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Once again, we are seeing that using the liability side of banking for market discipline doesn’t work.

That’s why deposit insurance exists in every sustainable banking system in the world.

It’s also why a floating foreign exchange rate is ‘superior’ to a fixed foreign exchange rate. With fixed foreign exchange rates, there is no such thing as credible deposit insurance.

The remaining weak link in US banking system liquidity is the interbank market.

The reason we have an interbank market is the remaining institutional structure that utilizes the liability side of banking for market discipline.

This includes the $100,000 cap on FDIC insured bank deposits and the Fed demanding collateral from banks when it lends.

Remove these two remaining obstacles for Fed member banks, and bank liquidity normalizes with no ‘cost’ or additional risk to government.

Unfortunately, no one in government seems to comprehend basic monetary operations and reserve accounting.

Including most if not all of the FOMC and the Treasury Secretary.


11 Responses

  1. It’s also why a floating foreign exchange rate is ’superior’ to a fixed foreign exchange rate. With fixed foreign exchange rates, there is no such thing as credible deposit insurance.
    Please explain. Don’t see what exchange rates have to do with deposit insurance?

    The reason we have an interbank market is the remaining institutional structure that utilizes the liability side of banking for market discipline. I think what you are saying here is
    that banks should borrow from the FED instead of each other as long
    as they follow the rules. Wouldn’t this make banks quasi-government institutions with regulated pay pacakges etc. If not then I want to become a banker and borrow and lend infinite amounts of money without collateral. EZ job. Big $$$’s

  2. 1. with fixed fx, like the gold standard, govt can’t support depositors with deficit spending without risking outflows of gold and default on conversion, for example

    2. banking is already like that. any bank can legally entirely fund itself with fdic insured deposits, so the fdic/occ regulate capital, asset quality, duration, etc. as if all liabilities were federally insured.

  3. with fixed fx, like the gold standard, govt can’t support depositors with deficit spending without risking outflows of gold and default on conversion, for example I understand the solvency
    part, but what does fixed fx have to do with it? Assuming the deposits
    are dollar denominated(not denominated in fx) and the dollar was pegged to the DM, what would happen if the government had to fund deposits in an pegged fx system.

  4. I am not getting this either. I can see the second issue, where the fed could stop demanding collateral from the banks.

    I don’t see the first issue at all.

  5. With fixed FX, the neoclassical intertemporal budget constraint becomes valid, since interest on sovereign debt is then set in private markets. Can’t credibly provide lender or insurer of last resort services in that framework. Even worse under gold standard.

  6. “that banks should borrow from the FED instead of each other as long
    as they follow the rules.”


    Peter Orszag, director of the Congressional Budget Office, directly addressed this point in yesterday’s hearing. He said it would not be a good thing to have the fed as the middleman in all these transactions and elaborated to the downsides. You can watch the video on c-span.



    “If not then I want to become a banker and borrow and lend infinite amounts of money without collateral. EZ job. Big $$$’s”

    Home builders did exactly this in decades past, they got into the banking business, gave loans to the builder half of their company, made insande allocations of capital, and left the government with the problems. Professor Black elaborates on this exensively on his book about the S&L crisis.


    The Best Way to Rob a Bank Is to Own One
    How Corporate Executives and Politicians Looted the S&L Industry

    By William K. Black

  7. Orszag’s demonstrated time and time again that he doesn’t understand the monetary system, particularly in his research in the area of so-called generational accounting.

  8. “Home builders did exactly this in decades past, they got into the banking business, gave loans to the builder half of their company, made insande allocations of capital, and left the government with the problems”

    I’m a bit confused by this continual reference to homeowners and builders, etc. This isn’t an issue of some defaulted home loans or some builders playing both sides of the game. We are dealing with trillions of dollars of leverage, prettied up through default swaps in order to dump MB securities into the market with leverage of 30 and 40 times the value of the underlying hard asset. To characterize this problem as an issue of defaulted mortgages, or somehow tied to mortgages (which is what I see all the time in the news) tremendously oversimplifies the issue because if that were the case, we could resolve this mess for a pittance of the amount the tsy is currently asking congress for. In fact, from what I have read, the entirety of defaulted mortgage paper in the US is something around 100B, yet we have consumed both of the macs at a cost of something like 50 – 100 billion, nationalized AIG at a cost of 85 billion, with more billions here and there, and now we have need of a constantly replenished pool of 700 billion more, with no end in sight. So, the issue is not one of these defaulted loans, and it is amazing to me that this is what people keep coming back to.

