Tuesday, 1 July 2014

On the Nature of Banks - 'Insured' vs. 'In Specie'

I've never been entirely sure why banks confuse people so much. They really are very simple creatures. They make loans and back those up with deposits and other borrowings, charge a margin for one over the other in return for making an underwriting decision, and undertake to swap their liabilities around in various manners to maintain their liquidity.

And that's about it really. In fact all the problems start happening when you let lending banks do anything much more than this.

In a monetary system there are two main ways of setting up a banking structure. You can either have an 'in specie' system where the central bank issues actual liabilities and assets in the denomination currency to back the banking system (also known, inaccurately, as 'full reserve'), or you can have an 'insured' system where the central bank promises to issue actual liabilities and assets when certain events happen. For the rest of the time they remain 'contingent'.

This is what a commercial bank's balance sheet looks like in an 'insured' scheme:

Insured Deposits are those covered by the country's deposit insurance scheme (here in the UK it is 100% of the first £85,000 per person). All other deposits are uninsured or 'bailed in'.

Bank Bonds are corporate bonds issued by banks, issued on the money markets usually as traded securities. Examples include Permanent Interest Bearing Shares (PIBS), or Bank Subordinated Bonds.  These differ from the 'fixed rate bonds' that you hear banks selling, which are really just a form of term deposit.

Preference Shares are very similar to bank bonds but have a lower claim on the banks assets and therefore should pay a high interest rate to offset the risk. They are also classed as equity instruments rather than debt instruments.

Ordinary shares are the normal shares/common stock in the bank and which receive the bank's variable dividend payment.

If a bank's lending turns out to be bad and the loan section therefore shrinks, then the losses accrue to the right hand side of the balance sheet from the bottom upward. Ordinary shareholders lose out first, then preferred shareholders, all the way up to insured depositors.

The Bank is then insolvent and the central bank (or other authorised government body) steps in to administer the failed bank under the insurance arrangements. Where necessary it issues Central Bank Reserves to pay the insured depositors, and writes the loss out to its own balance sheet. The assets of the failed bank are sold to other market participants, the central bank recovers its loss form those assets and if there is anything left the other creditors get a fraction of their investment back. 

So in reality the insured depositors don't really hold their money with the commercial bank. They hold it with the central bank because the risk has been transferred via the insurance policy. Which is what insurance was invented for. 

Change the accounting policy of a bank to require that it shows the insured element explicitly and you get this:

Change it again to require that the balance sheet is split into responsibility areas and you get this:

Remove the word 'contingent' and that is what an 'in specie' system will look like under the current policy settings.

Any other magical powers ascribed to 'in specie' systems are either due to hidden policy changes, (which can be just as easily be applied to an 'insured' system), a misunderstanding of how banks or money things actually work on the part of those making the claims, or (mostly) just plain political propaganda.

'In specie' and 'insured' systems are operationally identical. You can transform the balance sheet of one into the other. Nothing substantive changes. That's why MMT has always been agnostic on the subject.