\t\t\t\tI haven’t much time today. I gave a talk at a conference in Melbourne today (as noted in yesterday’s blog). I will edit the audio soon and post the presentation for those who might be interested. In general I made the obvious point – if you want people to reach their potential and participate in the economy there has to be enough jobs and hours on offer. But the blog topic today relates to a speech made by a senior RBA official in Sydney yesterday which has excited some conservatives. In that speech, the RBA indicated that it would always lend to private banks which had high quality assets (in AUD) but might be experiencing a temporary liquidity problem and were unable to meet its reserve obligations. This function is part of the public good responsibilities of the central bank and does not mean that they prop up failed capitalist businesses. The speech made the valid distinction between illiquid firms and insolvent firms. The point of relevance to Modern Monetary Theory (MMT) is that the central bank cannot control the money supply because as part of its commitment to financial stability it must be prepared to provide reserves to the private banking system. That point is in contradistinction to the mainstream macroeconomics which starts by teaching students that the central bank controls the money supply. Overall, the central bank must treat financial stability as a public good and therefore must always guarantee reserves on demand.
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\nModern Monetary Theory (MMT) considers financial stability to be a public good. The financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.<\/p>\n
An economy’s financial system is stable if its key financial institutions and markets function ‘normally’. To achieve financial stability: (a) the key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance; and (b) the key markets are stable and support transactions at prices that reflect fundamental forces. There should be no major short-term fluctuations when there have been no change in fundamentals.<\/p>\n
So financial stability requires that financial institutions do not face stresses that might impose economic lossses wider than their own customers and counterparties. Financial stability does not mean that financial institutions cannot fail. Clearly private enterprise carries the risk of insolvency and business failure is part and parcel of the ‘normal’ functioning of the financial system.<\/p>\n
Financial stability requires levels of price movement volatility that do not cause widespread economic damage. Prices can and should move to reflect changes in economic fundamentals. Financial instability arises when asset prices significantly depart from levels dictated by economic fundamentals and damage the real sector. Collapses brought on by injudicious speculation that do not affect the real sector or that can be insulated from the real sector by appropriate liquidity provisions are not problematic.<\/p>\n
The essential requirements of a stable financial system are:
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Some of these requirements can be provided by private institutions but they fall in the domain of government and its designated agents.<\/p>\n
Private goods are traded in markets where buyers and sellers exchange at prices that reflect the margin of their respective interests. At the agreed price, ownership of the good or service transfers from the seller to the buyer. A private good is ‘excludable’ (others cannot enjoy the consumption of it without being party to the transaction) and ‘rival’ (consuming the good or service specific to the transaction, denies other potential consumers its use).<\/p>\n
Alternatively, a public good is non-excludable and non-rival in consumption. Private markets fail to provide socially optimal quantities of public goods because there is no private incentive to produce or to purchase them (the free rider problem). To ensure socially optimal provision, public goods must be produced or arranged by collective action or by government.<\/p>\n
Financial system stability meets the definition of a public good and is the legitimate responsibility of government.<\/p>\n
The RBA recognise this and provide a detailed explanation<\/a> of their approach to financial stability which includes their efforts:<\/p>\n \n… to ensure that the payments system is safe and robust. The Payments System Board within the Bank has explicit authority for payments system safety and stability, and has the backing of strong regulatory powers.\n<\/p><\/blockquote>\n The RBA also note that their “mandate to uphold financial stability does not equate to a guarantee of solvency for financial institutions”. But the RBA still has “an important role in the management of crisis situations in co-operation … responsibility for monitoring financial markets, and payment and settlement systems …”<\/p>\n In addition, and linked to maintaining a viable payments system, the RBA “undertakes transactions in financial markets as part of its responsibility for the implementation of monetary policy, the provision of financial services to its clients and the management of its balance sheet”.