Time and interest are not so interesting
I wanted to add a quick follow-up to the previous post, inspired by its very excellent comment thread. (If you do not read the comments, I’ve no idea what you are doing at this site; I am always pwned by brilliant commenters.)
Cribbing Minsky, I defined the core of what a bank does as providing a guarantee. Bill Woolsey and Brito wonder whatever happened to maturity transformation, the traditional account of banks’ purpose? Nemo and Alex ask about interest, which I rather oddly left out of my story.
Banks do a great many things. They certainly do charge interest, as well as a wide variety of fees, both related and unrelated to time. Banks do borrow short and lend long, and so might be expected to bear and be compensated for liquidity, duration, and refinancing risk. Banks also purchase office supplies, manage real estate, and buy advertising spots. Banks do a lot of things.
But none of those are things that banks do uniquely. Banks compete with nonbank finance companies and bond markets for the business of lending at interest, and nearly every sort of firm can and occasionally does borrow short to finance long-lived assets. There is no obvious reason why any special sort of intermediary is needed to mediate exchanges across time of the right to use real resources. As Ashwin Parameswaran points out, there is no great mismatch between individuals’ willingness to save long-term and requirements by households and firms for long-term funds. Banks themselves largely hedge the maturity mismatch in their portfolios, outsourcing much of the whatever risks arise from any aggregate mismatch to other parties. Once upon a time, before we could swap interest rate exposures and sell bonds to pension funds, perhaps there was a special need for banks as maturity transformers. But if that was banks’ raison d’être, we should expect their obsolescence any time now.
But that is not and never was banks’ raison d’être, however conventional that story might be. Banks’ role in enabling transactions is and has always been much more fundamental than their role in lending at interest over long periods of time. It is not for nothing that we sometimes refer to cash money as “bank notes”. In some times and places, paper bills issued by private banks served as the primary means of commercial exchange. Here and now, the volume of exchange of bank IOUs to conduct transactions entirely dwarfs the scale of loans intended to survive for an extended length of time. When we buy and sell with credit and debit cards, merchants pay a fee for nothing more than a banks’ guarantee of a customers’ payment. Banks issue deposits to merchants with varying degrees of immediacy for these purchases, but charge no interest at all to debit and nonrevolving credit card customers.
Interest over time is, of course, at the center of how banks make money. But the question is why banks have any advantage over bond investors and nonbank finance companies in earning an interest spread. One traditional story has to do with relationship banking: local banks know local businesses (in part by having access to the history of their deposit accounts, in part because of social and community connections), and are able to lend profitably and consistently to firms whose creditworthiness other lenders could not evaluate, and can helpfully smooth over time variations in lending interest rates due to changes in the firm’s financial situation over time because the ongoing relationship prevents firms from jumping during periods when they are “overcharged”. I think there is something to this story historically, but fear it’s growing less and less relevant as the business consolidates into megabanks that require “hard” centrally verifiable statistics rather than “soft” local information to justify making credit decisions. In any case, if managing relationships actually is banks’ special advantage, note that it has nothing to do with maturity transformation and everything to do with evaluating creditworthiness and providing a guarantee.
Even if there’s something to the relationship banking story, it’s not sufficient to explain the resilient centrality of banks. Why can’t local nonbank finance companies couldn’t enter into persistent relationships with firms, evaluate creditworthiness, and earn the same smoothed interest rates as banks? Banks’ advantage in earning an interest rate spread comes ultimately not from anything special about their portfolio of assets, but from what is special about their liabilities. Banks pay no interest at all or very low interest rates on a significant fraction of their liabilities, low-balance checkable demand deposits. The class of bank creditors called “depositors” accepts these low rates because 1) they deem the bank to be highly creditworthy, and so don’t demand a credit spread; and 2) they gain an in-kind liquidity benefit because “bank deposits” serve as near perfect substitutes for money.
To me, a bank is any entity that can issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered. Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich. The value of his assets far exceed his liabilities; he is not a highly levered entity. Goldman Sachs, on the other hand, was a bank even before it received its emergency bank charter from the Federal Reserve. Prior to the financial crisis, despite being exorbitantly levered and having no FDIC guarantee, market participants accepted Goldman Sachs’ liabilities as near substitutes for money and were willing to leave “cash” inexpensively in the firms care. The so-called “shadow banks”, the conduits and SIVs and asset-backed securities, were banks before the financial crisis, because their highly rated paper was treated and traded as a close substitute for cash despite the high leverage of the issuing entities. Shadow banks wrapped guarantees around a wide variety of promises that, after a while, we wished they hadn’t.
