As policymakers, we try to be level-headed and sensible, and sometimes that narrows our thinking too much. You really need to be able to think “outside of the box”. Over time, it is crazy ideas that often prove right…(Kenneth Rogoff)2
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Bossone, B., 2001b, “Do Banks Have a Future? A Study on Banking and Finance As We Move Into the Third Millennium,” Journal and Banking and Finance, Vol. 25, No. 12, pp. 2239—76.
Bossone, B., 2002a, “Thinking the Economy as a Circuit”, in Modem Theories of Money, ed. by S. Rossi and L. P. Rochon, forthcoming (Cheltenham, United Kingdom and Northampton, Massachusetts) Edward Elgar.
Bossone, B., 2002b, “Should Banks Be ‘Narrowed’?” Public Policy Brief No. 69, The Jerome Levy Economics Institute of Bard College.
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Bossone, B., and J. K. Lee, 2002, “In Finance, Size Matters,” IMF Working Paper 02/113 (Washington: International Monetary Fund).
Bossone, B. S. Mahajan, and F. Zahir, 2002, “Financial Infrastructure, Group Interests, and Capital Accumulation,” IMF Working Paper, forthcoming (Washington: International Monetary Fund).
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McAndrews, J., and W. Roberds, ,1999b, “A General Equilibrium Analysis of Check Float,” Journal of Financial Intermediation, 8, pp. 353—77.
Pullen, J. M., 1987, “William Anderson (fl. 1797-1832), on Banking, the Money Supply, and Public Expenditure: A Forgotten Interventionist,” History of Political Economy, Vol. 9, No. 3, pp. 359—85.
Saint-Paul, G., 1992, “Technological Choice, Financial Markets and Economic Development,” European Economic Review, 36, pp, 763—781.
Sarr, A., 2000, “Financial Liberalization, Bank Market Structure, and Financial Deepening: An Interest Margin Analysis,” IMF Working Paper 00/38 (Washington: International Monetary Fund).
Schumpeter, J. A., 1934, The Theory of Economic Development. An Inquiry into profits, Capital, Credit, Interest, and the Business Cycle, (Cambridge, Massachusetts: Harvard University Press).
Townsend, R.M., 1980, “Models of Money with Spatially Separated Agents,” in Models of Monetary Economics, ed. by J. H. Kareken and N. Wallace (Minneapolis: Federal Reserve Bank).
Townsend, R.M. and K. Ueda, 2001, “Transitional Growth with Increasing Inequality and Financial Deepening”, IMF Working Paper 01/108 (Washington: International Monetary Fund).
VanHoose, D. D., 1988, “Deposit Market Deregulation, Implicit Deposit Rates, and Monetary Policy,” American Economic Journal, December, Vol. 14, No. 4, pp. 11—23.
Biagio Bossone is Advisor to the Executive Director of the IMF for Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, and is also associated with the Banca d’ltalia. Abdourahmane Sarr is an Economist in the Financial Institutions and Markets Division of the Monetary and Exchange Affairs Department, IMF. The authors wish to thank R. Basu, J. D. Crowley, R. Flood, D. He, L. I. Jácome, Hidalgo S. Rossi, P.O. Sakho, and H. Van Greuning for their helpful suggestions. They are particularly grateful to P. Honohan for discussing at length with them various critical aspects of the paper, and to thank A. Mirakhor for his comments and support. The opinions expressed in this paper are the authors’ only and do not necessarily coincide with those of the individuals and institutions named above.
From: “Rogoff reflects on global economy, research, academia, and chess”, IMF Survey, Vol. 30, No. 22, Nov. 26, p. 379.
In a fascinating book, Alvi (1989) discusses the importance of the act of giving in economics and in world economic history.
Berthélemy and Varoudakis (1996) emphasize the reverse type of threshold effect whereby the economy may need to reach a minimum level of financial deepening before there is a significant effect on growth. In fact, as the authors recognize, the two threshold effects are mutually reinforcing: economic growth enable marginal agents to accumulate enough wealth to support the transaction costs involved in accessing financial services and resources, thereby increasing financial depth; in turn, greater access accelerates capital accumulation, productivity and growth. (See also Saint-Paul, 1992). Townsend and Ueda (2001) study this dynamics in an optimal intertemporal consumption model with costly participation in the financial system and a threshold level below which participation is not feasible. The dynamics is simulated using data for Thailand.
Bossone, Mahajan and Zahir, cit. discuss this issue at some length.
The fact that the largest share of bank liabilities typically consists of term deposits in more advanced economies should not be seen in contradiction with the proposition that loans create demand deposits. Once demand deposits are issued through lending, their final holders may convert them into term deposits. In the final equilibrium, therefore, the addition to the stock of demand deposits held in portfolios may be less than the amount of demand deposits originally issued via lending.
The banks and the central bank may interact at any stage of the process; this explains why, in Figure 1, the corresponding money flows are not Roman-numbered.