<\/p>\n In this context, there was an interesting speech given by a senior official at the Reserve Bank of Australia (RBA) in Sydney yesterday (June 28, 2011) – Collateral, Funding and Liquidity<\/a>.<\/p>\n This speech seems to have excited a few conservatives out there.<\/p>\n First, there are two sides to a balance sheet – the liabilities side and the assets side. The RBA official argued that the global financial crisis:<\/p>\n \n… brought into sharp relief the liabilities side of a financial institution’s balance sheet, that is, the funding structure.\n<\/p><\/blockquote>\n In that context a number of large financial institutions failed or required massive bailouts because they could not fund themeselves. The RBA official noted however that the funding issues were symptomatic of the quality of their assets.<\/p>\n Yet in the public debate the focus is often on the liability side – and the RBA official singled out the ratings agencies for their recent ratings downgrades of Australian banks. In May, Moody’s downgraded the debt ratings of Australia’s four largest banks and claimed that it was due to their excessive dependency on international lending markets.<\/p>\n After the financial crisis, which restricted the supply and raised the cost of wholesale funds in global capital markets available to Australian banks, the banks shifted towards local deposits. In part, this was aided by the rise of the household saving ratio after a period of dis-saving associated with the credit binge that drove economic growth in the pre-crisis period but eventually burst as the sub-prime markets collapsed.<\/p>\n So a collateral effect of our national government running massive and increasing budget surpluses from 1996 to 2007 (bar one year) was that local banks were under greater pressure to obtain funds from abroad. Please read my blog – The role of bank deposits in Modern Monetary Theory<\/a> – for more discussion on this point.<\/p>\n In terms of the mad assessments that the ratings agencies are making at present, the RBA official said:<\/p>\n \nIn my view, the pendulum has swung too far in focusing on liabilities. Such a swing is evident in the proposed change to Standard & Poor’s ratings methodology for the global banking system. The proposed new methodology shifts the assessment of financial strength of an institution markedly towards funding and away from asset quality. Asset quality should still be paramount and should be given a far larger weight than liabilities in assessing financial strength, along with the extent of leverage (capital).\n<\/p><\/blockquote>\n All banking regulation should focus on the asset side of the balance sheet which relates to the “quality and value of its assets”. The liability side should not be the focus of regulators. The risk of bank insolvency can only really be assessed once we understand their capital structure and the assets that are supported.<\/p>\n The RBA official then said that with the financial crisis, banks were forced into what he called a “funding-driven world” because “(t)hey can no longer assume that the funding will be readily forthcoming at a given price”.<\/p>\n In this context, the “structure and maturity profile of liabilities” which essentially relates to the probability that bank liabilites “mature at a faster pace than assets” is worthy of analysis. Banks engage in a sequence of debt rollovers to keep their “funding” needs satisfied while holding longer-dated assets.<\/p>\n Clearly, the capacity to attract funds is related to the quality of the asset portfolio that the banks hold.<\/p>\n The Speech then entered headline territory and clearly excited some commentators.<\/p>\n The RBA official said:<\/p>\n \nIf a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral.\n<\/p><\/blockquote>\n So the central banks should be prepared to lend to private banks if they have strong assets even if their liabilities side is problematic. In assessing the desirability of lending to banks the central bank distinguishes between “illiquity” and “solvency”. A bank that is temporarily illiquid (that is, cannot raise funds in the private capital markets) may not be insolvent given their asset structure. The distinction relates to the matching difficulties embodied in the maturity transformation process that banks engage in noted above.<\/p>\n That is, liabilities are generally of shorter maturity to assets.<\/p>\n In this context, the RBA official said in relation to short-term liquidity issues that:<\/p>\n \n… it behoves the central bank to look through those uncertainties to the underlying asset quality of the institution under question, and be prepared to lend secured against quality assets if the situation warrants.\n<\/p><\/blockquote>\n When the “systemic uncertainty” increases (so banks will not even lend to each other in the interbank market) then the central bank has to ensure that financial stability is maintained and so they stand ready to provide whatever liquidity is required.