Fixing the small banks

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Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.


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27 Responses to Fixing the small banks

  1. Offshore Company says:

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  2. acudoc says:

    In all of these discussions by monetary experts, the underlying assumption is that a money supply needs to be controlled by a cadre of experts. I don’t accept this assumption, preferring to revert to the Austrian School of economics and its understanding that money, chiefly in the form of gold and silver, arose naturally in the course of history as the preferred medium of exchange, and that interference in that system by fraudulent banks or fraudulent governments sabotaged its workings.

    Nowadays, so-called experts are quick to denigrate a pure gold standard and encourage one theory or another in which a fiat standard is manipulated constantly to achieve some set of policy objectives, none of which have been accomplished in the last 100 years, yet the machinations continue unabated, probably until the world division of labor is destroyed by these same experts.

    Hugo Salinas Price, not an economist with an advanced degree from an Ivy League school, only a mere Mexican billionaire businessman, has correctly analyzed the financial problem, in my opinion, in a short and sweet, easily understood essay:

    Even the monetary experts at the world’s central banks will eventually protect themselves through some kind of a gold standard, all the while urging the rest of us indentured servants to continue to use their expertly managed fiat currencies.



    you can’t hold the price of gold constant without periods of high unemployment which represents massive real losses.

    with fiat you can sustain full employment at all times, for all practical purposes, with a JG and by simply by counting bodies in the jg pool and making fiscal adjustments


  3. MamMoTh says:

    Why isn’t this post in the Proposals or Mandatory Readings section? It should be.


    MamMoTh Reply:

    ok, how could I miss it? My mistake.



    no, michael just changed it, thanks!


  4. Richard Benson says:

    Goldman’s offshore deals deepened global financial crisis

    A look at Goldman’s shadowy offshore deals.

    NEW YORK — When financial titan Goldman Sachs joined some of its Wall Street rivals in late 2005 in secretly packaging a new breed of offshore securities, it gave prospective investors little hint that many of the deals were so risky that they could end up losing hundreds of millions of dollars on them.

    McClatchy has obtained previously undisclosed documents that provide a closer look at the shadowy $1.3 trillion market since 2002 for complex offshore deals, which Chicago financial consultant and frequent Goldman critic Janet Tavakoli said at times met “every definition of a Ponzi scheme.”

    The documents include the offering circulars for 40 of Goldman’s estimated 148 deals in the Cayman Islands over a seven-year period, including a dozen of its more exotic transactions tied to mortgages and consumer loans that it marketed in 2006 and 2007, at the crest of the booming market for subprime mortgages to marginally qualified borrowers.

    In some of these transactions, investors not only bought shaky securities backed by residential mortgages, but also took on the role of insurers by agreeing to pay Goldman and others massive sums if risky home loans nose-dived in value — as Goldman was effectively betting they would.

    Some of the investors, including foreign banks and even Wall Street giant Merrill Lynch, may have been comforted by the high grades Wall Street ratings agencies had assigned to many of the securities. However, some of the buyers apparently agreed to insure Goldman well after the performance of many offshore deals weakened significantly beginning in June 2006.


  5. Winslow R. says:

    “I think this scheme would still require citizens to move their deposits out of the commercial banks and into this state sponsored bank?”

    The State would likely move their deposits but I don’t see why citizens would move their deposits. Even so it would be of no concern to State policymakers?

    The main purpose is to find an entity, outside of New York, that can credibly raise capital. I’ve heard the reason the federal government tries to keep the State government weak is so the State Governor will have a difficult time running for election against the State Senator ( so much for Mosler’s per capita State rebates). Yet if the State Governor position was made stronger, the State Senator might rather run for State Governor than stay in Wash. DC.


    Winslow R. Reply:

    The timing of this was eerie, perhaps North Dakota’s Dorgan should run for State Governor.

    Dorgan says he will not seek re-election in fall.

    “Dorgan’s decision stunned members of his party, who control the Senate but are facing spirited challenges from Republicans in several states. Democrats were confident heading into the new year that Dorgan would run for re-election even as rumors intensified that Republican Gov. John Hoeven would challenge him in November.”


