Equity financed banking is inefficient

I see that Tyler Cowen and John Cochrane are having an exchange about banking. First, Cowen expresses a nuanced view of banking, then Cochrane takes the opportunity to promote his narrow (aka equity-financed) banking proposal, and Cowen questions how successful equity-financed is likely to be in practice.

With my latest paper, I have something different to contribute to the discussion: a model of how banking — and the leverage of banks — promotes efficiency. From a macro perspective the argument is really very simple: we all know from the intertemporal Euler equation that it is optimal for everyone to short a non-interest bearing safe asset. (The Friedman Rule is just an expression of this fact.) The point of my paper is that we should understand banking as the institutionalization of a naked short of the unit of account.

How is this efficiency-enhancing? A naked short position requires you to sell something that you do not have. It is a means of creating a temporary “phantom” supply of what is sold, until such time as the short position is closed out. The Euler equation tells us that a “phantom” supply that supports short positions is exactly what the economy needs to achieve intertemporal allocative efficiency.

Of course, the problem with a naked short position is that if a short squeeze (aka bank run) forces the closure of the positions too early, bankruptcy will be the result. The paper is a careful study of what is necessary to make this role of the banking system incentive feasible, and finds (alongside many other studies) that competitive banking is inherently unstable. Two means of stabilizing banking in the context of the model are (i) the natural monopoly approach: permit a non-competitive industry structure, but regulate what banks can charge; or (ii) the central bank approach: set a lower bound on the interest rate banks can charge.

So I don’t think that Cowen really captures what banks do when he presents “transforming otherwise somewhat illiquid activities into liquid deposits” as the primary liquidity function of banks. In my model banks promote allocative efficiency by creating “phantom” units of account. But I think Cowen does capture a lot of the regulatory complexity that is created by the liquidity function of banks.

Cochrane is the one, whom I really think is working from the wrong model. I’ll go through his points one by one.

1) We’re awash in government debt.

So what. Unless the government is going to start guaranteeing private sector naked short positions in government debt, it doesn’t matter how government debt we have, because it will do nothing to solve the monetary problem. We need banks because they do make possible for the private sector in aggregate to support a naked short position in the unit of account (that’s what bank deposits are) and this is necessary for intertemporal allocative efficiency.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid

This view fundamentally misunderstands the settlement process in securities transactions. I responded to this view in a previous post and will simply quote it here:

Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.

3) Leverage of the banking system need not be leverage in the banking system.

Because the purpose of banking is to promote economic efficiency by providing society with “phantom” units of account, we need leverage in the banking system. What Cochrane calls “banking” cannot play the role of banks as I model them.

4) Inadequate funds for investment

My model of banking does not provide funds for investment — as least as a first order effect. My model of banking only provides funds for transactions. On the other hand, as a second order effect by promoting allocative efficiency, it seems likely that banks make investing more profitable than in an environment without banks. So an extension of the model that shows that banking promotes investment should not be difficult.

In short, both Tyler Cowen and John Cochrane are in desperate need of a better model relating the macroeconomy to banking. It’s right here.


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