Why Have Commercial Banks

Why Have Fractional Reserve Banking?Rajnish MehraArizona State University

Edward C. PrescottArizona State University

14 August 20141Definition of a Commercial BankA bank is an institution which BOTHAccepts demand deposits from the publicOriginates loans

*Definition is the one in the 1971 U.S. Banking Act of 1971* From Raghuram G. Rajan, Do We Still Need Commercial Banks?

22The definition rules out:

Money market funds as they do not originate loans

Finance companies as they do not offer demand deposits

* From Raghuram G. Rajan, Do we Still Need Commercial Banks?33Two Economic Reasons For Commercial Banks In the Past Are:They economized on resources allocated to digging gold out of the ground when there was a gold standard

There typically was not enough US government debt to serve as reserves for all demand deposits now there is 44A Bogus Argument for Fractional ReservesSave on costly equity financingAdmati, DeMarzo, Hellwig and Pfleiderer demolishes that argument in, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Requirements: Why Bank Equity is not Expensive (2011)It comes down to the Modigliani-Miller TheoremValue cannot be created by shuffling balance sheets55There is a pervasive sense in discussions of bank capital regulation that equity is expensive and that higher equity requirements, while beneficial, also entail a significant cost. The arguments we examine, which represent those most often made in this context, are fallacious, irrelevant, or very weak.Admati, DeMarzo, Hellwig, and Pfleiderer (2011)66Transactions are not Part of Theory of ValueWith valuation theory, the primitives include the commodity spaceHouseholds and firms can exchange each commodity for value and value for each commodityHouseholds face a value (budget) constraintAn agent selecting the commodity vector in a technology set picks the one that maximizes value77What is Value?Relative prices are determined in the theory of valueIrving Fisher hypothesize that MV = PT, the quantity theory, where one unit of M is one unit of value for determining PMeltzer estimated the M1 demand function, M = v(i) Y, where i is the nominal interest rate88Lucas developed micro foundations for this money demand functionLucas and Nicolini (2013) make a case that the demand for money theory for transactions is still aliveCooley and Hansen (1991,JME) established that with this transaction based theory of money, the consequences of monetary policy for output and employment are small 99Do Banks Perform a Socially ValuableMaturity Transformation Function?Data source: Flow of Funds for end of 2012Demand deposits small relative to total business sector borrowing Checkable deposits 0.08 GNPs (L104, line 10)Time and savings deposits 0.57 GNPs (L105, line 12)101011Business borrowing, 2.30 GNPs !This includes household businesses (home mortgages)Bigger number if car loans treated like home mortgagesNon-collateralized loans (credit cards) are small11PROPOSAL:Abolish Fractional Reserve BankingReplace commercial banks with transaction banks A sister trust corporation to a transaction bank would remainIt would set up and monitor trust that are used to make business and other loans121213The people evaluating loan applications at a bank and trust company would continue to do what they have been doing though they would all be employees of the trust companiesThere is no loss of information relative to a system with commercial banks13Transaction BanksTransaction Banks would have 100% reserve, on which they receive tax-free interest. Any interest they pay demand depositors is tax freeReserves are a type of Federal Government debt that only the Fed can hold (R)The other government debt is privately held (D)Fed can increase R by issuing reserves to buy some DD automatically becomes R when held by the FedThe composition of government debt changes accordingly1414With this SystemNo too-big-to-fail problemNo possibility of a bank runNo need for costly commercial bank regulation and deposit insuranceResource costs of deposit insurance is at least 50 basis point a year per dollar of depositsCurrently small banks are going out of business because of big regulation costs

1515What About Financing Businesses?The value of US businesses is about 3.5 GNPsCurrently half financed by debt and half by equityIn 1960 three-quarters funded by equityFact: Currently very little of businesses are financed by commercial banks accepting demand deposits and making loans to businesses1616Types of Businesses in NIPACorporations, with value about 1.5 GNPs (L213 Line 23)Unincorporated businesses, with value about 0.5 GNPs (B103 Line 33)Household businesses value about 1.5 GNPs (B.100 Line 2)Add 1 GNP of government debt yields household net worth, 4.5 GNPsNet asset position of Rest of the World is near zero for most countries including the U.S.1717Theory of Value and the D-D EnvironmentThe D-D model is probably the most important paper in banking. It has fostered so much important research1818Does the Diamond-Dybvig Model Establish a Reason forFractional Reserve Banking?We make a distinction between the D-D environment and their banking mechanism. The latter is a particular mechanismOne of the equilibria to their mechanism supports the anonymous social optimum for their particular environment1919Essence of D-D EnvironmentA long term investment that has a high return and is costly to liquidateA preference shock that results in some people wanting consumption in period 1. It is called a liquidity shockPreference shocks are private informationAll people identical ex-anteSocial welfare is their ex-ante expected utility

