February 19, 2020
Daniel K. Tarullo, Harvard Law School
To be honest, I have always been a bit bemused by the longstanding theoretical debate as to whether banks are best understood as money creators or financial intermediaries. As in the explanations provided in the introductory chapters of most banking law casebooks, I have assumed that deposit-taking banks are a particular kind of financial intermediary whose lending does increase the aggregate money supply (i.e., they rarely get to keep the money they “create”), but that they are constrained by some combination of their credibility, solvency, and applicable regulatory requirements, as well as the growth of the monetary base. At least three of these constraining factors implicate, among other things, a bank’s funding capacities, importantly including its ability to attract and hold deposits.
As a purely practical matter, I have also been puzzled as to why those traditional deposit-taking, transaction account-creating institutions known as commercial banks should command so much attention right now. The financial crisis revealed flaws in monetary policy and serious deficiencies in financial regulation. But it’s hard for me to see either set of problems as especially attributable to the peculiar money-creating feature of commercial banks.
As to monetary policy, it is absolutely the case that most of the pre-crisis macroeconomic models used by central banks (and by most non-governmental economic forecasters) essentially excluded a role for financial markets and firms in affecting economic output. Credit was implicitly assumed to flow more or less mechanically from changes in interest rate policy and other conventional variables such as employment. As a result, the models badly underestimated the depth of what eventually became the Great Recession.
But the features of financial markets that led to this outcome are by no means limited to commercial banks. Loss of confidence by funders, general uncertainty on where the bottom would be for asset prices, declines in capital to dodgy levels, and hoarding of liquidity by financial firms experiencing the preceding developments all contributed to a contraction of credit substantially greater than what the models predicted. If one had to pick a single feature of the crisis that best reflected its severity factor, it would probably be the near freeze in wholesale funding markets. While some larger commercial banks were significant borrowers in these markets, the then free-standing investment banks such as Bear Stearns and Lehman Brothers were so dependent on these markets that they could not survive the investor pullback.
The crisis was, in the first instance, a funding crisis that began by starving large intermediaries and ended up denying credit to households and non-financial businesses. The disappearance of wholesale funding was the push that set the row of dominoes falling. And, as suggested by Howell Jackson’s post in this symposium, it was the failure to anticipate the virulence of the disintermediation that accounted for the sizeable forecast errors.[1]
A similar point can be made about financial regulation. There is no question but that many commercial banks were inadequately capitalized in the years preceding the crisis. But while hundreds of banks failed during and after the crisis, and hundreds more survived only because of federal government support, the commercial banks closest to the heart of the crisis were those that involved themselves substantially in capital market activities, as through the creation and/or support of special purpose vehicles used to securitize and then sell bundles of mortgages. Again, the proximate cause of the crisis was the run on wholesale funding, the very lifeblood of the shadow banking system. This was intermediation gone wrong with a vengeance.
The distinctive deposit- (and thus money-) creating feature of commercial banks thus seems to have been considerably less important to the evolution and destabilization of credit markets than the manifold variations on intermediation that have been loosely characterized as shadow banking. Commercial banks’ share of lending in the U.S. economy has been in decline for decades. In fact, one could make a case that it is the relative decline, rather than the potency, of commercial banks that has contributed to contemporary challenges for both monetary policy and financial regulation. The growth of shadow banking in the decade or two preceding the crisis constituted a major such challenge.
As has often been pointed out, the U.S. banking system was quite stable and reasonably profitable in the forty years following the New Deal banking and deposit insurance reforms. Then occurred what today we would call a disruption of the banking industry by a combination of macroeconomic turmoil, increased international and non-bank competition, and – in what was at least partially a response to these factors – deregulation. These changes together fractured the regulatory system established in the 1930s.
The culmination of thirty years of deregulation was the Gramm-Leach-Bliley Act of 1999. That legislation cleared away the vestiges of the Glass-Steagall separation of commercial and investment banking, thereby accelerating the integration of capital market activities with conventional lending that was already underway and had already put pressure on traditional commercial banks. Yet neither that law nor the financial regulatory agencies put in place a new regulatory regime that responded to these fundamental changes in financial markets. To my mind, at least, even the important post-crisis regulatory reforms have only partially responded to the new, and still evolving, circumstances. At least one of the changes redirects us to the subject of “money creation,” though not of the sort associated with deposit creation by commercial banks.
“Shadow banking” refers not simply to the functions of credit intermediation and maturity transformation, but also to the creation of assets that are thought to be safe, short-term, and liquid. As such, these instruments were considered “cash equivalents” similar to insured deposits in the commercial banking system – similar, that is, to “money.”[2] The years preceding the financial crisis saw a surge in the volume of dollar-denominated, seemingly safe, seemingly liquid financial instruments – short-term debt backed by collateral. Both a rise in the demand by investors for safe, liquid assets as tools for precautionary or transactional liquidity and a rise in demand for short-term financing by financial intermediaries looking to fund longer-term assets played important, probably reciprocally reinforcing roles. The result was explosive growth in a number of variations on this basic theme – including money market funds, repo, and securities lending.