An important element to note at this stage is that the demand pattern resulting from this step should validate the demand expectations that gave rise to the loans in the first place. Delays in matching the demand will impact on the relative prices of output and production factors in those sectors.
Note that capital goods producers financed by banks could also sell the capital goods to investing enterprises at credit, in which case investing enterprises may not need to raise funds from intermediaries. As the investing enterprises sell their output, they reimburse the capital goods producers who in turn reimburse the banks. This implies that the banks either extend loans to capital goods producing firms at longer maturities or they roll over their loans until these are repaid. Alternatively, banks can extend credit directly to investing enterprises that in turn pay for the production of the capital goods on delivery and reimburse the loans as they start generating income. The circuit can therefore be completed with only stable demand deposits and without long-term savings. Stable demand deposits on bank books mimic savings, although they are not intended for long-term intertemporal consumption smoothing.
This implies that the new money is good only to the extent that banks select their credit risks efficiently, allowing competitive production to be actually delivered by the firms that originally borrowed the money.
In very low income countries, where financial savings mainly consist of demand deposits, banks play also the role of financial intermediaries.
Such exclusivity rests on the government and society restricting the acceptance of money only to liabilities issued by a small set of licensed agents. No rent would be involved if, hypothetically, all the agents in the economy issued their own liabilities and had them accepted as money. On the other hand, non-bank intermediaries do not extract seigniorage from borrowers since they may only reallocate existing liquidity across agents. Unlike interest on commercial loans, but like payment for production inputs, interest payments on a firm’s obligations to a non-bank financial intermediary represent a production cost item against the firm’s revenues. As such, they represent compensations to investors for parting with liquidity and to intermediaries for providing intermediation services. Therefore, they do not involve net real resource transfers from the firm to the investors or the intermediary.
These problems are widely observed in low-income countries and also in transition economies. The Economist (2001, pp. 77-78) reports in an article, “The Banks That Don’t Lend”, that in Central Europe “…banks can do only half their job. They have plenty of deposits, but finding somewhere useful to lend the money is well-nigh impossible…The result is that, after ten years of transition from communism, the banking systems…are still ineffective economic actors [and] capital hungry enterprises are robbed of a source of finance”.
See Bossone and Lee, 2002. Lower wages may in fact provide some offsetting. Bossone, Honohan and Long (2001) attempt to take into account the low wage effects by using per capita GDP as a proxy for wages, and find that the offsetting effect is only partial.
As noted in the Introduction, institutions providing payments services only (in the process of which stable liquidity arises simply because money is transferred from the payor to the payee) do not have to intermediate those funds as investment deposits for a rent. These funds are a mere byproduct of the way the payments system functions.
Our proposal differs from those advocating narrow banking. These aim to remove liquidity and solvency risks from banking by requiring banks to fully back their deposit liabilities with safe short-term assets and by preventing all other intermediaries from issuing demandable debt. Therefore, while narrow banking would retain deposit-financed lending but would restrict its use, a DCI system would remove deposit-financed lending but would allow inside money creation on a nonlending basis. For a comprehensive review and evaluation of the narrow banking proposals discussed in the literature, see Bossone (2001c, 2002b). Subsection IV.B below compares the implications of our proposal for financial stability and resource allocation with those of narrow banking.
DCIs may not distribute liquidity to other than individual depositors. Since depositors can pay the fees out of the new money they receive, one could say that DCIs distribute liquidity on a net basis. Still, since the fee portion is the income of the DCI, it needs to be transparently charged and shown in the income statement. This fee income is the reason investors would want to start a DCI. DCIs may provide other services, such as consulting services in cash management to enterprises. For the purpose of our analysis, however, it is essential that they only provide payments services.
For instance, DCIs aiming at achieving large market shares may prefer to attract many small depositors rather than few large ones. On the other hand, intermediaries wishing to offer DCI payments services within broader financial service packages may aim at fewer but larger customers. Each DCI will need to use statistical techniques or judgment to forecast factors affecting net deposit outflows in order to determine the amount of inside money that can be distributed without running into liquidity problems. The central bank would be watchful of an initial drop in the currency to deposit ratio that could lead to excessive money growth for a given base money stock, and would stand ready to reduce the stock through open market operations (see Subsection III.C).
If deposits decrease and the DCI determines that there are no deposits to be distributed, then, just like in conventional banking where loans would not be made in such a situation, cash dispensing would not take place. In conventional banking, credit would shrink as some loans are amortized and no new credit is extended. In a DCI system, the stock of money would remain constant.
In conventional banking systems, the private rent element can be justified by the need to restrict market entry to private-sector entities with enough reputation to ensure public confidence in the use of privately-produced money instruments (deposits) collateralized with illiquid and opaque assets (loans). (See also footnote 13.) In the case of DCIs, the absence of the asymmetry between liquid liabilities and illiquid assets eliminates the justification for granting them with the right to a rent.
