Distributed Economics

There is a lot of discussion on the net, good and very accurate discussion, about the reserve requirements, and the current almost absence of same. The Eric deCarbonnel post (hat tip Andre. G. and Mickanomics) has a nice summary of the situation in the US. There is one unfortunate problem though with these discussions -  fractional reserve requirements no longer have anything to do with controlling how much money a bank can lend.

What has replaced it, is the regulatory capital requirement. Regulatory or equity capital is a completely separate pile of money that the owners of the bank are required to provide when a bank is started, and maintain at a minimum ratio to their loan book, as the bank is run. The FDIC requires that this be at least $2 million when a bank is founded, plus the anticipated startup costs.  The Basel treaties then specify what percentage or leverage ratio the Bank is allowed to maintain between its equity capital and its loan book, and also what kind of financial instruments the Bank can hold the equity capital in.

There are two things then that control the immediate size of the loan book, of any bank in a Basel treaty conforming country. The amount of money it has on deposit (including savings accounts, and term deposits), and the size of its equity or regulatory capital. The fractional reserve requirement, i.e. the difference between the total amount of money it has on deposit, and the total money it has lent out, is relevant only insomuch as it is not allowed to lend out more money than it has on deposit. Just to ensure that complete confusion reigns, the recommended maximum total capital ratio, ie. the leverage ratio of equity capital to amount being loaned, is 10%. The same as the textbook fractional reserve requirement.

This is the 21st century. Weren’t we supposed to have moon bases by now?

It makes some sense, if you only think about the situation at the individual banks. If a bank makes a loan that doesn’t get paid back, and the loan loss can’t be covered out of profits, then equity capital is there, to in theory, prevent the depositors losing the money in their accounts. This is what is being referred to when there is talk about ‘recapitalizing’ the banks. Obviously too, given that this is all that stands between the depositors, national deposit insurance funds, and significant losses in the case of loan defaults, it’s critical that the equity capital be held in extremely safe forms of financial instruments.  This is why so much of the discussion and rules around equity capital are framed by the risk of default represented by the underlying securities, and the desirability of keeping that as low as possible. Solutions to the current crisis that involve increasing the equity capital are also being floated.

You can see the mental process path that’s being followed here. If banks take a hit to their equity capital, it reduces their loan capacity. If they take a hit that’s bigger than 10%, they have no equity capital left, and then their depositor’s money is endangered. Do everything possible to prevent that happening, the depositor’s money is now safe, and banking can go back to being boring again.

Unfortunately, system design doesn’t work well, when only the individual entities are considered, and not the interactions between them. Concentrating on the risk of individual bank losses, ignores the larger issues being created by a system whose core set of rules, embodies a relationship and an interdependence between loans and the money supply. Especially, if owing to “financial innovation”, some loan instruments are being allowed to masquerade as money.

The simple answer then, to the question  – what is the limit on commercial bank lending? -  is that for any given Bank, it is the  lesser of the total of their deposits (minus a very small fractional reserve requirement that applies only to Net Transaction accounts), or ten times their equity capital. It follows then, that the instantaneous limit for all the Banks, is simply the sum of their deposits, or equity capital allowance.

But that’s merely the instantaneous limit. It tells us  nothing about the way that the system will evolve over time, as loans are made, money is created, loans are repaid and money is destroyed, within the commercial banking sector. Especially within a larger system, that allows debt to be turned into financial instruments, and those instruments to be used as part of the bank’s equity capital.

Or to put it another way, what controls the total amount of equity capital in the system? The old reserve requirement, and its associated commitment to deposit a part of that reserve with the Central Bank, provided the central bank with direct control over the money and loan supplies.  What is the equivalent control over the total quantity of equity capital in the system, since it now effectively regulates the money supply? The quick answer, which will be explored in considerably more detail in the next post, is that there isn’t one.

The regulators were concentrating on local risk at the banks. They appear to have overlooked the systemic risks associated with removing control over the money supply.

