Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, May 29, 2016

Some questions concerning equity-financed banking

John Cochrane has another fun and provocative post making his pitch for equity-financed banking. He makes a lot of great points. But I'm still left feeling a little uneasy. In particular, I wonder whether some of his sweeping claims have any firm theoretical backing. It could be I just haven't thought hard enough or long enough about it. In any case, in the spirit of promoting discussion, let me describe some of the things that bother me.

Actually, before I start, I should preface my concerns with a couple of observations. Policies directed toward stabilizing the banking sector target both the asset and liability side of bank balance sheets. The "narrow banking" proposal of 100% reserves, for example, is a policy designed to make bank assets safe. The "100% equity-financed banking" proposal on the other hand is a policy designed to render bank liabilities safe (run-proof). According to Cochrane, " assets aren’t risky! A diversified, mostly marketable portfolio of loans and mortgage backed securities is far safer than the profit stream of any company." The problem evidently lies on the liability side. Moreover, the issue here is not simply one of ascertaining whether banks are "over-levered" (I'm willing to agree that they probably are). The issue is whether debt (fixed-value promises), especially demandable debt, has a role to play in the business of banking at all.
The main question I have is: where's the theory? In the benchmark neoclassical model, some version of the Modigliani-Miller theorem typically holds. The theorem states that under a very specific set of assumptions, the liability structure of a firm does not matter. We know that these assumptions (e.g., symmetric information) do not literally hold in reality. When information is asymmetric, debt can be superior way to fund assets relative to equity (see here and here, for example). Demandable debt may have socially desirable properties when liquidity demands are private information; see here. In a world where exchange media (including collateral assets) are valued, it could matter very much how the "pizza" is sliced into tranches designed to serve special uses.

What explains the widespread use of the debt contract and the prevalence of fractional reserve banking? The explanation is unlikely (in my view) to be "government distortions" or "greedy bankers." It seems to me that asymmetric information in financial markets is a pertinent real-world friction. Could it be that debt represents a sort of "second-best" solution to the problem of efficient (low-cost) financing in a world of asymmetric information? Might the same not be true of demandable debt? Implicitly, Cochrane must be thinking that these benefits are quantitatively small. Maybe so, but senior liability tranches do seem rather highly valued in the market place, especially as exchange media. Private monetary instruments have always been in the form of debt, not equity. Why has this been the case?

Cochrane begins his post with the statement "My premise is that, at its core, our financial crisis was a systemic run. The mechanism is familiar from Diamond and Dybvig."  The Diamond and Dybvig (1983) model can indeed be interpreted as a theory of bank sector fragility. But we should keep in mind it's also a theory that explains the benefits of an illiquid bank sector (a point stressed by Wallace, 1996). Moreover, it's also a theory that explains the desirability of demandable debt. We want demandable liabilities (according to this theory) because, well, imagine going to an ATM wanting to withdraw cash and then having the blasted thing make you fill out an insurance claim attempting to verify whether you do indeed have a pressing need for liquidity. (In fact, banks were known to do this during the banking panics of the 20th century.)

Now, I suspect that Cochrane may reply that while demandable debt in its traditional form once had a useful role to play, markets and communication technologies are now developed to the point that renders the demand deposit liability superfluous. Call me a hopeful skeptic. Cochrane claims that "unlevered bank equity would have 1/10 less the volatility it has today, so we're talking about 2% volatility on an annual basis." I'm not sure where he gets these numbers, though I do agree with him qualitatively. (On the other hand, how do we know that banks will not hold riskier assets if they are equity financed?)

In any case, just how much volatility is "too much" for depositors wanting transactions balances with a steady value to ensure that payment obligations can be met in all circumstances on a timely basis? Evidently, depositors value the fact that they can redeem their bank money at par for cash quite a bit. What Cochrane advocates is the replacement our present ATMs with one-armed bandits spitting out random returns whenever we want to redeem our bank equity shares for cash. That sounds like a lot of fun, but it may not be very practical. Perhaps the volatility of these returns will not be so great (how do we know?). Maybe we'll be able to withdraw only 98 cents on the dollar more often than not "by chance" (as the Gorton-Pennacchi insiders skim us outsiders while claiming "bad equity returns" as the culprit. Again, how do we know?)