  6. Winslow R. says:

    interesting article

    “North Dakota is the only state in the union to own its own bank.The Bank of North Dakota (BND) was established by the state legislature in 1919 specifically to free farmers and small businessmen from the clutches of out-of-state bankers and railroad men. The bank’s stated mission is to deliver sound financial services that promote agriculture, commerce and industry in North Dakota. ”


    Matt Franko Reply:

    That sounds like a good idea for the states to look at.

    But I dont know if I agree fully with the authors’ statement:

    “The savings and loan model collapsed completely in the 1980s. Since then, all banks have been allowed to create credit as needed just by writing it as loans on their books, a system called “fractional reserve” lending. Banks can do this up to a certain limit, which used to be capped by a “reserve requirement” of 10 percent. That meant the bank had to have on hand a sum equal to 10 percent of its outstanding loans, either in its vault as cash or in the bank’s reserve account at its local Federal Reserve bank. But many exceptions were carved out of the rule, and the banks figured out how to get around it.”

    Reads like she is ignoring the liability side such as deposits? I think this scheme would still require citizens to move their deposits out of the commercial banks and into this state sponsored bank? thus perhaps causing “bank runs” on the commercial banks as depositors move their money into the state bank, which is something policymakers are trying to avoid…Resp,


  7. warren mosler says:

    more like people feel ‘safer’ at JPM or have reasons to keep balance there. and money center banks have different requirements regarding retail deposits, last i saw.

    but yes, it’s a problem for most all banks


  8. Ramanan says:


    So you are saying that:

    Small banks have deposits and customers move deposits all around for payments. The size of the bank becomes important here. The bigger the size, the more easier is it to attract deposits (without active involvement) and the other side is that smaller banks have a higher chance of losing deposits. Because of reserve requirements, this increases the cost of reserves for smaller banks and they need a higher “markup” for loan pricing to make profits which is even worse for them.


  9. Richard Benson says:

    Believe it or not, up until earlier this month, FHA, Freddie Mac and Fannie Mae had been granting loan approvals to borrowers who were spending 55 to 65 percent of their gross income on their house payments. Not anymore. Borrowers are now restricted to spending no more than 45 percent of their income on their house payment or up to 50 percent with compensating factors like lots of cash in reserve or large down payments.

    Mortgage industry guideline changes for 2010


  10. Floccina says:

    In your model why would the banks run our checking accounts? Would the banks start to charge us a realistic fee for managing our accounts?

    BTW in an ideal Post-Keynesian monetary system is there any reason at all for National governments to borrow money by issuing debt?


    warren mosler Reply:

    no reason for gov to issue secs with a non convertible currency and floating fx.

    the fed is responsible for setting up and managing the payments system and calls the institutions that run the checking accounts banks.

    hard to say about fees


  11. warren mosler says:

    yes, income and net financial assets from public sector net spending (tax cuts and spending hikes) are ‘replacing’ private sector debt, and thereby working to restore output and employment.

    That’s what demand management is all about. Just need to do a lot more of it.


  12. Richard Benson says:

    Laggner: We could have isolated the money centers and put them in temporary receivership. Then, we could have created — with a mere $100 billion — a thousand community banks. If you believe in fractional reserve lending [in which banks lend multiples of their deposits], something we don’t support, they could have created a trillion dollars in new credit that would have flowed to small and medium-sized businesses. Those are the parts of the economy that are choking. Because there has been no reform, it looks like we are going to be spending more money. We are going down this very treacherous path, where debt continues to skyrocket. Private-sector debt is being offset by the public sector. Meanwhile, the cost of funds for small and medium-sized businesses has gone up, while the cost of borrowing for the survivors is little to nothing, and they are speculating with that money, as opposed to letting it flow through into the real economy.


  13. warren mosler says:

    thanks guys, all good posts!


  14. JKH says:

    The overall risk framework makes perfect sense as such.

    It’s also interesting to ponder the potential effect on the overall flow of funds:

    Simplifying the world to one of small banks and big banks, the default outcome would be a full intermediation sequence that includes expanded Fed lending to small banks, expanded deposits at big banks, and expanded excess reserves held by big banks. It’s ironic that the big banks would serve a useful social purpose by being deep in the loop in “funding” the small banks.