The hardest problems to correctly diagnose in distributed systems almost invariably involve two or more concurrent bugs interfering with each other. In the banking system at the moment, we have the Asset Backed Security bug, allowing banks to create an arbitrary quantities of loans; and the Equity Capital snafu, which has essentially introduced a slow leak into the money supply. Next post, i’ll run through a detailed example of how they interwork with each other.

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Viewed from a computer scientist’s perhaps somewhat jaundiced perspective, the history of Fractional Reserve Banking and the many changes that have been made to it over the centuries is one of neither careful design, nor careless conspiracy  - careful conspirators typically don’t publish their meeting’s minutes online. Rather it is a history of kludges.

Every time the banking system has blown up, either in the form of some kind of speculative credit bubble, or through a collapse in the value of money through general inflation, the proximate cause has been identified and “fixed”.  Almost inexorably, or so it seems, thereby setting the larger economic system on track for the next problem.

One of the classic problems acknowledged in the textbook implementation of the Fractional Reserve Banking System is the inherent problem in relying on statistical multiplexing of a small reserve to satisfy deposit demands. What happens if a Bank hits a statistical outlier, and more than 10% of the bank’s depositors turn up on the same day asking for funds?  The other 90% of the bank’s deposits is represented by loans, and not immediately available. The probability of this happening depends on a number of factors, but two obvious, and historically relevant ones,  are the size of the bank, and its geographic coverage. The smaller the bank in terms of the number of its depositors and loan recipients, and the more locally based its depositor base, the more vulnerable it is to external events. For example, a bank that takes all its depositors money and makes five large  loans with it, is much more exposed if one of them defaults, than one that makes one hundred.

As a side note, this also means that the stability of a fractional reserve based banking system itself, depends in part on the distribution of monetary tokens within the community. A society where all the monetary tokens are controlled by a small number of people, is potentially far more vulnerable to banking crises than one where ownership of monetary tokens is more evenly distributed.

The pattern of a large number of small, locally based banks, was especially the case in the 18th and 19th centuries, when there a much higher incidence of bank runs than even today. Customer demand for money that exceeded the available reserves could just happen  randomly, because at the end of the quarter money had to be transferred from depositors to lenders at different banks. Ludwig von Mises also mentions this problem occurring in the Austrian Banking system in The Theory of Money and Credit.  It could happen because some event acted to co-ordinate borrower’s demand for funds – say a local crop failure requiring food to be purchased with savings, which might also put pressure on the bank from both directions, if the crop failures also caused local  farmers to default on their bank loans. It could even happen because the owners of the town’s other bank started a rumour, in order to get customers to switch their deposits.

From the perspective of the people running the banks though, this is regarded more as an annoyance than a real issue with the system itself. After all the depositor’s money is out there somewhere  in the form of a loan which will eventually be paid back. If the depositors would only wait, then they could receive their funds. Silly people for not understanding modern banking concepts and panicking. This is what comes of letting the common people have bank accounts. Etc.

The solution that was found in Great Britain in the 19th century was to introduce the concept of a central bank, in their case the Bank of England, as the lender of last resort. If a bank didn’t have enough funds to satisfy instantaneous demand, the Bank of England would provide funds to do so, and the Bank could then repay the Bank of England when its loans came due. Problem solved.

From 1866 onwards there were no financial crises in Britain at least for the rest of the 19th century. The banking system in the United States of America on the other hand, which at that time consisted of a large numbers  of very small banks,  saw repeated local bank panics, and occasionally some non-local ones with their associated major financial crises. It wasn’t until the early 20th century, that the United States copied the British system and setup the Federal Reserve Banks to act in a similar role as lenders of last resort in 1913. Following the wide spread bank failures during the Great Depression there,  a further support in the form of deposit insurance was introduced to the American system (and subsequently copied in Europe), and since then, there have been remarkably few bank failures, at least until the Savings and Loan crisis in the 1980’s.