I want to be clear here. I am not suggesting that Cochrane's proposals are a bad idea when all considerations are factored in. I'm just questioning whether it's the open-and-shut case he makes it out to be. If it is such a great idea, I wonder why banks have not offered the product on their own? (I am sure there is no shortage of explanations here, but still, it's worth having them spelled out.)
There is one final thing I want to touch on before I sign off here. The main reason Cochrane preferes equity over debt is because equity is evidently "run-proof." I don't know, he may have his own special definition of "run." There are macroeconomic models of multiple equilibria (see Roger Farmer) where shareholders might be compelled to "run" on equity, driving its price lower, leading to all sorts of negative pecuniary externalities and self-fulfilling crises. Getting rid of debt will not necessarily get rid of financial crises.

Of course, getting rid of debt will get rid of bankruptcy. But I am sometimes led to question whether bankruptcy is quantitatively relevant for causing or exacerbating recessions. As Cochrane points out:
Our crisis and recession were not the result of specific business operations failing. Failure is failure to pay creditors, not a black hole where there once was a business. Operations keep going in bankruptcy. The ATMs did not go dark.
Absolutely. I can recall several times when an airline went bankrupt with no noticeable side-effects (passengers were treated terribly, but that was normal even outside of bankruptcy). Bruce Smith (2002) reports evidence suggesting that bank panics are not always associated with output losses. If so, then what's the big deal? As Cochrane explains, when equity takes a plunge, we all pull out our hair, but the firm is under no obligation to do anything on our behalf. But with debt--demandable debt in particular--we can demand--demand--our money back. And the firm has to ... has to what? I'm not really sure. The firm can just continue to operate as usual and restructure its debt, no? After all, bankruptcy is just a rearrangement of claims against a firm's assets (well, I suppose in some cases senior management gets the ax, but not always). In the old days, banks were permitted to temporarily suspend withdrawals without legal repercussion. As well, bank clearinghouses might issue currency substitutes in lieu of specie, etc.

These considerations lead me to wonder whether interventions on the asset side of bank balance sheets might not be a better way to promote a run-free banking system. Alternatively, as Cochrane suggests, we might consider opening up the central bank's balance sheet to the public. As I've mentioned before, the U.S. treasury does permit the public to hold online UST accounts at While the system is not set up for making payments, there is no reason why, in principle, it could not be. I'm not suggesting this as a panacea, of course. But I think the idea, or some variant of it, deserves serious consideration.


  1. Isn't the point here that depositors want their money redeemable on demand and safe. If this wasn't the case there would be no depositors and only holders of bank equity. If banks only offered equity and not DDLs as you call them, then I know what people will do with their money. Forget iphones, I'd be in the business of selling safes and domestic security systems. I can't see why anyone would bother mounting any argument for equity banking. (Perhaps John Cochrane has himself already set with shares in security companies.)


  2. You ask why we don't already have equity-financed banking if it is such a good idea. But we do already have it, in the form of MMMFs that handle redemptions using a floating NAV formula. And they hold marketable securities that they can sell to handle redemptions. They are using your ideas about the good information properties of debt to provide liquidity on demand.

    The main problem is that the process of securitization doesn't work very well, again due to information costs. The optimum would have us minimize these costs for bank investments (by not securitizing them), for users of bank liabilities (by making these traded liabilities some form of debt), and for monitoring of banks (by relying very heavily on debt funding, applying the Diamond-Dybvig logic). Our current system of transforming illiquid investments into liquid securities is clearly second-best.

    1. OK, we already have equity-financed banking in the form of floating NAV MMMFs. I suppose my question is why this product hasn't driven out conventional bank money. There could be regulatory reasons, of course (e.g., deposit insurance, etc.)

    2. The two reasons that come to mind:

      1. banks are better integrated into the payments system (I'm thinking of debit cards here, I don't know about ACH)

      1b. banks issue dollars to approved borrowers. I don't think anyone else can do that.But this doesn't answer why that money isn't moved into an MMMF immediately after issue.

      Monetary financing of bank loans is an important feature of the current system. Carolyn Sissoko pointed this out on Cochrane's blog. It is also noted in academic critiques of narrow banking. Otherwise the need to raise equity before making loans could be an important constraint during downturns. Thus we probably want to keep our current system of loan origination, and keep asking why banks want to securitize loans, instead of just holding them and offering high-yield accounts right within the bank.

    3. Why hasn’t “this product” “driven out conventional bank money?” My answer is that conventional bank money is subsidised.