Pullen (1987. p. 368) reports that William Anderson in his “Inquiry of Banking” of 1797 argued that banknotes (equivalently, inside money) in excess of specie reserves, and the profits arising from excess issue, ought to belong to the nation. Pullen noted that William Anderson’s conclusion if valid, would lead logically to the nationalization of the function of credit creation, or to the imposition of 100 percent cash reserve ratio for credit creation.
Payments to the government consist of tax payments and payments for purchases of government goods, securities and assets. DCIs may purchase government securities on their own behalf only with their own capital and not with the primary liquidity arising from the public’s deposits.
Like in conventional banking systems, DCIs can economize on primary liquidity, for given volumes of deposit distribution, by setting up mutual (intra-settlement) liquidity facilities and payments netting arrangements.
This is a seemingly paradoxical, yet major, result of a system that creates and distributes claims on real resources through acts of giving, rather than lending.
Obviously, in the post-allocation period, depositors are free to transfer their deposits to other DCIs or to use them when and as they wish.
Any net deposit outflow from A to B requires an equal net reserve flow in the same direction. As the deposit outflow carries on, A loses all its reserves in favor of B and fails. To the extent that A and B were both reserve compliant before A’s failure, all residual deposits of A can be allocated to B, who will then have enough reserves to remain compliant even after the deposit allocation. DCI A can exit the market while depositors are as well off as before the failure.
It can be shown that in the hypothetical case of a bank and a DCI having an identical balance sheet (with the only difference that the DCI asset side would report distributed liquidity instead of loans) the cost saving effect obtains on condition that the difference between the bank’s non-performing assets and capital is greater than the product of the DCI’s allocated uncovered liabilities and the required reserve ratio.
Note that this guarantee does not create moral hazard since DCIs do not lend funds and their distribution capacity is constrained by regulatory requirements.
Note, again, that this liquidity requirement is equivalent to a capital requirement since DCIs cannot purchase secuirities with the public’s deposits.
An interest rate target is operationally achieved by the central bank standing ready to intervene in the money market daily, at the banks’ initiative, to limit interest rate volatility and periodically through OMO at its own initiative, to meet banks’ demand for reserves. This implies that a failing DCI is to be granted access to reserves if the central bank aims at its target. Note, however, that, unlike a conventional bank, a DCI cannot be temporarily illiquid since illiquidity indicates that it is being competed out of the market by more efficient DCIs. Therefore, in a DCI system the central bank is never confronted with the option of extending financing to an illiquid but otherwise solvent DCI. Any lending of last resort to an illiquid DCI would necessarily alter competition. An interest rate target policy would not be consistent with a DCI competitive market.
Potential balance of payments problems that an increase in the demand for nontradables could induce would also be corrected by the devaluation or through a transition to a flexible exchange rate regime.
Cashin and others (2001), reporting on the results of recent household consumption surveys, conclude that real exchange rate depreciation is a key component of a successful poverty reducing adjustment strategy through its beneficial effect on export-led growth, its impact on the production structure by supporting labor-intensive agriculture (which employs the majority of the poor), and the reduction of rents earned by urban households through import quotas and exchange controls. By offsetting the income incentive on the demand for imports, an exchange rate devaluation also fosters import substitution in favor of domestically produced goods for the food-consuming urban population.
The DCI liquidity distribution mechanism requires individuals to have some initial non-zero deposits to be able to receive new distributions. For this reason, the mechanism may appear to benefit the rich more than the poor and to bear no benefits for the have-nots. There are various considerations to be made. First, The incentive built in the DCI mechanism induces individuals even with very small initial endowments to enter the DCI system and to accumulate wealth progressively in a way that would not be possible under conventional banking. Second, some DCIs may have an incentive to apply higher distribution rates to smaller depositors higher (see Subsection III. A). Third, the establishment of a DCI system is not inconsistent with the existence of micro-finance institutions that extend small credits to poor households and producers but again these insititutions are constrained (see Subsection II.C).
The effect would be permanent since DCI money is created on a nonlending basis. In conventional banking, on the other hand, the money created via lending is destroyed as loans are repaid (the “reflux principle”, in circuit terminology). This requires banks to create more money on a gross basis than is destroyed if the money stock is to grow in line with nominal GDP growth.
For the interaction of network externalities and scale economies in the production of financial intermediation services, see Bossone and Lee (2002).
More precisely, credit risk would be zero for DCIs and very low albeit non-zero for narrow banks (since these do extend credit). On the other hand, DCIs would run a higher liquidity risk than narrow banks since, by construction, they are based on fractional reserves while narrow banks operate on a 100 collateral basis.
- β’(Pt+1)> 0 can therefore be thought of as a productivity shock as the price of A increases. This productivity shock may result from a more efficient use of existing labor, as assumed in the text.
The two-period lived agents assumption is used for tractability only.
Note that the use of B for lending or investment purposes would not require any prior act of saving and it simply derives from the existence of a stable float. We noted this same point when discussing the circuit process in very low income countries where financial markets are typically incomplete or missing, and investment can be financed with a stable bank demand deposit base.