From a distributed systems perspective, these are both good and valid solutions to the problem created by excessive demand for instantaneous funds.  Essentially what both these changes did was to distribute the problem represented by instantaneous demand for funds that exceeded the available local reserves of a small bank across the entire banking system.  While the available funds/loan balance of  single  bank could be badly de-stabilised by a single customer with a large deposit moving their account to another bank say, within the context of the entire banking system, this is a non-event.

Unfortunately, either lulled into a sense of complacency by the absence of bank panics, or perhaps because it was something that was never explicitly acknowledged,  the Central Banks appear to have forgotten the other purpose the individual bank’s reserve requirement played in the monetary system.

Providing a limit on the total quantity of loans made available by all the commercial banks.

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What is the limit on the amount the Commercial Banks are allowed to lend?

The story of credit crises is usually told from the demand side. The irrational exuberance of speculators down the ages drives inflated prices for over priced assets.  Inevitably the bubble bursts. Inevitably everybody pays the price. But the supply side of this formula always seems to get overlooked.  Why are the commercial banks able to supply a seemingly  limitless quantity of  loans to fuel the credit bubble? Why does a speculative bubble in Beanie Baby’s merely cause general embarrassment, while one in real estate cause massive economic dislocation?

This is a deceptively simple question, in the context of the larger fractional reserve banking system, since it is not just the quantity of the  loans that is potentially problematic. Through the fractional reserve process, commercial bank lending also has potential money supply implications. If there is no limit on the total quantity of commercial bank loans, then there is effectively no limit on the commercial banks’ ability to create money through the fractional reserve re-deposit process.

It is also notable that discussion of the problem of credit supply last year, concentrated on the supposed fear that the banks have of the risk in lending to each other in the inter-bank markets, rather than the possibility that they might simply not have had any money to lend.

Hypothetically then, the question can be framed in at least three ways. Either there is a limit on bank lending, in which case it might be reasonable to suppose that it is that limit that is preventing inter-bank lending, and not a sudden outbreak of pathological loan aversion in bankers; or there isn’t, in which case the money supply is being controlled by the commercial bank’s individual lending policies  rather than the central banks, which would be contrary to every foundational Economics textbook.  The third possibility  is that there is supposed to be a limit on lending, but some elements of the financial industry have found a way around it. However, given the entanglement that fractional reserve lending creates between the money and loan supplies, how exactly could this even be detected?

Going back to the previous post, a side effect of the fractional reserve banking system is that it creates two different kinds of debt within the economy. One is straightforward transfers in exchange for IOU’s of various kinds, either between individuals, businesses primarily in the form of bonds, and the government (treasuries). The other are the loans from the commercial banks, which represent a deposit somewhere in the banking system. For want of any better ideas, I’m going to channel physic’s particle/anti-particle structure and call them anti-deposits.  Commercial bank originated loans for long. Debt that results from a direct transfer of monetary tokens will be referred to as transfer debt.

If there is something going wrong uniquely within the fractional reserve banking system, then one expected outcome might be a change in the proportion of anti-deposits  to transfer loans within the general economy. If the amount of outstanding commercial bank loans is increasing faster than the quantity of transfer loans for example. Conversely, if the actual cause of the systemic problems that we’re currently living through is in fact government transfer debt, or increases in “fiat money” as I was confidently told by an Austrian economist back a few months, then we would also see a change, but it would be an increase in the amount of government originated transfer debt relative to commercial bank originated anti-deposits.

The quantity of outstanding debt within the United States economy is reported on a sector basis in the Z1 Flow of Funds report, Table D.3 The chart below shows the per sector information on Debt Outstanding.

From the explanatory notes in the current report. Foreign debt represents amounts borrowed by foreign financial and non-financial entitities in U.S markets only. Domestic financial sectors consist of government-sponsored enterprises, agency and GSE backed mortgage pools and private financial institutions.

The sectors aren’t totally clean with respect to being able to divide into transfer versus anti-deposit (bank originated debt). The domestic financial sector debt is for the most part being derived from bank loans in the forms of mortgages, since it includes Fannie Mae and Freddie Mac, who buy mortgages from U.S. banks and repackage them as bonds. Presumably also student loans, under the guise of Ginnie Mae.