<\/p>\n Operationally, the RBA lends to banks as a last resort at a rate “which is a small spread (normally less than 10 basis points) to the cash rate”. The cash rate is the current policy target rate.<\/p>\n The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance. In achieving this aim the central bank may: (a) Intervene into the interbank money market (for example, the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds.<\/p>\n In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.<\/p>\n Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. From the perspective of MMT, all these transactions are horizontal and net to zero.<\/p>\n Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. Prior to the crisis many countries (such as Australia) maintained a default return on surplus reserve accounts (for example, the Reserve Bank of Australia paid a default return equal to 25 basis points less than the overnight rate on surplus reserve accounts).<\/p>\n Other countries like the US and Japan did not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). As we will show presently, the support rate becomes the interest-rate floor for the economy. After the crisis emerged most central banks began to pay a return on reserves.<\/p>\n The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.<\/p>\n In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.<\/p>\n The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.<\/p>\n The central bank seeks to minimise the fluctuations in the interbank rate from its target policy rate. To achieve that aim the central bank supplies funds to the banks to ensure that the demand and supply of overnight funds is consistent with the current policy rate.<\/p>\n The central bank thus provides marginal lending facilities to the banks which are used to lend money at the discount rate to commercial banks (the central bank as lender of the last resort).<\/p>\n In this context the RBA official said:<\/p>\n \nEmergency liquidity provision would clearly need to be a higher rate than this, otherwise institutions would avail themselves of this source of liquidity even in normal times. That is, the central bank should be a last resort, not a first resort.<\/p>\n Within the Reserve Bank’s operating framework, a reasonable benchmark would be the rate charged on the standing overnight facility, which is 25 basis points above the cash rate. This facility is called upon at various times throughout the year, generally as a result of small unexpected technical hitches in the money market. For example, over the past financial year, it was utilised on two occasions, with a total of $363 million drawn, and for a term of no more than one day.\n<\/p><\/blockquote>\n He also noted that when there is a crisis, the central bank will provide the funds at a rate lower than the “market rate” for obvious reasons. So:<\/p>\n \n… the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding, a distinction which is often overlooked in such discussions.\n<\/p><\/blockquote>\n The central bank also may discount the “value of the collateral it is lending against” for its own protection in the event of a sudden collapse in asset values.<\/p>\n In summarising, the RBA official said:<\/p>\n \nFinally, to link back to the arguments I made earlier, I will talk briefly about concerns surrounding the extent to which Australian banks rely on foreign funding. If a liquidity issue were to arise around this funding, it is of critical importance that the foreign-currency denominated funding is fully hedged into Australian dollars, which indeed it is. This means that the liquidity issue is in Australian dollars rather than in foreign currency … The Reserve Bank can meet a temporary liquidity shortfall by lending Australian dollars against the stressed bank’s assets denominated in Australian dollars. The vast bulk of the Australian banking system’s assets are denominated in Australian dollars.\n<\/p><\/blockquote>\n In other words, the central bank ultimately guarantees that the reserves required to facilitate the payments system will be made available to the private banks. That capacity will typically not be drawn upon because there are penalties and collateral discounts applying.<\/p>\n As noted above, the RBA speech generated a reaction in the financial press today with one commentator accusing the central bank of behaving illegally.<\/p>\n In the right-wing Business Spectator article (June 29, 2011) – The RBA’s liquidity spin doesn’t wash<\/a> – (written by Christopher Joye) we read that:<\/p>\n \nFirst, Debelle acknowledges that the RBA’s liquidity services represent a direct subsidy from taxpayers to the banking system …\n<\/p><\/blockquote>\n Debelle was the RBA official (who by the way I taught at one time).<\/p>\n Once you read a conservative talk about taxpayers funding anything you know the commentator does not understand the operations of the monetary system. Please read my blog – Taxpayers do not fund anything<\/a> – for more discussion on this point.