      First, it’s subsidized via deposit insurance. Of course deposit insurance ostensibly pays for itself (as the FDIC) does I think. However, there’s only one way to give the country’s depositors an absolutely 100% cast iron guarantee they’ll get their money back, and that’s to have government, with its power to grab near infinitely large amounts of money off taxpayers, stand behind the FDICs of this world. PRIVATE insurers just can’t give that 100% cast iron guarantee. And that “grab off taxpayers” is a subsidy.

      Second, “money is a creature of the state” as the saying goes. That is, in any economy which wants a form of money rather than barter, there has to be general agreement on what constitutes money and how to limit its production. Money producers are thus in a privileged position (i.e. they are subsidised). E.g. if the state prints and spends money into the economy (e.g. on infrastructure), the state reaps seigniorage profits: it gets infrastructure in exchange for bits of paper with “$100” stamped on them. Likewise, back-street counterfeiters profit from money creation. And as to private banks, they create money and lend it out, rather than (as in the case of counterfeiters) simply spend it.

      Any increase in private banks’ “print and lend” activities is inflationary (assuming the economy is already at capacity), so the state has to impose some sort of counteracting deflationary measure: e.g. raise taxes. In that case, taxpayers subsidise private money creation.

      Least that’s my theory.

    4. Ralph,

      1. There may be a subsidy, but not sure this was the case (say) during the Scottish Free-Banking Era, for example. There is clearly something economically and socially desirable about this type of money-debt instrument, even if it may be over or under supplied at times.

      2. Cochrane claims that bank assets are safe. If so, then bank runs can only be liquidity driven events. If so, the LOLR facility is not a bad soln. The Fed, for example, made profits off its LOLR intervention for the U.S. taxpayer. And this was the first (shadow) bank crisis in U.S. since the 30s.

      3. I don't buy your theory about the privilege of money creators. Firms and agencies create debt. If the debt has good properties, it may circulate as a payment instrument. The money creators have an incentive, like any firm, to make sure they don't over-issue debt/equity. Doesn't always work perfectly, but the same is true for non-bank firms as it is for financial intermediaries.

      Thanks for your comments!

    5. What does Cochrane mean when saying that bank assets are safe? Sure, they form a diversified portfolio. But that doesn't mean the we can safely fund that porfolio mostly with dollars, because the beta of USD just doesn't match the beta of the loan portfolio - especially if it contains things like subprime loans.

    6. David,

      Re your point No.1, it strikes me that what is important (for the purposes of this discussion) about the Scottish free banking era was that the gold standard operated, and gold blocks inflation. (The price of bread in Britain in 1900 was the same as it was 100 years earlier in 1800.)

      But that just means that the subsidy I claim to be inherent to private bank money creation works in a slightly different way to where there is a fiat monetary base.

      Under a fiat base, it’s possible for private banks to lend out an excessive amount of freshly created money and cause excess inflation (when banks and everyone else has a fit of irrational exuberance). In contrast, given the gold standard, that’s not possible – at least “long term” inflation is not possible.

      But it’s still possible for there to be inadequate aggregate demand, and hence negative inflation. In that scenario, private banks can create and lend out new money. That certainly has the merit of dealing with the inadequate demand. But I see no excuse for money lenders (aka banks) being the ones who print money (and hence deal with the inadequate demand) any more than restaurants or garages should issue new money.

      In short, under a gold standard as under a fiat base regime, private banks’ right to create new money is a special and unjustified privilege, i.e. it’s a subsidy, or so I’m claiming.

      Re your point No.2, I’m skeptical about your claim that the Fed “made a profit out of LOLR”. It’s easy for the Fed to make a profit out of that activity because (in similar fashion to the above private banks) it can print near infinite amounts of money at no cost to itself. If it lends that out a ridiculously low rate of interest (which it actually did during the crisis) it still comes away with a profit. In contrast, Warren Buffet loaned a few billion to Goldman Sachs at 10%. I assume that 10% is a bit nearer Bagehot’s “penalty” and more realistic rate.

      Incidentally, I’d be VERY INTERESTED in your views as to exactly how much the Fed did lend out during the crisis and at what rate of interest. There are all sorts of wild estimates thrown around: up to about $20trillion. The best information I can find is an article by Mick West (link below) which claims the Fed loaned about $600bn for about 18 months. As to the rate of interest, he is vague on that, but most of the loans were at a near zero rate, weren’t they?
      Re your point No.3, I agree that money creating private banks aim to lend only to sound borrowers (though NINJA mortgages rather call that point into question). But I think the basic flaw in that argument is that the mere fact that those banks can create and lend out money ARTIFICIALLY reduces the rate of interest. Thus borrowers who were previously not viable become viable.