Reliance on private mechanisms to create seemingly riskless assets generally worked in the relatively calm years leading up to the financial crisis. But then a series of shocks to some of the key assets backing the money-like debt called into question both the value of collateral and the viability of the entity borrowing against that collateral. In many cases, discretionary back-up support provided by the creators of those instruments or the sponsors of special purpose vehicles that had created them was key to the assumption that the instruments were effectively cash. As financial-market stress became more acute, questions arose about the ability or willingness of large financial institutions to follow through on their implicit commitments, precisely when this was needed most. Investors were reminded of their potential exposure, leading to the sometimes-disorderly flight that crippled wholesale funding markets. The unwinding of this illusion of risklessness helped transform a dramatic correction in real estate valuations – which itself would have had serious consequences for the economy – into a crisis that threatened the entire financial system. Just as those liquid assets were treated as near-cash when created, the disappearance of this liquidity from the market bore some resemblance to the removal of cash from an economy at its most vulnerable moment.
The crisis itself reined in some of the more obvious excesses of short-term funding in general, and of certain forms of cash equivalents in particular. Some of the elements of the post-crisis regulatory program also addressed these funding issues: Changes in accounting and capital rules rendered much more expensive bank support for special purpose vehicles and some other shadow banking mechanisms. Liquidity regulation placed constraints on the use of short-term, money-like funding by banks themselves. But there was by no means a comprehensive approach to shadow banking and wholesale funding, especially that which occurs outside the perimeter of prudentially regulated banking organizations. With the apparent disinclination of current regulators to take any steps to address emerging vulnerabilities, the potential for further problems is growing (though, as of this writing, has not yet gotten to critical levels).
What response might be warranted to the continuing regulatory lacunae? My thought is that there should be two components. First, the Dodd-Frank Act’s authority for prudentially regulating non-bank financial institutions whose activities or failure pose systemic risk needs to be resurrected. Trump Administration appointees have come close to saying they will never designate any firms, opening the way for latter-day AIGs to threaten the entire financial system. Second, vulnerable forms of maturity transformation should be subject to appropriate regulation no matter where they are found. Where there is substantial reliance on short-term funding for such transformation, risks are likely to be present. Those risks will be greater to the extent that the maturity transformation also entails significant leverage. There need not be a homogeneous “bank like” regulatory framework, since the asset/liability mixes of different forms of intermediation can vary a good bit. Some relatively straightforward measures like minimum margining requirements for all securities financing transactions would be a good start and would, not coincidentally, be directed at the money-like assets being created in these transactions.
To return to the debate that has occasioned this symposium, I don’t know how much does, or should, turn on the side one takes. I noticed that several of the contributors who identify themselves as holding the money view range well beyond the money-creating feature of deposit creation in their concerns with financial policy – an instinct with which I am obviously sympathetic. And, while some who hold the money view criticize Tobin’s embrace of the intermediation view expressed in his well-known 1963 paper,[3] I would draw attention to his subsequent writing. Not only did he freely characterize demand deposits as “inside money,” in recognition of the fact that banks were a special kind of intermediary.[4] More importantly, he advocated for some pretty robust regulation precisely because of the risks associated with the particular form of intermediation represented by the commercial bank business model.[5]
I hesitate to ascribe such a longstanding debate to semantics. It’s definitely more than that. But I wonder whether there is more common ground than may first be apparent. As a former regulator, I have been concerned that we lack a regulatory mechanism to capture all financial activity in which cash-like assets are created, whether that activity is conducted by traditional commercial banks, non-bank parts of bank holding companies, or firms not currently covered by prudential regulation. What I hope can unite all views in this discussion (this is not really a simple two-sided debate) is attention to the systemic effects of maturity transformation and liquidity creation wherever it may be found in financial markets and firms.[6]
One final note — as alluded to by Charles Kahn in his contribution to this symposium, and as discussed in growing economic and legal literatures. The emergence of digital currencies and increasing involvement of Big Tech companies in payments systems together raise the prospect of another disruption of financial markets, again with the potential for significant impacts on monetary policy and financial stability. The challenge to the business model of depository institutions – especially smaller banks – may be even greater than that posed by shadow banking. Again, though, the focus should be on the liquidity and credit-creating machinery of these financial innovations, and on the existence and development of regulatory authority to protect against threats they may pose to financial stability.[7] If digital currencies could (as they have not to date) replicate one or more of the three core attributes of money, there might even be a more fundamental challenge to the prevailing circumstance in which political authority has the ability to exercise control over money creation.[8]
[1] For a complete review of the failings of pre-crisis “workhorse” macroeconomic models, see Ben Bernanke, The Real Effects of the Financial Crisis, Brookings Papers on Economic Activity 251 (Fall 2018).
[2] For a formal discussion of the treatment of shadow bank debt as money, backed with empirical evidence, see Adi Sunderam, Money Creation and the Shadow Banking System, 28 J. Fin. Intermediation 939 (2014).
[3] James Tobin, Commercial Banks as Creators of “Money,” Cowles Foundation Working Paper 159 (July 24, 1963).
[4] James Tobin, Financial Innovation and Deregulation in Perspective, Bank of Japan Monetary and Economic Studies, Vol. 3, No. 2, at 19, 23 (Sept. 1985).
[5] See especially his paper at the 1987 Jackson Hole Symposium: James Tobin, The Case for Preserving Regulatory Distinctions.
[6] When Morgan Ricks called his book The Money Problem, he did not limit himself to the money-creating function of bank deposits. On the contrary, he was most concerned with drawing attention to the range of other liquidity-creating institutions and instruments, to some of which I have referred in the text.
[7] This, of course, in addition to the securities law, consumer protection, and money laundering issues that have already commanded a good deal of attention.
[8] For a review of how the state progressively exercised more control over money, and a discussion of how private digital currencies could reverse that historical trend, see Barry Eichengreen, From Commodity to Fiat and Now to Crypto: What Does History Tell Us?, NBER Working Paper 25426 (January 2019).