the banks that we do need, fed minn

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DECEMBER 2012 4

V. V. Chari

Christopher Phelang

University o Minnesota andFederal Reserve Bank o Minneapolis

Introduction

Te financial crisis o 2007-08 and consequentGreat Recession generated substantial discussionand debate over uture banking regulation. Largelyabsent, however, has been a careul reexaminationo whether the beneficial services provided bytraditional banks outweigh the inherent financialragilities o those banks and their associated coststo society.

Tree major benefits are usually said to justiytraditional bank reliance on short-term debt, thesource o their inherent ragility. In a previous

article, we assessed—and ound wanting—twoo these proposed rationales: (1) the benefit omaturity transormation, or creation o long-termfinancial assets rom shorter-term assets and (2) thebenefit o efficient monitoring o bank managers,through appropriate alignment o investor incen-tives. (See Chari and Phelan 2012a.)

Here we discuss the third justification, that tradi-tional banks are beneficial and necessary becausethey provide payments services essential to the effi-cient unction o modern economies. We concludethat while this rationale was compelling in anearlier historical era—prior to modern advances ininormation and communication technology thatacilitate transactions o all sorts—the necessaryservices can now be provided through existingfinancial vehicles that do not rely on traditionallystructured, inherently ragile banks.

We begin by briefly reviewing the structuralsource o traditional bank ragility and proceed

he “Banks” We Do NeedServices once said to justify traditionally

structured banks are now available throughmore efficient, less risky financial vehicles

ABSTRACT

Banks are prone to panic-induced runs due to their tradi-

tional structure of short-term, unconditional liabilities and

long-term, illiquid assets. To avoid systemic crises caused

by such panics, governments tend to bail out failing banks.

Traditional banking systems thus impose external costs.

Three major theoretical benefits are often used to

justify a banking system that relies on short-term debt

despite these costs: (1) maturity transformation, (2) efficient

monitoring of bank managers and (3) facilitation of

financial transactions . In a previous paper, we argued that

the first two justifications, while seemingly compelling,actually suggest financial arrangements very different from

our current system.

In this paper, we examine the third justification, that a

banking system reliant on short-term debt is essential for the

facilitation of transactions. We find, in fact, that this reliance

is more costly than generally recognized and, moreover,

that socially beneficial financial transactions can and should

be provided at less cost and risk by both restricting and

broadening the payments system. Transactions should be

restricted to institutions that continuously mark to market

the value of their assets and issue equity claims to owners.

Such accounts should also be broadened to include financial

vehicles that are readily available, thanks to advances in

information and communication technologies, and possiblyquite different from current banks.

gThe authors thank Narayana Kocherlakota, Dick Todd and

Kei-Mu Yi for useful comments and Doug Clement for editorial

assistance. V. V. Chari thanks the National Science Foundation

for supporting the research that led to this paper.

Economic Policy Papers are based on policy-oriented

research by Minneapolis Fed staff and consultants.

The papers are an occasional series for a general

audience. Views expressed are those of the authors,

not necessarily of others in the Federal ReserveSystem.



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to consideration o the necessity o banks, despitethis ragility. We then address the main topic o this

paper: the argument that banks as currently struc-tured are necessary because their demand depositsacilitate financial transactions. We conclude thatthe current structure o banks is unduly costly tosociety and that essential payments services can,with modern inormation and communicationtechnologies, be provided with less ragile and moreefficient financial institutions.

The inherent fragility of banksIn what sense are banks and similar financial insti-tutions ragile? Our previous paper discusses thisquestion in detail; here we provide a synopsis,reerring interested readers to the earlier discussion.

Te assets o financial institutions are, by andlarge, financial assets, and claims on them areprimarily financial liabilities. Teir financial assets consist mainly o conditional promises to deliverdollars at uture dates. Tese assets, such as homemortgages, are ofen long term and illiquid. Teir

financial liabilities consist mostly o a variety o obli-gations to deliver dollars at particular dates, undercertain circumstances. Banks in particular haveliabilities that are mostly short term and uncondi-tional, such as demand deposits and certificates odeposit.

Governments have a strong

incentive to intervene to bail outdebt holders o banks in orderto prevent the entire financialsystem rom ailing. Paradoxically,expectations o such bailouts canincrease the incidence and deptho financial crises.

