Thursday, March 10, 2016

The Money Problem: Rethinking Financial Regulation

[This post will appear shortly at the Harvard Law School Forum on Corporate Governance and Financial Regulation but it seems fitting to pre-post it here as my inaugural blog post.]

In my book, The Money Problem: Rethinking Financial Regulation, recently published by the University of Chicago Press, I offer a novel take on the “shadow banking” problem—arguably the central challenge for modern financial stability policy.  I contend that financial instability is, and always has been, largely a problem of monetary system design.  Structural monetary reform could pave the way for a dramatic reduction in the scope and complexity of modern financial stability regulation.

It is a truism of finance that banks are in the “money creation” business.  Every student of introductory economics learns how this works: banks create deposits, which function as money.  Less well understood is that modern financial systems have a parallel system of money creation, sometimes called the “shadow banking system.”  This term means different things to different people, but I use it to refer to entities that lack a banking charter but that use large quantities of short-term or demandable debt, continuously rolled over, to fund portfolios of financial assets.  Shadow banks’ short-term liabilities are, functionally speaking, more or less equivalent to bank deposits.  These instruments are classified as “cash equivalents” for accounting purposes; the terms “near money” and “money market” also apply.  (A nonexclusive list of cash equivalents would include: financial commercial paper; asset-backed commercial paper; Eurodollars; short-term repurchase agreements; securities lending collateral delivery obligations; auction rate securities; and money market mutual fund shares.)  In 2007 and 2008 these markets unraveled in a series of classic runs or panics, precipitating the worst economic calamity since the Great Depression.

The book makes the case that, when it comes to financial stability policy, panics—widespread redemptions of the financial sector’s short-term debt—should be viewed as “the problem” (the main one, anyway).  More to the point: panic-proofing, as opposed to, say, asset bubble prevention or “systemic risk” mitigation, should be the central objective of financial stability policy—at least insofar as financial stability policy is about preventing macroeconomic disasters.  The U.S. financial system, largely by historical accident, was effectively panic-proof from 1933 until around the turn of the twenty-first century.  This period was one of remarkable macroeconomic stability and growth, notwithstanding the occasional recession.

The recognition that shadow banks are engaged in money creation raises fundamental questions of institutional design.  The prevailing modern approach to monetary system design involves entry restriction, or confining money creation to the government itself and to a set of specially chartered banks.  This approach requires, as an essential prerequisite, a general prohibition on a specific funding model—a prohibition for which a banking charter confers an exemption.  Thus, in the United States no person or entity may incur “deposit” liabilities without a banking charter (12 U.S.C. § 378(a)(2)).  The emergence of shadow banking on a large scale, however, raises the question whether the legal category “deposit” is formalistic and obsolete.  Is there a respectable basis for the differential legal status of deposits and (nondeposit) cash equivalents?  If the issuance of deposit liabilities is a legally privileged activity with restricted entry, shouldn’t the issuance of cash equivalents be so as well?

And this is only the beginning of the inquiry.  If the government chooses to license third parties to engage in money creation, under what terms and conditions should they operate?  How should we think about the relation between this activity and the direct issuance of base money by an arm of the state, such as a state-owned central bank?  And how (if at all) should the government exercise control over the supply of monetary instruments?  These questions subsume a variety of others: about the operation of monetary policy; about the administrative independence of the monetary authority from the fiscal authority; about the mechanics of the payment system; and about “seigniorage,” or government revenue that arises from money creation.

It should be clear that we are dealing with a multifaceted institutional design challenge.  Given the importance of the topic, one could be forgiven for assuming that these issues must already have been fully thought through.  Surprisingly, they have not.  The basic legal-institutional design considerations that are pertinent to the establishment of a monetary system have never been well articulated.  Look, for instance, at the standard textbooks on money and banking, on macroeconomics, and on bank regulation.  This is where one might expect to see a systematic treatment of these issues, but it is not to be found.

The Money Problem treats these issues in an integrated way.  In the process it offers a blueprint for a revamped money and banking framework.  The blueprint is not radical; on the contrary, it is fairly conservative.  It represents a modernization of the existing U.S. system of money and banking along functional lines.  In accordance with the prevailing modern approach described above, the system would employ entry restriction—it would confine money creation (including the creation of cash equivalents) to the government itself and to existing insured banking entities.  This means implementing a general prohibition on a particular funding model.  Specifically, the use of large quantities of short-term or demandable debt, continuously rolled over, would be off-limits for nonbanks.  The use of this funding model would be the very legal privilege that a banking charter conveys.  The failure to reach a functional legal specification of what constitutes a monetary instrument is the original sin of banking law—it has allowed money creation to bypass our system of sovereign control.  The system would require a degree of international cooperation, which can be accommodated under the existing Basel Accord framework.

Once “broad” money creation has been so confined, the question remains how to regulate chartered banking entities.  I argue that the longstanding U.S. regulatory framework for insured banks—consisting of strict portfolio constraints, capital requirements, cash reserve requirements, supervision, and deposit insurance with risk-based fees—embodies a coherent economic logic.  It incorporates standard private-sector techniques, widely used in insurance and debt markets, for counteracting the effects of moral hazard.  The book’s blueprint follows through on the implicit logic of the existing system.  Some tweaks are in order (a derivatives push-out; removal of per-account coverage caps on guaranteed monetary liabilities; treatment of risk-based fees as seigniorage) but not a major overhaul.

The blueprint just described would bring money creation under sovereign control.  The system can be understood as a public-private partnership for the issuance and circulation of monetary instruments.  The monetary-financial system would be panic-proof; the funding of portfolios of financial assets with large quantities of defaultable short-term debt (privately issued near-monies) would not exist on any meaningful scale.  The reforms described here would greatly enhance the “resolvability” of nonbank financial firms, diminishing the need for emergency support and ameliorating too big to fail.  I argue in the book that implementing such a direct and structural approach to fragile short-term debt funding—properly understood, a revamp of the monetary framework—could set the stage for a substantial scaling-back of our existing hypertechnical financial stability apparatus.

The book is available for purchase here.

Monday, December 21, 2015


I will start posting when my book launches in Feb./Mar. 2016.  Stay tuned ...