    In my admittedly limited understanding, all of this is the resulting fallout that has occurred as the insane amount of leverage resting on these notes unwinds as these packaged securities get marked to market. Leverage is the issue here. Please somebody correct me if I am off in the weeds here.

    I recently read that AIG was the originator of default swaps on a lot of worthless commercial paper. And, as it happened, a lot of the commercial paper AIG held swaps over was held by funds. Can you imagine what would have happened if AIG had been allowed to fail? These securities would have immediately been downgraded, and the result would have sent them spewing into the market as those funds offload them per regulatory requirement. The instantaneous takeover of AIG was done, so I am told, because the massive number of swaps they originated would have forced funds to liquidate so much paper that it would have crushed the market within days.

    Am I out in the weeds here, or is this essentially correct?

  9. Warren,

    Can you give your thoughts on the article below:

    Memo to Ben Bernanke & Hank Paulson: Confidence is a Function of Capital, Not Liquidity

    During the presidential debates on Friday, Senator John McCain (R-AZ) said that we are “at the end of the beginning” of the economic recession that is affecting the US and the entire world. We completely agree. So let us try to describe in financial terms why we believe that the legislation currently being finalized in Washington will be ineffective in achieving the stated goal of restoring liquidity to financial institutions and thereby make it possible for banks to begin to expand their balance sheets and lending books, both of which are currently contracting at an alarming and accelerating rate. In a soon to be published article by Alex Pollock and John Makin, both of American Enterprise Institute, “The RTC or the RFC: Taxpayers as Involuntary Equity Investors,” the two respected financial observers write:

    “Do we need a ‘new RTC’ as the U.S. Treasury is proposing-or something else? We believe that an alternative framework is needed. Its key elements should be two: recognition of systemic risk embedded in the illiquidity of mortgage-backed securities and capture of the upside of a rescue for taxpayers, not for banks and (former) investment banks that created the bubble…. A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital.”

    Pollock and Makin point out that simply buying bad assets from banks does not solve the most basic problem, naming restoring confidence in one another among financial institutions by ending questions regarding solvency. In this regard, click here to see a proposal circulated by and among individual members of Professional Risk Managers International Association over the weekend. The plan has two big virtues from our perspective: 1) it minimizes the outlays by the Treasury by keeping bad assets in private hands and 2) it provides a capital facility for solvent banks, a provision that is missing from the drafts we’ve seen of the assistance proposal now under consideration in Washington.

    It is important for all Americans to understand that this financial crisis began more than a year ago with the collapse of liquidity in many types of mortgage assets, but the battle is quickly shifting to concerns about capital and solvency. The Federal Reserve System, Federal Home Loan Banks and the Treasury have already advanced huge amounts of liquidity in the form of debt to financial institutions in an attempt to help them stabilize their funding sources and slowly begin to re-liquefy. Click here to see a map of the balance sheet of the Federal Reserve Bank of New York maintained by our friends at Cumberland Advisers. But unfortunately neither these existing sources of funding nor the proposal to provide even more debt-financed support gets to the core issue that is undermining in the financial system, namely worries about solvency.

    Consider two models for government assistance. The first is the Resolution Trust Corporation (“RTC”) model of the 1980s, which was used to buy up bad assets following the S&L crisis of the 1980s. The older model comes from the 1930s and the Reconstruction Finance Corporation (“RFC”), the most authoritarian federal agency that has ever existed in the United States. Directed by Jesse R. Jones, the RFC used its vast legal powers to test the solvency of banks and commercial companies and, when those institutions were proven solvent, they were allowed to re-open. Those financial institutions that were determined not to be solvent were closed by the FDIC and either sold whole or in pieces to other institutions.

    Below are two very simplified numerical illustrations to highlight the failings of the current plan in Washington by way of a comparison between (1) the RTC/Paulson model and (2) the 1930s RFC model, which is conveniently illustrated by the purchase of WaMu by JPMorgan Chase (NYSE:JPM). Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out – a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future. Significantly, the advances from the FHLBs and the covered bonds issued by WaMu’s bank subsidiary were conveyed through the receivership and assumed by JPM. More on this in our next comment.

    The RTC/Paulson Model

    Suppose the Treasury’s bailout fund purchases $1 billion dollars worth of illiquid assets from a participating bank at par value, which for laymen is the face value of a loan or security. In that $1 billion, the bank actually receives $900 million of cash that was raised via deposits or other forms of debt and $100 million in its own capital, assuming a 10:1 leverage ratio. This is how bank operations work, a little bit of capital and a lot of leverage — as described in the Jimmy Stewart film “Its a Wonderful Life.” If the bank sells assets to the Treasury below par value (or the current, adjusted value if an adjustment or write-down has already been made), then the selling bank takes a capital loss and the other providers of liquidity, whether via deposits, debts or official sources of funding like the Federal Reserve System and Federal Home Loan Banks, are also taking an implicit if as yet unrealized loss.