V. V. Chari Christopher Phelan

P H O T O G R A P H B Y S T A N

W A L D H A U S E R



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Tis reliance on short-term debt makes banksragile in that they are particularly vulnerable to the

risks o insolvency and the possibility o confidencecrises. Since bank assets are much longer term andilliquid than their liabilities and because the valueo these assets fluctuates, a bank’s net worth alsofluctuates a great deal.

Te illiquidity o banks’ assets and the demandablestructure o their liabilities thus expose banks to criseso confidence. Since a bank typically will not be ableto meet the demands o all depositors within a shortperiod o time should they all choose to withdraw,banks are vulnerable to sel-ulfilling panics in whichdepositors withdraw their unds simply because theybelieve other depositors will do so. Tis panic is anentirely rational response even i the bank is solvent(though illiquid).

Governments have a strong incentive tointervene to bail out debt holders o banks in orderto prevent the entire financial system rom ailing.Paradoxically, expectations o such bailouts canincrease the incidence and depth o financialcrises. Once depositors believe that their depositswill be protected in the event o systemic ailure,they have less incentive to monitor bank managers,who, in turn, have increased incentive to take onrisk, knowing their ailures are implicitly insuredby taxpayers.

In this way, expectations o bailouts can lead

financial systems to rely excessively—rom a socialperspective—on short-term debt to und long-termassets. Fragile banking systems thus impose externalcosts, and regulation may thereore be sociallydesirable.

Are banks necessary?Te ragility o the banking system together withthe reality that such ragility may well lead to occa-sional massive bailouts compel us to ask why soci-eties would choose regulatory systems that allowfinancial institutions to und illiquid assets whose

value can fluctuate rapidly with short-term debt

and demand deposits.One could perhaps argue that banks werenecessary prior to the electronic inormation agebecause no other orms o financial intermedi-ation were easible. With the advent o high-speedcomputers and modern communications, however,alternative financial institutions can provide similar

services with ar less potential or crises. We discusssuch alternatives later in this paper.

We now examine the possible social benefitso a financial system in which illiquid assets with

volatile values are unded by demand deposits andshort-term debt. Tis cost-benefit analysis acili-tates the design o a better regulatory system orbanks, clearly a matter o considerable importance.

Te previous paper examined two o the threemajor theoretical justifications or the relianceo the banking system on short-term debt:(1) demand deposits allow banks to engage insocially useul maturity transformation and (2)demand deposits allow or efficient monitoring obank managers. Tis paper considers the thirdmajor justification: (3) demand deposits facilitate

financial transactions.o anticipate our conclusion, we believe that

while all three justifications are compelling, theypoint us to a financial system very different romthe one currently in place. Te first two justifica-tions suggest that it is important to have institu-tions that finance long-term assets with short-term debt, but we have argued that the assets thatare so unded should not have close substitutesin publicly traded markets. In this paper, we willargue two main points regarding the useulness obanks in acilitating transactions. First, we arguethat regardless o technology, the social benefit to

using banks to acilitate transactions is lower thanthe private benefit, thus potentially explaining whythe historical ubiquity o bank-acilitated transac-tions does not imply their efficiency. Second, weargue that the necessity o bank-acilitated trans-actions is much less obvious than it was a centuryago, beore advances in inormation and commu-nication technologies allowed us to create verydifferent institutions than we currently have toacilitate transactions.

Our analysis will suggest a ramework orthinking about regulatory policy or institutionsthat acilitate payments. Te economic case or

regulating such institutions is convincing, giventhat the ailure o the payments system imposessignificant external costs. We argue that institu-tions that acilitate payments should primarily issueequity-like claims such as those issued by standardmutual unds. Current practice hopelessly conflatesthese two economic cases into a single institution



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called “banks” and exposes the economy to unnec-essary risks and recurrent costly bailouts.

Assessment of the transactionsfacilitation viewTe most obvious service that banks provide now,and have offered throughout their ubiquitous exis-tence, is payments services. Historically, banks haveallowed individuals and firms to pay or goods andservices through their provision o bank checksand other widely accepted claims. Tereore, thoseindividuals and firms haven’t had to resort to costlybarter or specie trade.

