My recent review of Andolfatto (2018) reminds me that underlying the debate between mainstream and heterodox approaches to money is a fundamental dispute over a factual question: Do financial markets and/or non-bank financial institutions provide the same services as banks?
Mainstream approaches typically claim that “clearly” financial markets and non-banks do provide the same services and that the differences are just a matter of degree. In my view, these claims are factually wrong. In this essay I am going to work through a taxonomy of liquidity that is designed to distinguish between the fundamentally different types of liquidity provided by the different types of financial contracts. In my view it is a category error to treat these different types of liquidity as if they were equivalent and interchangeable.
Preliminary question: What do banks do?
I’m going to take it as given that we can agree that banks create money by issuing monetary liabilities. Given this, what I think a lot of modern scholars miss is that those monetary liabilities can be either on balance sheet or off balance sheet. There is a tendency to focus, as Andolfatto (2018) does, on banks’ on balance sheet lending, where the banks issue money in order to fund loans. In fact, however, banks’ contingent, off balance sheet liabilities have for the past few centuries played a crucial role in the monetary system – and they still do today.
When a bank earns fee income by selling the issuer of an asset a credit line that will be used to repay the asset’s owner in the event of a default, the bank is monetizing that asset. Effectively by taking on the tail risk of the asset, the bank turns the asset into the equivalent of a bank liability, even though the bank’s liability is contingent. These contingent bank liabilities are extremely common and may go under the name of acceptance, letter of credit, standby facility, bank credit line, etc.
Because the focus of the mainstream literature on banking is on balance sheet banking, mainstream scholars typically distinguish banks, where debt is held on balance sheet, from markets, where debt is traded. But this framing elides the fact that very often debt is tradable only because of an off balance sheet bank guarantee. As a result, in using this framing mainstream scholars often draw a distinction between banks and markets that is fundamentally misguided.
More recently banks have taken on another role in markets. Morgan Guaranty Trust, which later became JPMorgan Chase, played a crucial role in the development of the modern repo market by market making in repo on the balance sheet of the depository institution so that repo regularly accounted for 10% or more of the depository institution’s assets and of the depository institution’s liabilities from the late 1990s on. Of course, JPMorgan also became a tri-party clearing bank for the repo market. Now that JPMorgan has pulled out of the repo market, the Federal Reserve itself stands ready to lend on the market through its Reverse Repo Program.
Similarly, banks like JPMorgan Chase have been dealers in the derivatives markets since their earliest development, and even today JPMorgan’s depository institution accounts for more than 20% of the US derivatives market (see Table 3 of the OCC’s latest derivatives report). So nowadays we have depository institutions that are not only supporting financial markets via the guarantees they provided to the assets traded on them – as depository institutions have always done – but that also are the key market makers in markets that are viewed as essential to so-called “market-based” lending.
In short, drawing a bright-line distinction between financial markets and banks is a mistake.
Even so, the traditional equity and bond markets continue to operate with relatively minor connections to depository institutions (at least as far as I am aware). These financial markets can properly be viewed as “market-based” lending that is distinct from banks. Thus, while it may be correct to draw a clear distinction between traditional capital markets and banks, it’s also essential to recognize that markets in most other assets, including commercial paper, securitizations, repo, derivatives, etc., rely heavily on the explicit and implicit support of depository institutions for their basic functioning.
This understanding of the nature of financial markets motivates the following taxonomy of liquidity.
In addition, to distinguishing between the market, hybrid and bank liquidity that can be provided to an asset, this taxonomy makes another point: different types of liquidity provide very different services to the asset owner.
Market liquidity is the first entry, as it is the archetype that provides the most common mental reference point when one discusses liquidity. Market liquidity refers to the ability to sell an asset without suffering much loss in terms of price. Implicit in the concept is that there is a “true” sale for accounting purposes and that the seller of the asset successfully transfers all of the risk of the asset to the new owner. Thus the balance sheet of the seller of the asset increases by the value of the asset which is received in cash and decreases by the removal from the balance sheet of the risk of the asset (both credit and liquidity).
Nowadays one sometimes hears repos referred to as a kind of market liquidity. This diagram is designed to point out the limitations of repo-based liquidity. As the chart indicates in the row titled “Overnight reverse repo”, repo allows the asset owner to have access to cash without transferring any of the risk of the asset away. This is a very important distinction between market liquidity and repo-based liquidity. Arguably the latter should be called funding and the term liquidity should not be associated with repos at all. Certainly the two concepts are very, very different.
There are two other entries under Hybrid liquidity. The discount market is a historical phenomenon that was very important in 19th century Britain. Bills could trade easily on the discount market as long as they had been “accepted” (i.e. guaranteed) by a bank. A discount market sale was not, however, like a capital market sale: in order to sell a bill the owner had to endorse it, and the endorsement obligated the owner to pay up in the event that the bill went into default. Thus a discount market sale is an effective transfer of the liquidity risk of the bill, without transferring the credit risk of the bill.
A credit default swap is designed to protect the buyer against the credit risk of the asset. Effectively an asset owner can pay the equivalent of an insurance premium in exchange for a promise of payment if the asset goes into default. Note that in this case, the asset owner continues to hold the asset unencumbered on her balance sheet and thus receives no cash upfront from the seller of credit default swap protection. This explains the zero in the “Principal value of asset” column. (Note also that I have depicted credit default swaps here as if they are an effective way to transfer the credit risk of an asset. In fact, these markets are very complicated and there is some concern recently regarding how successful credit default swaps are at transferring the credit risk of an asset.)
There are two entries under “Bank-based liquidity”. The first is a “bank credit/liquidity facility”: this represents the case where for a fee a bank guarantees payment on an asset. As in the case of a credit default swap, this functions effectively as insurance for the holder of the asset, there is no transfer of the asset to the bank, and of course the asset owner receives no payment for the value of the asset from the bank. (On the other hand, the fact that the asset is accompanied by a bank guarantee typically makes it easy for the asset owner to transfer the asset to a third-party in exchange for goods or cash, for example on money markets like commercial paper or discount markets.)
Another important form of bank-based liquidity is the central bank discount window. All loans at the discount window are recourse loans, and as a result in exchange for the central bank’s cash the owner of the asset is able to lay off the liquidity risk, but not the credit risk of the asset.
The point of going through this Taxonomy of Liquidity in somewhat excruciating detail is to make it clear that it is a mistake to talk about “credit” or “liquidity” as if they are simple one-dimensional concepts. Similarly, it is very difficult to draw a bright line distinction between financial markets and banks. Anyone who wants to model money needs to be aware of these issues.