Maturity transformation, issuing inexpensive liquid promises today in exchange for promises that pay a high rate of interest over a period of time, is one strategy that banks use to exploit the advantages conferred by the resilient moneyness of their liabilities. Issuing guarantees for a fee — swapping their money-like liabilities in exchange for some other party’s less money-like IOUs — is another way that banks exploit their special advantage. These activities are not mutually exclusive: lending at interest over time and bundling the price of the guarantee into a “credit spread” embedded in the interest rate combines these two strategies.
But maturity transformation is really nothing special for banks: depositors’ willingness to hold the liabilities of highly levered banks at low interest means banks can invest at scale in almost anything and earn a better spread than other institutions. Whether that spread comes from bearing maturity risk or credit risk or currency risk or whatever doesn’t matter. What is uniquely the province of banks is their ability to issue, in very large quantities relative to their capital, money-like liabilities in exchange for the illiquid and decidedly unmoneylike promises of other parties, and thereby effectively guarantee those promises. It is this capability that makes banks special and so central in enabling commerce at scale among mistrustful strangers.
A final point about banks as I’ve defined them is that they simultaneously ought not exist and must exist. In financial theory, the interest demanded of an entity by its liability holders should increase in the leverage of the institution. There ought not to be entities that can “lever up” dramatically, often against opaque and illiquid assets, without creditors demanding a large premium to hold its deposits. Yet banks exist, and existed long before deposit insurance immunized some creditors from some of the risks of bank leverage. They existed in spite of financial theory, with the help of marble columns and good salesmanship and perhaps the small assurance that came from knowing that if depositors were ruined, the banker would be too. Under a wide range of political and institutional settings, banks come into the world and gain people’s trust despite their inherent fragility, because humans are susceptible to elevating gods, because commerce requires scalable and trustworthy guarantors. People require commerce enough to collectively hope for the best and overlook the inherent contradiction between leverage and trustworthiness. Nowadays, we mostly rely on the state to overcome this contradiction. But recall that no one thought that AAA tranches of structured vehicles had a state guarantee, yet they were often treated as near-money assets. It was just unthinkable that the rating agencies could be so wrong on so vast a scale. If you think about it, you’ll come up with other examples of entities that became able to act as banks, to issue near-money paper despite high leverage, because failure became conventionally unthinkable, even in the absence of any state guarantee or ability to extract one via the knock-on costs of failure. Our propensity to anoint banks is ultimately a social phenomenon, not a product of economic rationality.
Then the state itself is a special kind of bank. Like any bank, the state is perfectly creditworthy in its own banknotes. But unlike other banks, many states make no promise that their notes should be redeemable for anything in particular. “Currency-issuer” states (as the MMTers put it) are highly creditworthy because they don’t make clear promises they might be ostentatiously forced to break. That the failure of states is conventionally unthinkable lends another layer of resilience to the state-as-bank. Successful states use their capacity to intervene in economies — both gently through good stewardship and roughly via taxation — to ensure that the liabilities they issue remain valuable and liquid in commerce. This capacity to intervene renders states and state-guaranteed banks somewhat more resilient than private banks, although not infinitely so. Ultimately the value of any state’s irredeemable notes depends on its capacity to organize and tax valuable real production.
Addendum: Note that the subsidy to sellers described in the previous post depends specifically on the notion of banking systems organized and guaranteed by the state, rather than the more general definition of banks used in this piece. A person who surrendered some real good or service directly for the AAA paper of some CDO bore risk and probably got screwed. But if the same vendor surrendered a real resource for Citibank deposits which had been issued to the buyer against that same AAA paper as collateral, the seller was protected from the risk engendered by her semi-transaction. (“Semi”, because she surrendered something real, but received nothing real in return, creating a risk of nonreciprcation that did not exist before, see e.g. Graeber). It is the state guarantee of bank IOUs, whether explicit or tacit, that effectively socializes the risk of a sale, rather than merely obscuring it or rendering it conventionally unthinkable.
- 15-Jul-2012, 8:15 p.m. EEST: Added addendum re importance of state guarantee to the engineering of a subsidy to sellers.
- 16-Jul-2012, 4:55 a.m. EEST: Fixed an ambiguously phrased sentence, many thanks to Ritwik for pointing out the issue: “requirements by households and firms for long-term
- 16-Jul-2012, 5:05 a.m. EEST: “somewhat more resilient than
more circumscribedprivate banks”, “against thethat same AAA paper as collateral”