Here, we raise the possibility that banks existbecause they provide a privately useul unction—the acilitation o transactions in a orm that payshouseholds interest—but the social useulness isless than the private useulness.

he starting point o our assessment involvesthe central bank and monetary policy. he centralbank creates money, which, or simplicity, we willcall “cash.” Cash typically earns no interest. Ourirst key point is that, to the extent that monetarypolicy is conducted so as to keep inlation—andthus the (nominal) interest rate—ineicientlyhigh, private agents have strong incentives todevelop private payments systems to economizeon the use o cash. Interest-bearing demanddeposits (checking accounts) at banks are one

example o such a private payments system.Because o the interest received in such accounts,households and irms will ind it advantageousto switch rom cash to these private depositsas their means o payment. Clearly, then, therewould be private beneits to the introduction opayments systems like checking accounts.

But do these private benefits imply equivalentsocial benefits? I one household’s use o demanddeposits imposed no costs on other households,the answer would be yes. But i use o such demanddeposits does indeed impose costs on other house-holds, the net social benefit o demand deposits

will be lower and can, in act, be negative. In theappendix, we present an example economy wherethese net social benefits rom demand depositsare indeed negative, even though each householdfinds it in its interest to use them (since theprivate benefits are positive). In Chari and Phelan(2012b), we present a more general model where

the net social benefits rom interest-bearing meanso payments can be either positive or negative,

but are nevertheless always less than the privatebenefits.

Te reason one household’s use o demanddeposits imposes costs on other households is asollows: Introducing bank-provided paymentsleads to an expansion o the “means-o-payment”supply, now defined to include both cash and theamount o demand deposits. Tis higher means-o-payment supply leads to higher prices in theaggregate economy, which reduces the purchasingpower o other households’ deposits and cash—butindividual firms or households do not take this intoaccount when they choose to use demand depositsover cash. Tis pecuniary externality (that is, anexternal cost imposed through prices rather thanreal resources) can cause households to use depositsinstead o cash in cases where they wouldn’t, hadthey internalized this cost imposed on other house-holds, and this externality implies that net socialbenefits o demand deposits are lower than netprivate benefits.

With net private benefits o banking exceedingnet social benefits, it is clear that the banking systemwill be inefficiently large. In the model presentedin the appendix (online at minneapolised.org),because the net social benefits are negative, not onlyis the banking system inefficiently large, the optimal

size o banks is zero.Te model in the appendix is but a simple example,

and the implications rom it seem unrealistic. However,we would argue that recent developments in commu-nication technologies and financial innovations mayin act make the model’s implications more than just ahypothetical scenario.

Historically, communication costs and limiteddevelopment o financial markets have led to the useo systems in which only a raction o a household’sfinancial wealth could be used or payments. Withimprovements in communication and financialmarkets, however, we can conceive o a world in

which each individual can instantaneously accessall o his or her financial wealth to make payments.We can also imagine a world in which settlemento transactions is instantaneous. In this world, cashbecomes unnecessary, and precisely because cash isunnecessary, there is little or no need or paymentssystems that arise rom the need to economize



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MMMFs are not open-end mutual funds

One modern financial institution, the money

market mutual fund (MMMF), which appears to

resemble an open-end mutual fund as described

above, is quite different in practice. MMMFs were

perceived as promising one dollar for each share

held as opposed to a claim to a pro rata share ofthe fund’s assets. MMMFs in this sense resemble

banks more closely than they do ordinary mutual

funds.

During the financial crisis of 2007-08, there were

no runs on ordinary mutual funds, including mutual

funds invested in assets very similar to the assets

held by MMMFs, nor were there any concerns by

policymakers about runs on such ordinary mutual

funds. In sharp contrast, after the fall of Lehman

Brothers in September 2008, the Reserve MMMF

was subject to significant withdrawals. It suspended

withdrawals from the fund and eventually returned98 cents on the dollar to shareholders. Policy-

makers instituted a variety of policies, including a

program to insure the shareholders of all MMMFs.

on cash, that is, arise because monetary policy issetting the inflation rate too high.

In the 1800s, it would have been inconceivable topay or groceries, or example, by using a debit cardassociated with one’s mutual und or stock portolio(and in doing so, stocks were immediately sold, andthe grocery received its settlement while the shopperwas still at the counter). But today, this scenario isnot ar-etched. In a world with virtually costlesscommunication, banks as specialized providerso transactions services would simply be obsolete.Tese observations lead us to conclude that the actual

importance o banks in the payments system is likelysmall today and will likely become even smaller inthe near uture. Tis is the third and final key point inour assessment o the transactions acilitation view.