      Put another way, the alternative is for the STATE to issue more money when aggregate demand is inadequate, and in that scenario (assuming the state spreads the new money over wide areas of the economy, public and private, rather than concentrate on BORROWERS) there would not be much effect on interest rates.

      Notice that I’m implicitly attacking a major piece of conventional wisdom, namely that demand should be adjusted by adjusting interest rates.

  3. Dear King of the Andals (which is what I gather Andolfatto means),

    First I’d like to say I am privileged to to a discuss banking with royalty..:-)

    You say the DD theory “explains the benefits of”…”demandable debt”. Surely all DD are saying is that any economy needs a stock of money, which is not the revelation of the century.

    Almost ANYTHING can be used as money: metals (rare metals or base metals), wood (tally sticks) etc etc. And private sector debt can be used as money.

    However there is an inherent problem with private debt: it’s never totally safe, witness the recent crisis. Thus the opponents of the existing bank system (Cochrane, Milton Friedman, Lawrence Kotlikoff and others) argue that the only form of money should be state issued money (base money).

    Next, you ask “how do we know that banks will not hold riskier assets if they are equity financed?” My answer to that is that they can hold as risky assets as they like, and if some of them go bust as a result, why should we care? There’s no chance of a proportion of the nation’s money supply going up in smoke, which is what happens under the existing system unless taxpayers come to the rescue of banks.

    And as former governor of the Bank of England, Mervy King explained in his “Bagehot to Basel” speech, a sharp fall in equity values has nowhere near the catastrophic effects that a bank crisis does (even when billions of dollars of taxpayers’ money is used to rescue banks). See King’s para starting “At the heart..”.

    However, I note that Bruce Smith, who you cite, disagrees with King’s take. Strikes me there’s a problem with Smith’s argument: it’s where he says the Friedman rule “makes money too good an asset”. My answer to that is that so far as strict economics goes, he could be right. However, the political reality is that the population demands a totally safe form of money, and if they don’t get it, they’ll riot.

    Next, you say “What Cochrane advocates is the replacement our present ATMs with one-armed bandits spitting out random returns whenever we want to redeem our bank equity shares for cash.” No: under full reserve banking there is no guarantee that bank equity can to turned into cash. Anyone who wants to store $X and be absolutely sure of getting it back must have it lodged at the central bank (or perhaps, as per Milton Friedman’s version of full reserve, have some of their money put into short term government debt).

    Next, “These considerations lead me to wonder whether interventions on the asset side of bank balance sheets might not be a better way to promote a run-free banking system.” A problem there is that that strategy curtails risky and possibly very productive loans and investments. E.g. some of the loans to Silicone Valley start ups were doubtless high risk. I see no reason to curtail those loans as long as taxpayers are not on the hook when they go wrong.

    1. Ralph, I'm afraid my surname is associated with a much less illustrious history, but I'm very glad you enjoy debating with me nevertheless! :)

      No, DD does not claim that we need a stock of money. In Newmonetarist models, the need for money comes from a breakdown in credit markets (limited commitment). Money is useful when one wants to trade with anonymous agents. DD is a statement about optimal risk-sharing when some assets are illiquid. I have a paper that combines both money and DD banking, if you're interested.

      I'm a little surprised by what you say in your final two paragraphs. Under full reserve banking (which I thought you were a proponent of) the composition of the liability side of the bank doesn't really matter -- it constitutes a sure claim against reserves. My statement about the ATM was in reference to Cochrane away from full-reserve banking.

  4. The reason banks have not offered equity financed banking is because they get a massive subsidy for avoiding equity. They get the subsidy in 2 ways - tax treatment of debt and government guarantees of the liabilities. Under such a system, the downside risk is bourn almost entirely by the taxpayer and the upside goes to the bank and is taxed at a lower rate.

    Government guarantees are necessary to prevent runs from wiping out the bank. Even the belief that the bank is insolvent destabilizes the bank. The information asymmetry does not protect depositors in this case. Once the guarantee is in place, the bank wants to maximize expected return with no care for variance, fat tails, or any other risk measure.

