuing short-term liabilities – that is, they intentionally put themselves in the position of continually requiring refinancing. An extreme example would be an early 1980s-era thrift institution that holds 30-year fixed rate mortgages while issuing demand deposits. Such an institution requires continuing access to refinancing on favourable terms because the interest rate it earns is fixed and because it cannot easily sell assets. This can be described as an illiquid position that requires access to a source of liquidity – Federal Home Loan Banks or the Fed.

Still other kinds of financial institutions specialize in arranging finance by placing equities or debt into portfolios using markets. They typically rely on fee income rather than interest. In normal circumstances they would not hold these assets directly, but if markets become disorderly they can get stuck with assets they cannot sell (at prices they have promised) and thus will need access to financing of their inventories of stocks and bonds. Some might hold and trade assets for their own account, earning income and capital gains, or might do so for clients.

Thus there are many kinds of financial institutions. Minsky distinguished among traditional commercial banking, investment banking, universal banking and public holding company models. A traditional commercial bank makes only short-term loans that are collateralized by goods in production and distribution. The loans are made good as soon as the goods are sold – this is the model the Real Bills doctrine had in mind (book manuscript, econ problem). The bank’s position is financed through the issue of short-term liabilities such as demand and savings deposits (or, in the nineteenth century, bank notes). The connections among the bank, the “money supply” and real production are close – the sort of relation the quantity theory of money supposed. Essentially, the firm borrows to pay wages and raw materials, with the bank advancing demand deposits received by workers and suppliers. When the finished goods are sold, firms are able to repay loans. Banks charge higher interest on loans than they pay on deposits – with the net interest margin covering bank profits and subsidizing the payments system where deposit rates do not fully cover the bank’s costs managing deposit accounts. This helps to explain the high leverage ratio of banking: to keep the differential between loan and deposit rates low the bank needs a high asset to capital ratio in order to earn an acceptable profit rate on owner’s equity. Alternatively, banks would need to make the payments system a profitable operation – charging fees for deposit accounts and payments. However, if there are viable alternatives – such as cash – there will be limits to bank ability to squeeze profits out of the payments system. High bank leverage is the trade-off for keeping interest rates on loans and deposits low.

So when Minsky says we can analyse every economic unit as if it were a “bank,” he is drawing attention to the fact that all units have balance sheets. To some degree or other, each has issued financial liabilities to help finance positions in assets. Non-financial firms as well as financial institutions hold a portfolio of assets expected to earn returns, used to accumulate wealth and to service liabilities. Households typically finance “positions” in housing and consumer products, although increasingly they also accumulate financial assets for retirement. Financial institutions typically run with much higher leverage ratios, although the line between financial and non-financial firms has narrowed considerably. Is GE a financial firm or a non-financial firm? And after Michael Milken, even firms we clearly would want to classify as non-financial have increased leverage ratios – since none wants to be seen as a “cash cow” take-over target. Large firms typically do not want to have “unused” leveraging capacity. Households – at least in the English speaking world – also increased leverage, although presumably for different reasons, mostly, to maintain rising living standards.

There are two main kinds of leverage: using debt to finance spending and asset purchases – which raises the liability-to-asset ratio (or, liability to capital ratio) – and devoting more of prospective income flows to debt service. While related, these are not exactly the same thing. Further, leverage is loosely related to liquidity. Issuing more debt relative to assets and raising debt service commitments exposes an economic unit to the possibility that problems will be faced making a payment due on liabilities. Even if the assets are “good” such that they can eventually generate sufficient income flows to meet all debt commitments, or can be eventually sold to cover those commitments, the debtor might not be able to meet a payment on time. That can be seen to be a liquidity problem. If the assets can be pledged as collateral against a loan, the liquidity problem can be resolved. But given Keynes’s notion of fundamental uncertainty, one cannot be sure that future income flows or receipts from asset sales will actually be sufficient.

Some have claimed that the Global Financial Crisis that began in 2007 was really nothing more than a liquidity crisis – the world just “missed a payment.” Short-term liabilities could not be rolled-over, assets were not accepted as collateral against borrowing and fire sales of assets crashed their prices. In my view – for reasons discussed below – that is a simplistic way of looking at the problem. While it is possibly true that things would have been better if all payments could have been postponed indefinitely, that view ignores the problem of uncertainty. Telling my banker that if she is willing to wait 20 or 30 years, I should be able to make this month’s payment on my mortgage does no good. She is going to look at it as a default – perhaps due to loss of my job – and not as a liquidity problem.

Financial institutions play a hugely important role in providing “liquidity” services. As Minsky always argued, what they do is to make payments for their debtors. And they do this by providing their own liabilities in place of the liabilities of their debtors. So to some extent, it is always true that a “default” can be avoided if one can convince a bank that the problem is liquidity, so that it will make the payment. In that case, the bank is “anticipating” future income or revenues from asset sales, making the payment and accepting the borrower’s IOU. It is in that sense that they are “intermediaries.” This, in turn, is because their IOUs are more liquid than the IOUs of non-financial economic units. In part that is because their IOUs are accepted at par – dollar for dollar. And that brings up three issues: bank capital, deposit insurance and access to the lender of last resort – all of which need more exploration.

In the absence of government deposit insurance, if deposits are to maintain parity (with each other and with cash), losses on assets must be very small because the commercial bank’s equity must absorb all asset value reductions. It is the duty of the commercial banker to be sceptical; as Minsky loved to say, a banker’s cliché is “I’ve never seen a pro forma I didn’t like” – borrowers always present a favourable view of their prospects. This is why careful underwriting is essential. While it is true that loans can be made against collateral (the goods in the process of production and distribution), a successful bank would almost never be forced to take the collateral. A bank should not operate like a pawn shop.

Read the paper at the link above for more discussion.

 

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