Could the real cause of today’s financial malaise have less to do with greedy bankers, bad regulation and poor monetary policy, and more to do with the effects of the information technology age on banking?
That at least is the argument proposed in a new book, “The end of banking – money, credit and the digital revolution” by Jonathan McMillan, a collective pseudonym for two authors who are keeping their identities secret, but who hail from the world of banking and academia.
Not to say the financial system was free of instability before the IT age, it’s just that the way in which the instability was dealt with was entirely different.
The authors argue that whilst credit had to be recorded on paper in the industrial age, in the information age it suddenly became possible to record credit electronically. This one fact made all the difference:
With the advent of computers and electronic communication networks, credit became detached from banks’ balance sheets. This had far-reaching consequences for the effectiveness of banking regulation.
New forms of banking emerged, and banks organized their activities such that regulation did not apply. Institutions such as money market mutual funds (MMFs) started to perform banking over a complex network of balance sheets and outside the regulators’ spotlight. Banking that is not or only lightly regulated is often called shadow banking. Within a few decades, shadow banking became more important than traditional banking.
The rise of shadow banking, they note, revealed that banking itself was not limited to banks — a fact totally missed by the public and regulators, who failed to recognise the new boundaries and interlinkages in hand.
Regulators consequently never stood a chance of supervising the system properly. The interlinkages between regulated and unregulated financial worlds were far too poorly understood. In fact, the more they regulated the banks, the better the opportunities became for third parties who could stride both the regulated and unregulated domains. Regulated markets in this way became contaminated by the bad practices of a non-regulated market, to the disadvantage of those who operated within the regulations.
It’s an important point because it sums up the sociopathic nature of a market system that encourages those who don’t abide by the rules to exploit those who do.
And, as the authors note, it was the digital age which in many ways facilitated these processes:
In a world with fast-paced financial innovation, financial institutions can move banking anywhere where banking regulation does not apply. Regulators are set for a race they are bound to lose. The boundary problem of banking regulation has become insurmountable in the digital age.
Given the whack-a-mole nature of the problem — i.e. the fact that regulating bad practices doesn’t eliminate them, just pushes them further into the shadows — the authors argue the best course of action may be to do away with banks altogether.
While this looks very similar to the proposition advocated by digital financial crusaders like Marc Andreessen, we have to stress it’s very different. The likes of Andreessen want to kill off banks by doing what banks can no longer do due to stricter regulations. His plan is mainly regulatory arbitrage.
What our pseudonymous authors propose, however, is that the functions of money and credit are separated and assigned to the public and the private spheres, respectively.
As they explain:
This way, the financial system can provide for a functioning price system and support a decentralized and capital-intensive economy. The stability, productivity, and fairness of our economy will no longer be compromised by the organization of the financial system.
So whilst Andreessen and co. would happily continue using privately-issued liabilities as money, our authors would prefer it if credit became fully segregated from money. In their vision, public authorities would retain control of money creation, but credit creation would become fully disintermediated.
To understand the difference, one must first understand that in the authors’ eyes the biggest mistake the public made in the digital age was to assume that the private liabilities of banks were tantamount to money, and should be used as such.
As the authors eloquently put it:
For many people, banks creating money squares with the idea of government having a monopoly on issuing money. Let us be clear that banks do not issue cash; that is, they do not print dollar bills. Only the government is allowed to do so.
This confusion is understandable. It hails from the introduction of government guarantees for banks’ privately issued liabilities, which blurred the lines between privately issued money and government money to all concerned:
…with government guarantees in place, depositors know that their money is safe no matter what. They have no incentive to step in if their bank takes excessive risks. Knowing this, banks indeed take excessive risks.
So how does this all relate to the digital revolution? Well, the theory is that information technology helped to support many more options than simply holding loans on a balance sheet until maturity. Thanks to IT banks could now slice, dice and redistribute credit over a chain of balance sheets at a negligible cost. The result was a bifurcation of the market, well illustrated by the below chart:
In many ways, the global financial crisis is thus a misnomer.
What happened in 2008 was really a shadow banking panic. Institutions that had taken advantage of unregulated markets effectively stuck a gun to the head of regulators and demanded a bailout. It was the equivalent of the banks saying: “Bail our unregulated businesses out (despite the fact we never abided by the rules) or the financial system gets it.”
The regulators had no choice but to comply because by then they realised that nobody really knew where regulated liabilities ended and where the unregulated liabilities began.
But given that guarantees were only supposed to apply to bank deposits, not the private unregulated sector, the regulators attempted to harmonise the system by introducing stricter banking legislation ex post-facto to all.
According to the authors, this was an error because it failed to differentiate between banks and banking.
As the authors note regarding efforts to impose higher capital requirements:
Banks will react to higher capital requirements as they did before. They will migrate banking activit, and new financial institutions will emerge that will create inside money in an obscure way such that they will avoid banking regulation.
The financial crisis of 2007-08 has proven that an unregulated banking sector can quickly create enough inside money to become systemically relevant. With systemic relevance comes implicit government guarantees and, hence lower financing costs.
Unfortunately central banks lacked the tools to deal with such a thoroughly modern digital crisis. The tools they were used to deploying were designed in the industrial age, when traditional banking dominated. But they had no ability, for example to take the federal funds rate below zero.
So what’s to be done?
In the authors’ opinion the solution must account for the new electronic banking age we find ourselves. This they believe comes down to building a financial system without banking:
A financial system without banking is a financial system without inside money. It does not imply a financial system without financial institutions that provide payment services, advice on investments, and asset management. There will also be financial institutions that process loan applications and offer access to capital markets for companies.
But how do you prevent the formation of inside money given that even non-financial firms are making strides in this capacity?
In the authors’ opinion it’s all down to accounting standards. Their key proposition, consequently, is to redefine what constitutes technical solvency as:
The total value of the real assets of a company has to be greater than or equal to the value of the company’s liabilities.
Because this replaces the term assets for “real assets” — something defined as any asset that is not financial but which represents ownership claims on material or immaterial objects — it ensures a company cannot fund financial assets with credit.
The best way to read the rule is as: The total value of financial assets of a company has to be less than or equal to the value of its equity.
As they explain:
This reading highlights that companies have to back assets that are someone else’s liability with their own funds, that is, equity. Companies cannot finance credit with someone else’s credit.
Credit itself is not constrained by the rule, it just becomes directly dependent on a company’s equity valuation.
Over in the public outside-money world, meanwhile, the authors propose that money issuance be fully digitised so that policymakers are able to charge both liquidity fees (negative interest rates) or to distribute unconditional income as and when needed for price stability reasons.
As they conclude, in this way the intimate link banking creates between money and credit is broken:
It assigns the current payment function exclusively to money. The monetary authority can exert full control over the quantity of money in circulation, because credit can no longer be transformed into money. Under a systemic solvency rule, credit creation does not lead to money creation.
If you’re still foggy on the details it is worth getting the book, since all the thought processes are meticulously explained.
Related links:
Mythbusting finance 2.0 – FT Alphaville
The real disruption at the heart of banking – FT Alphaville
Money hierarchy, the global perspective – FT Alphaville
The theory of money entanglement (Part 1) – FT Alphaville
On the elimination of privately issued money – FT Alphaville
Why capital gain-like revenues are driving financial profits – FT Alphaville
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