2020Mechanism Design ProblemThere are environments for which the good D-D equilibrium allocation is optimalBUT, there are D-D type environments for which this equilibrium is not the optimal allocationHow can this be? ANSWER2121In the private information economies with one ex ante type, if there are shocks to preferences the optimum can have non-degenerate lotteriesHappens when they are useful in differentiating the ex post typesSee Prescott and Townsend (1984, IER) and Cole (1989, IER) for an example.Bottom line: Fact that it is a good mechanism in some environment does not mean it should be set up2222Diamond-Dybvig EnvironmentsWe distinguish between the environment and the banking mechanism they employThe D-D environments can be represented as economies using the Prescott-Townsend extension of the theory of value to environments with private informationEquilibrium exists, is optimal and generically uniqueIs the use of this theory appropriate for D-D environments?2323Banking is not a Mechanism Design Problem as Argued by Wallace (1996)Cant justify setting up the D-D banking arrangement because its good equilibrium supports the anonymous Pareto optimum for the D-D environmentModifying the preference ordering, but not the technologies, in a way that preserves liquidity demand in period 1, the good D-D equilibrium is not optimalThis is accomplished by selecting preferences such that the valuation equilibrium has consumption lotteries which are non degenerate2424Runs are a Characteristic of the Optimal Arrangement for Some EnvironmentsTri Vi Dang, Gary Gorton, and Bengt Holmstrom (2010) have an example where banking crises are a propriety of the optimal mechanism in Financial Crises and the Optimality of Debt for Liquidity ProvisionThis implies banking crises are not prima facie evidence of market failure252526This is a good use of mechanism design theoryEstablishes some observation does not establish a market failure

CONCLUSION.26Mechanism Design Theory is of Little Use in Designing a Financial System2727Properties of a Good SystemShould be nearly optimalBorrowing lending system is optimal if people can privately save at the market rate (Cole and Kocherlakota, 2001)Hansen and Imrohoroglu (1992) show the simple borrowing and lending arrangement is nearly as good as the costless AD allocation of unemployment riskThe proposed transaction bank system is a borrowing and lending arrangementGiven the high cost of insurance, only big idiosyncratic loses should be insured2828A Good System Permits InnovationOur financial system has been improvingBid-ask spreads down assets very liquidFees for managing assets downCost of diversifying down index fundsBrokerage fees down ETFs zero at VanguardThere will be new products and arrangementSome will failOthers will make the system better2929 The proposed transaction banking system has these properties3030A Possible ProblemPrivate agents may create substitute for this interest bearing currency to make transactions. This is commonly called shadow banking Money market funds and similar institutions will carry out transactions if interest on government debt higher than interest on reserves.

Is there a solution?3131A Possible SolutionPut a 100% tax on net interest income of limited liability businessesThis would make borrowing from one group and lending at a higher interest rate to another unprofitableMaybe I am overlooking something and smart people will figure out a way to get around itIf a way occurs to you, please let me knowWe want to be confident that a system will work before implementing it3232With this System How will Businesses be Financed?Answer: By mutual organizationsEquity financing is a mutual arrangementHouseholds pooling money and lending to business and to state and local governments is a mutual arrangementThere are mutual funds and trusts that hold mortgagesInsurance and pensions funds have a mutual elementMaybe banning limited liability insurance businesses would be a good thing3333Mutual Arrangements is the Way to Finance BusinessesMost currently is financed mutually

Lets look at US capital accounts and private sector net worth accounts

My unit is GNP, which equals Gross National Income3434How are U.S. Businesses Financed?Following statistics come from McGrattan and Prescott (2010) published paper. All data and computer programs are available on Minneapolis Federal Reserve Bank website.3535

U.S. Fixed Asset TablesAverages Relative to GNP, 1999-200836U.S. Capital StocksRelative to GNP, 1999-2008Tangible Capital, End of Period4.053Private assets, private, FA 1.12.175Fixed assets, public, FA 1.1.580Consumer durables, FA 1.1.306Inventories, NIPA 5.7.5.137Land, FOF B.100-B.103.856Intangible Capital, End of Period 1.718Plant specific1.198Technology capital.519Total Capital5.77137Private Sector Balance SheetAverages for 1999-2008 Relative to GNPTotal Assets6.79 Tangible assets3.78 Government debt0.50 Private debt2.51Total Liabilities2.51Net Worth4.28Source: Flow of Funds Tables D3 and B100.e38Question: Why Net Worth Less than K?K is 5.77 GNPSPrivate sector net worth less government debt is 3.78 GNPsWhat about the 2 GNPs difference? 39K is 5.77 GNPSPrivate sector net worth less government debt is3.78 GNPsWhat about the 2 GNPs difference?

Answer: The nature of the tax code.Question: Why Net Worth Less than K?40The cost of intangible capital to a business is half it costs because intangible capital investment are expensed and not capitalizedEffectively the government pays half the cost and gets half the return. Thus it is half owner.Answer: The Nature of the Tax Code41Concluding RemarkWe need financial reformThe new system should be simple and transparent to mitigate the time-inconsistency problemThis helps insulate the transaction system political manipulationWe should rely even more on mutual arrangements for the financing of businesses42Tangible Capital, End of PeriodA4.053

Private assets, private, FA 1.12.175

Fixed assets, public, FA 1.1.580

Consumer durables, FA 1.1.306

Inventories, NIPA 5.7.5.137

Land, FOF B.100-B.103.856

Intangible Capital, End of Periodb 1.718

Plant specific1.198

Technology capital.519

Total Capital5.771