<\/p>\n But the claim by the Joye related to point made by the RBA official that I noted above – that the lending rate attached to emergency lending by the RBA “is still likely to be less than the market rate, as otherwise there would be no need for recourse to the central bank. Thus the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding.”<\/p>\n That just tells me that the central bank takes it responsibility for maintaining stability in the financial system seriously and is recognises that in times of stress the normal prices (rates) do not apply. Its charter is to ensure the payments system continues to function. As long as the asset side of the bank is sufficient to ensure solvency then the central bank’s operations maintain the “public good”.<\/p>\n The other point is that the central bank can make these loans by simply altering balances in the banking system. It can do that independent of the state of tax revenue at any time that it chooses. There is no relation between the RBA lending and treasury tax revenue.<\/p>\n Joye further claims that “lender of last resort” facilities mean that the central bank is providing funds to:<\/p>\n \n… banks that cannot fund themselves in the private markets – which Debelle fails to observe meets the legal definition of insolvency – the central bank performs a very odd social function indeed. In short, the central bank lifts itself above the ordinary operations of the Corporations Act and decides, in its unilateral judgement, which banks are insolvent and which banks are having what is euphemistically known as a “liquidity”, as opposed to “solvency”, crisis. I have written about this many times before. Under Australian law, there is no distinction: if you cannot meet your current liabilities, you are trading insolvent. Period.\n<\/p><\/blockquote>\n The legal framework may not be a good guide to how we should consider the public good of financial stability. Banks are particular institutions especially in a highly oligopolistic sector (as in Australia). If a small corner store operating in a relatively competitive environment goes broke some losses occur. Creditors lose, employees lose and consumers lose their local (and typically liked) supplier. But the contagion effects will be small. There is no “public good” element in such a business failure. The damaged entities are typically the business’s customers and suppliers. There may be a some extraneous collateral damage but it will be relatively small.<\/p>\n But as noted above, financial institutions are central to the functioning of the credit system which, in turn, impacts on the wider real economy. If a bank fails the consequences are likely to be significant.<\/p>\n Further, banks engage in “maturity transformation” – lending to us over long periods to buy homes, as an example but raising funds at shorter maturities. Other businesses also face this situation but on an attenuated basis.<\/p>\n So it is legitimate for the central bank to distinguish between illiquidity (a temporary problem) and insolvency (a failure of assets plus capital to cover liabilities). The first problem can be easily overcome by the lender of last resort facility. The latter suggests bankruptcy.<\/p>\n Joye’s take on the “maturity transformation” problem facing banks (the conversion of “short-term savings into long-term loans”) is suggestive of a:<\/p>\n \n… fundamental business flaw: if we ever demand those savings back, the bank may not be able to repay us. Hence the need for ‘central banks’, which have been established in developed countries around the world to furnish public sector liquidity support to failing private banks.\n<\/p><\/blockquote>\n The point he is making seems like a non-point. Central banks were created to maintain financial stability in a unified currency system. All sorts of strange events (like us all withdrawing our savings) might occur but do not because the institutional structure with the central bank at the apex (with all the currency capacities according to it because it is part of the consolidated government sector) creates confidence.<\/p>\n I also noted Joye trying to claim authorship of a concept – that financial stability (including the provision of liquidity) is a public good. He says:<\/p>\n \nAs a final point, Debelle makes the case that “the central bank’s provision of liquidity can be regarded as a ‘public good'” referencing a 2008 paper by two RBA economists. This seems symptomatic of an RBA tendency of avoiding appropriate referencing of third-party work if that material does not originate from within its central banking orbit.<\/p>\n The policy concept of liquidity as a public good was first outlined formally in Australia in a Melbourne Business School paper published by Professor Joshua Gans and myself in early 2008. Fortunately, this paper was referenced by the two RBA economists that Debelle footnotes.\n<\/p><\/blockquote>\n I note that Warren Mosler and myself wrote a public submission in 2002 which was part of the Review of the Commonwealth Government Securities Market<\/a> conducted by the Commonwealth Treasury.<\/p>\n