    Insiders can skim outsiders in any publicly traded firm, but this is a zero sum game and does not spill over into the rest of the economy. The actions of a few highly leveraged big players created a massive crisis for the rest of us. The government has a legitimate role in preventing such a crisis. After all, the guarantee isn't there to keep depositors safe - it is there to prevent a liquidity crisis where firm A depends on Firm B payments to make payments to Firm C and they all fail because Firm B's bank is insolvent. A "run" on equity would not have any of these spillover effects.

    Your idea of going to the ATM and getting an a percentage of your deposit as a claim against equity sounds as if you badly misunderstand what Cochrane is saying. Deposits would not form the basis for equity under Cochrane's system. Equity would be raised through public offerings not through depository mechanisms. Deposits would still exist, but checking accounts would be similar to safety deposit boxes. The funds deposited could not be used to finance investments. Higher fees would be charged, but this would be small compared to the cost of the great recession.

    1. Ben,

      You claim that

      "The reason banks have not offered equity financed banking is because they get a massive subsidy for avoiding equity."

      As I admitted in my post, there are probably good reasons to suspect that banks are over-levered. But surely, it can't all be regulation. There was no deposit insurance during the U.S. free-banking era (1836-63) for example, and yet fractional reserve banks proliferated.

      I think that George Selgin would disagree with many of the assertions you make in your second paragraph.

      In terms of your final paragraph, I may very well have misunderstood Cochrane. I was critiquing the notion of 100% equity-based banking (against illiquid assets, not reserves). Cochrane himself admitted some volatility in returns, but that it would be small. Of course, he may have in mind that some form of 100% reserve deposit banking might coexist, but I think that's a separate matter (a statement about what to do with the asset side of banks' balance sheets.)

  5. I am not saying there is no other reason besides regulations for the existence of debt financed banking. The regulations exacerbate this and create a bigger conflict of interest - making this the primary reason for avoiding equity today. I don't think Cochrane is right to say 100% equity is optimal - I think Admati's ideas are superior.

    The free banking period did see proliferation of fractional reserve banking, but also a lot of run based panics that we seldom see today.

    Selgin and the entire Austrian school would dispute my 2nd paragraph. They don't acknowledge spillover effects in the banking sector. If you see the transaction only as a matter between two consenting parties, you ignore the effects on the rest of the economy. Do you agree with Selgin? Consider the last 3 sentences of my 3rd paragraph. This is the argument for protecting against runs that proliferated under free banking.

    1. And as I made clear in my post, I'm not saying that banks are not presently over-levered owing to regulatory distortions, etc.

      It is not entirely clear to me what the source of the panics was in U.S. history. The noted monetary historian Warren Weber, who has studied the U.S. free-banking era extensively, notes that state banks had to load up on state debt in order to acquire their charter. These banks were often subject to runs when it was rumored that state finances were in trouble.

      Note too that Canada suffered none of the nonsense that the U.S. did in terms of bank failures during the Great Depression. Laws preventing banks from branching into neighboring states were likely responsible. Taking all of this evidence into account does not to me seem to point to an "inherent fragility" in private sector banking solutions. I am not sure what you draw on to support your views with the degree of confidence you display.

    2. That is an interesting comment about laws preventing banks from branching into neighboring states. John Cochrane made a similar diagnosis of banking problems in the European Union, and pointed out the value of pan-European banks that were diversified geographically.

  6. " If it is such a great idea, I wonder why banks have not offered the product on their own?" -

    There are already schemes which link a mutual fund to an ATM/debit card - cf. google for "Reliance Any Time Money Card" for reference - and NB this post is in no way an endorsement-or-criticism of the product, I've no real opinion or substantial knowledge of it, only to note that it's been around in India for some time.

    But a real objection to the scheme is that there is clearly demand for interest bearing deposit accounts, with more interest better. My suspicion is that pushing equity-banking through legislation will lead to the construction of complex structured products which have the character of current commercial/consumer loan-backed deposit accounts, which leads to a Dodd-Frank style law defining equity-backed banking as opposed to loan-backed banking.

  7. David, interesting post. It is worth noting, as is shown in the free banking literature, that there have been stable banking systems with demandable debt. The Scottish free banking case of 1715-1845 is one example. Over a hundred years of financial stability.

    Now it may be impossible to ever get to such a system again, and maybe Cochrane's proposal is a practical solution to the messed up financial system we have today. But cases like Scotland do raise the theoretical question you outline in the post.

    1. Yes, that's right. If I remember correctly, I don't think Scottish banks had limited liability. If not, an obvious incentive to stay safe!