What should “banks” look like, i not the tradi-tional but ragile demand-deposit bank? As men-tioned in the introduction, alternative financialinstitutions can provide similar services to thetransactions acilitation services that traditionalbanks offer with ar less potential or crises. Onesuch example is the open-end mutual und. Teseunds do not owe their shareholders a fixed dollaramount, but instead only the value o their per-

centage o the und on the day the shareholderwishes to withdraw. I an unexpected surge owithdrawals occurs, the und simply sells a su-ficient quantity o the und’s assets and gives theproceeds to the withdrawing shareholders. Aferthis, the remaining shareholders still hold exactlythe same assets per share as beore. No shareholder

gains by being earlier in line than other sharehold-ers. Tereore, a belief that a run will occur cannot

cause a run or a mutual und—the sel-ulfillingnature o runs that afflicts banks with demand de-posits is thus avoided.

What should “banks” look like,

i not the traditional but ragiledemand-deposit bank?

Alternative financial institutionscan provide similar services tothe transactions acilitationservices that traditional banksoffer with ar less potential orcrises.

Implications for policyBanks have been a durable part o the economiclandscape or many centuries, and economic theorydoes explain why it might be efficient to set up insti-tutions that und long-term assets with short-term

debt. Teory also illustrates that it might be optimalor private agents, but undesirable or society atlarge, to establish such institutions. Tese com-peting lessons rom economic theory also provideguidance or regulation o such institutions.

As discussed in the earlier paper, both thematurity transormation and the efficient moni-



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References

Chari, V. V., and Christopher Phelan. 2012a. What Assets

Should Banks Be Allowed to Hold? Economic Policy Paper

12-3, (May) Federal Reserve Bank o Minneapolis. Online atminneapolised.org.

Chari, V. V., and Christopher Phelan. 2012b. On the SocialUseulness o Fractional Reserve Banking. Working paper.

University o Minnesota. Online at http://www.econ.umn.edu/~cphelan/research.html.

toring views suggest that, given the costs imposedby crises and attendant bailouts, it may be desirable

to allow financial institutions to issue short-termdebt only i their assets do not have close publiclytraded substitutes. Further, to minimize theincentive o governments to bail out institutions i acrisis occurs, such institutions should be separatedrom the payments system.

Any regulatory system must also take seriouslythe central role that banks have long played in thepayments system. We have argued that this rolemay well be an artiact o a bygone era. Advancesin inormation and communication technologymake it easible to access a wide array o assets,rom stocks in public firms to portolios o homeequity loans, to undertake transactions. We havealso argued that payments systems that require theuse o demand deposits expose the economy toconfidence crises and that it is possible to devisepayments systems that do not require the use odebt-like claims, but instead use equity-like claimsor transactions purposes.

Tese considerations suggest that the paymentssystem should be both restricted and broadened.ransactions accounts should be restricted to insti-tutions that mark the value o their assets to marketcontinuously and that issue mutual-und-like equityclaims to owners. Such accounts should be broadenedto institutions that are possibly very different rom

modern-day banks to include institutions such asstock and bond mutual und companies.

We emphasize that the money market mutualund as currently structured resembles a bank morethan it does a mutual und and thereore should notbe allowed to issue transactions accounts. So, orexample, Vanguard’s money market mutual und (ascurrently structured) would no longer be allowed toserve as a transactions account, but Vanguard’s 500Index Fund would.

Te ramework or regulatory policy implied byour analysis would lead to a banking system that isradically different rom the one we currently have.

Institutions that issue large amounts o short-termdebt relative to their assets would be regulated andrequired to hold relatively little o their assets inpublicly traded securities. Te liabilities o suchinstitutions would not serve as means o payment.Te payments system would consist o institutionsthat issue equity claims.

Economic theory tells us that we do need banks.Teory also points us to constructive ways in which

we can reorm the financial system to make itmore efficient and to ensure that crises that affectparticular financial institutions do not spill overinto the rest o the economy. R

the banks that we do need, fed minn

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