Mismatch

Bankers have always had a bad rap. Cicero, writing in De Officiis in 44 BCE, referenced Cato the Elder, the great Roman philosopher, who, when asked his opinion about lending with interest, replied, “What do you think of murder?” William Jennings Bryan, at the 1896 Democratic National Convention, railed against the bankers who would “crucify mankind upon a cross of gold.” Robert Frost (with more irony than poetry) called a bank “a place where they lend you an umbrella in fair weather and ask for it back when it rains.”

This is no apology, or defense, of bankers, but we should understand the central role banking plays in the economy. Banks take in deposits, and pay for them in the form of interest, and lend those deposits to people and businesses that want to borrow: to buy a house, to expand a business, and many other uses. Taking deposits from savers and recycling that capital to borrowers is the central purpose of banking. This function is fundamental to the economy, and it entails, inherently, by design, a mismatch between a bank’s assets (loans) and liabilities (deposits). There is simply no way around this basic design mismatch of recycling deposits to borrowers.

The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to guarantee bank deposits in order to prevent a run on banks. Most individuals today hold less than $250,000 (the current maximum amount insured) in their bank accounts, and their deposits are guaranteed whole by the federal government. But most of the $17 trillion in bank deposits is in accounts greater than $250,000, primarily by businesses that must have free access to their cash.

Banks’ central purpose is to recycle capital from savers to borrowers, but banks also have a central function in the exchange of money. Trillions of dollars flow every day among millions (billions) of individuals and businesses that has nothing to do with borrowing and lending. These flows represent the exchange of goods and services throughout the economy, and this exchange mechanism is the function of banks, without which the economy would fail.

Millions of businesses, ranging from your local restaurant to Wal-Mart, representing the vast majority of the economy, have monthly expenses greater than $250,000, and could not function if they were required to limit their bank deposits to that amount. Those deposits are the lifeblood of the economy. To safeguard the economy, these deposits, all deposits, must be guaranteed safe. But to do so requires a different regulatory regime.

The Bank Term Funding Program (BTFP) established last week is a step in the right direction. Banks are able to obtain loans on the par amount of collateral posted, thus avoiding having to sell government securities at a mark-to-market loss in order to meet liquidity demands by depositors. The BTFP should be extended to cover all government securities held by all banks.

Regulators should also consider a deposit “gating” measure, similar to the provisions in most hedge funds. This would limit (“gate”) the amount that can be withdrawn at the bank level. For example, withdrawals of more than 25% of the deposit base will not be permitted, with allowance for sums under $250,000 and in hardship cases. This would give regulators time to oversee a timely and orderly transition of the failing bank.

The simplest fix to the inherent mismatch in banking is to eliminate the banks. A Central Bank Digital Currency (CBDC) would stop bank runs since the central bank has an unlimited balance sheet. But we should proceed with caution. A CBDC disrupts the central banking function of recycling capital, a function not well-suited to government bureaucrats. Significant privacy concerns are also raised with a CBDC. But as a monetary exchange mechanism, a CBDC could be ideal, and that should be explored.

The bottom line is that banks serve two critical functions in the economy: as a recycler of capital from savers to borrowers, and as the mechanism for the exchange of goods and services. Bank deposits cannot be put at risk without catastrophic economic consequences. All bank deposits should be made whole.

There must also be tighter controls on how banks manage their balance sheets. Shareholders and bondholders must bear the cost of bank mismanagement, but not depositors.

Banking involves an inherent mismatch of assets and liabilities: that mismatch defines banking. But we can’t allow that mismatch to jeopardize the critical role banks play in the everyday flow of capital in our economy. All deposits must be guaranteed, through stricter rules on how banks can invest those deposits, or by establishing a CBDC.

I thought the sartorial choices of the two men at the top were hideously mismatched. What do I know?  British GQ Magazine had them as two of their best-dressed men of 2019. But I can live with the sartorial mismatch, just as we are going to have live with the inherent mismatch in the function of banking. Whether we like it or not.