Even so, it’s noticeable  from the chart above that bank originated debt is growing faster than other sources. Comparing proportionately the amounts owed by each sector in 1975 versus 2008, shows this quite clearly:

Proportionally, the last 30 years have seen a shift away from government debt towards commercial bank debt, primarily in the form of mortgages, since that is the main component of the Domestic Financial Sectors sector. They have also seen an extraordinary rise in the total amount of debt, as was shown in the original flow of funds chart, and it also appears that this new debt has predominantly originated from the commercial banks, chiefly in the form of mortgages.

In theory, the fractional reserve mechanisms don’t allow banks to issue arbitrary amounts of debt.  Originally they were  limited to a fraction of their deposits, now they are limited to a multiple of their equity capital. So what exactly has gone wrong that is allowing the commercial banks both to create so many loans, and to increase the money supply?

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Central banks  are charged with regulating the money supply. Regulating not in the sense of rules, and laws, although they do form part of the framework it operates in. Regulating in the sense of controlling the quantity of. This is from the leaflet,  Modern Money Mechanics, published by the Federal Reserve Bank of Chicago in 1968, and last revised in June 1992:

From the standpoint of money creation, however, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System. Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks’ decisions with respect to their assets and deposits.

Bank’s assets are for the most part their loans.

The  commercial banking fractional reserve system introduces a rather strange money particle/loan anti-particle recursive relationship between some, but not all, of the loans in the monetary system.  This isn’t true for loans made to companies that borrow money through the bond market for example. They borrow money by selling an IOU, as does the Government when it borrows money using treasury certificates.  It’s only within the commercial banking system that money takes on this strange duality, and can expand and contract with the extension and default of loans.

What am i trying to say there. If a loan goes bad in the corporate bond market, then the company goes bankrupt, and my ownership of that bond gets me into the queue of creditors for a claim of assets and not much else. There are no money supply implications. The money i gave the company in return for a bond, is out there somewhere with whoever the company gave it to in return for goods, services, or a passport for tax free exile.  If a bank loan based on my bank deposit defaults however, I still have my deposit. But there is a deposit out there somewhere that should really disappear. That the current implementation doesn’t allow this to occur is one of the stresses on the system.

The bigger problem though, is that since there isn’t a fixed quantity of money within the commercial banking system, it depends after all on how much lending they’re allowed to do, it’s critically important to scrutinise what’s happening within the system quite carefully.  For example, if an expansion of credit is occurring, is it because the system is expanding within it’s allowed limits, or has it found a a way to circumvent them?

The Federal Reserve seems to believe that by controlling the money supply, it also controls the loan or credit supply.  It controls the money supply, by requiring the banks to hold a small portion of their total deposits either in physical bank notes, or on deposit with the federal reserve bank. Let’s look at money supply regulation first.

Leaving aside the banking system’s day to day liquidity issues in terms of satisfying customer’s demands for access to the funds in their deposits, it is arguably the case that it doesn’t matter how much the banks keep in reserve, or how much of that is on deposit at the central bank, as long as it is a fixed portion of the local bank’s reserves.

As long as some known fraction of the money represented in deposits is required to be held at the Federal Reserve (or in bank notes and coins), then the Federal Reserve can calculate what the total money supply is simply by multiplying. It can set what level it thinks is appropriate for that total, and adjust the reserve amount appropriately, or it can inject money to increase it, again by the known percentage that is anchored by the reserve. The only difference from that simplistic perspective, between a 1% and 10% requirement is how much you have to multiply by to get the total money supply. This is the textbook presentation of the reserve based system.

