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.