    In this first example, the overall solvency of the bank is actually hurt and the issues of confidence and safety and soundness are left unresolved or even worsened. This is why we believe the proposal being considered in Washington will be ineffective at best and may actually worsen the crisis of confidence in US banks. The RTC/Paulson model does nothing to arrest the de-leveraging of the commercial banking system and may even worsen the crisis of confidence. In our view, Senator Dick Shelby (R-AL), the House Republicans and the members of either party who want to have political careers in two year’s time are right to vote no on this proposal.

    The RFC/WaMu Model

    In the second example, imagine that Treasury takes a $1 billion preferred equity position in a solvent but illiquid bank. Instead of only receiving 10% of the amount of the cash infusion from the Treasury as capital, the bank receives the full $1 billion as new capital to absorb losses and then serve as a basis to re-lever the bank’s balance sheet and make new loans. By putting capital into solvent but illiquid banks, the Treasury can help them to offset losses of existing assets and provide new capital to use to make new loans to support the real economy. Remember, when new capital is invested in a bank under the RFC model, all of those funds are available to support the bank’s balance sheet, including deposits and bond holders.

    If an insolvent bank is resolved by the FDIC, but its asset quality problems are too severe for a purchaser to assume the full burden of dealing with these assets (unlike the JPM/WaMu transaction), then the Treasury bailout fund could subsidize the transaction by purchasing preferred equity in the purchaser and providing a small but still significant option for the taxpayer to benefit from any recovery on the failed bank’s assets. This allows the FDIC to minimize the number of troubled institutions that it must operate as receiver and keeps the troubled assets in private hands, where the cost of resolution will be minimized in order to maximize profit. But as suggested by the proposal advanced by individual members of PRMIA mentioned at the top of this comment, the first goal is to keep as many banks and assets as possible out of government hands.

    The difference between the current, RTC type model and the 1930s RFC model can be summarized succinctly: The bailout proposal now before Congress does not deal sufficiently with the issue of solvency and ensures that the US banking system will continue to deflate and de-lever, meaning that less and less credit will be available to the private economy and the recession is likely to be far longer and deeper. The present situation in the US economy is not nearly as bad as the 1930s, but if Ben Bernanke and Hank Paulson don’t soon refocus their attention from liquidity to solvency of depository institutions, the US economy could end up in a situation that is much worse that the 1930s given the huge inflation of asset values seen over the past decade. This situation is soluable and can be quickly repaired, but only if we make capital and the leverage it can support work for us, not aganst us as is now the case.

    With the RFC model, on the other hand, by quickly moving to inject capital into solvent banks, we can actually reverse the process of deleveraging and deflation that is currently grinding the global banking system — and the world economy — into the ground. By using new leverage and private capital, we can not only re-liquefy the banking system but also decrease the length and severity of the now present recession. As we’ve said before and will no doubt say again, the roadmap for how to achieve this positive end is in Jones’ memoir, Fifty Billion Dollars: My Thirteen Years at the RFC. We know for a fact that the Library of Congress has many copies of this excellent book as well as copies of the congressional hearings regarding the creation of the RFC and Jones’ periodic reports to the Congress. But will anyone in Washington bother to read them?

  10. 3. with fixed fx such as the gold standard govt can’t deficit spend to make depositors whole as those $ are convertible into gold, and the bank deposits are far larger than the gold supply, so govt would run out and default on it’s conversion promise

    6. peter o is wrong. banks already can raise all the deposits they want via fdic insured deposits. the limiting factor is how many qualifying loans then can make based on their capital.

    8.. aig got short credit and then lost all their capital when the price of credit went up

    9. totally confused

    10. Still misses the point.

    To normalize bank liquidity you need to both remove the cap on fdic insured deposits and extend fdic insurance to fed deposits at member banks. This facilitates the banks borrowing unsecured from the fed as needed to fund their assets, and keeps any losses due to bank insolvency at the fdic, where they are now.

    you can also eliminate the glitch that caused the interbank market
    to grow by having the fed set rates for 1,2,3,4,5 and 6 mo borrowings from the window (eliminating the awkward taf).

    but this does not address agg demand, which requires a fiscal package, such as a payroll tax holiday.

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