The statistics on commercial bank reserves, and the Monetary Base for the United States of America, are reported in Report H3 by the Federal Reserve. The Monetary Base is the simplest statistic on the quantity of money in the system, and is defined as the total  of commercial bank reserves held at the Federal Reserve, plus the total of printed/coined currency. To wit:

As you can see, things start to get a little funky on the right hand side there when the Federal Reserve starts trying to resolve the 2008 credit crisis. Let’s look at things before that happens though. This graph is showing the totals for all physical currency and the reserves. It is the reserves that are supposed to be regulating the money supply, “through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities”. So all other quantities of money, within the fractional reserve system, should be derivable as some multiple of the reserve. (This incidentally, is i suspect where the Rothbard fallacy may originate. Individual banks lend a fraction of their deposits, however the federal reserve regulates their deposits, as a multiple of the reserve.)

Which unfortunately is not what is being shown in the chart above. Then again, what relationship should the total quantity of physical currency have, to the bank reserves? Physical currency isn’t controlled any more, in terms of a fixed relationship to reserves, rather it’s printed as needed. Even so, it’s reasonable to expect that that need would in some sense reflect a somewhat consistent percentage of the total quantity of money – which is essentially physical currency plus the sum total of all bank accounts. So the chart seems to show that the federal reserve is successfully keeping bank’s reserves constant, but either there has been a consistently growing demand for physical notes over bank accounts in the last four decades, or something else is going on.

The consistently growing demand for physical banknotes theory isn’t entirely discountable as it happens. The US dollar is accepted world wide, and a significant amount of physical cash is held outside the USA. That can be deduced simply from the large amounts that were found during and after the invasion of Iraq.

Digging a little deeper. M1 is the base measure of the actual money supply, and includes physical currency, demand deposits and other checkable deposits. Demand deposits are all bank deposits which allow immediate access, rather than savings accounts and similar, which require deposits to remain for a specified period of time. Looking at the historical data on the components of M1, from the Federal Reserve’s H6. Table 4, and please note the y-axis on this chart is in $ billions, whereas for the other two it is $ millions:

Interestingly, demand and checkable deposits do look like they are holding approximately stable in the last couple of decades at least. In fact they’re holding stable at roughly 10 times the reserves held by the central bank. So, the reserve requirement does appear to be successfully regulating the quantity of money held in demand and chequeing accounts. These in other words appear to be the Net Transaction Accounts, for which the banks are required to keep 10% either on deposit with the federal reserve, or present as physical cash in the bank vaults. So why then, is physical cash going up so much? After all, if the Federal Reserve is actually printing physical cash to increase the Money Supply, then the deposits wouldn’t be staying relatively constant, but would in fact be increasing to match.

Or in other words. Is physical cash being printed in order to increase the money supply, or is physical cash being printed because the money supply is increasing?  One last chart.

This chart shows the Total Reserve, the Monetary Base, M1, and the Total Liabilities of the US Commercial Banks from the H8 data series, table b1152a. Total Liabilities, is the sum of all the money deposited at the Banks by their customers, plus loans from other Banks. That table starts in 1973, and yes those are the right units.

What is the money supply? Is it just the checking accounts most people use for day to day cash, the Net Transaction accounts? Does it include savings as well? Physical cash in Iraq and elsewhere? There are economic arguments for and against counting each of those in fact, that’s why there are the different measures, Monetary base, M1, M2 and before it was discontinued M3.

If the money supply is just the amount held in Net Transaction Accounts, then the Federal Reserve is regulating it successfully. But that’s the only thing that is being regulated. Physical cash is clearly expanding, but that’s nothing besides the total amount of cash represented by deposits with commercial banks. The electronic money supply, the money that is represented as electronic 0’s and 1’s in a computer database somewhere is clearly growing exponentially. And has been for some time.

One definition of the money supply that isn’t explitly reported, but would seem to be fairly important in a fractional reserve system, would be the amount of money that the banks can lend a fraction of. As you might guess from the above chart, it certainly isn’t the amount held in Net Transaction Accounts.

So just as this post attempted to dissect the deposit side of the fractional reserve money/loan dichotomy in the context of the larger system, next time, we’ll look at the loan supply.

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