    I suppose the government could choose to take out some of the resulting excess reserves by issuing debt. But I assume you think that wouldn’t be necessary. The default configuration seems parallel to your longer term idea of allowing the deficit to be “funded” entirely through the banking system via excess reserves at zero natural rate of interest.


    JKH Reply:

    government debt such as CB system reverses, now that they’ve completed their testing :)


  15. Tom Hickey says:

    Brilliant post, Warren. Thanks for explaining this so clearly. I was not aware of how this affected small banks.

    I had been wondering why the Fed was not being used as lender of last resort like this instead of pursuing the obviously failed monetarist policy they are still committed to. My conclusion was that it was due to ignorance resulting from intellectual capture or they were just trying to build confidence. I find it hard to believe that the people in charge of Fed operations would not know this and wouldn’t explain it to the chairman if he didn’t realize it.

    Another point is that the bias of the banking system toward the small group of large (TBTF) banks puts small banks at a disadvantage in a variety of ways. Another thing that the government could do for small banks is to reform the banking system to create a more level playing field. Although this is not a short term solution, it should not be put off any longer and it should have been done when it was possible to make a deal with the oligarchs when they were facing insolvency. The political will is waning for this, but it still isn’t too late, given the level of public outrage.

    I think there is also another element at work in the overall monetary picture in addition to the fact that most people have no idea of how banking works operationally. There seems to be a lack of awareness that especially in a fiat system in which the government is the monopoly provider of the currency of issue, this provision is not only a prerogative of the sovereign government but also a responsibility.

    Money is a public utility that is provided to advance public purpose, e.g., facilitate commerce, sustain unemployment, etc. This means that the government has the responsibility to provide the necessary for national prosperity, i.e., economic efficiency, where nominal aggregate demand remains in balance with real output potential, so that there is neither a glut of money (inflation) nor a shortage of money (deflation and rising unemployment).

    Many people erroneously think that everything would be fine if only the government would just go away. A lot of popular thinking in this regard is based on the false idea that the economy produces “wealth” and government takes some of this wealth away from its rightful owners through taxation (and borrowing is future taxation) in order to spend (redistribute) it. This is the basis of many of the myths that have become political shibboleths, such as “sound money,” “fiscal responsibility,” and “pay as you go.”

    Until the government and people understand the actual role of money in the society as the “grease” of the economy and how it is the government’s prerogative and responsibility to provide the proper amount of it depending on changing economic conditions, the country and world will have a difficult time arriving at economic efficiency, optimizing output, and maximizing employment, along with price stability.

    It is obvious that a fiat currency has no intrinsic value other than paper, ink and the imprinted design. On these criteria, the design of a $1 note might be of greater value that a $100 note. The value of the currency lies in its use value. This is economic value as a medium of exchange rather than any real value as such. Anything would serve as long as the government accepted it at its payment offices. However, modern societies have found it most efficient to make the sovereign government the monopoly provider. That entails that money provision is a public utility that is central to the working of the economy.


    Floccina Reply:

    “However, modern societies have found it most efficient to make the sovereign government the monopoly provider. ”

    But that means that this non-intuitive thing, the monetary system is run by the median voter. I have been reading here and about free banking trying to learn. Surprisingly Warren and the free banking scholars seem to be saying a lot of similar things but free banking would not rely on educating the median voter about this difficult to understand topic. It is too easy for an ambitious politician to scare up votes by waving the deficit around and I fear that it will always be.


    Greg Reply:

    I concur with everything in your post Mr Hickey

    Its funny that you use the word “grease” as a metaphor for money Tom. I’ve thought about it the same way after contemplating much of what Ive learned at this site and over at “billy blog”.

    I really think our metaphors for money are at the heart of the political and economic debates.
    These do not change easily but I know mine has changed over the last few months. It seems the Austrians at heart dont want to fool with metaphors at all, they want money to be gold and gold to be money…………PERIOD! A nice easy to understand world where value (of money anyway) is pre defined. Monetarists seem to harbor the desire to live in a gold standard world without a gold standard. Recognizing the limitations on a gold standard in todays world they try to have a price for money .Both those schools of thought seem to treat money as something to covet in and of itself rather than using money as a means of maximizing the flows of potential goods and services.

    Somehow it seems we have to squelch the hoarding instincts involved with money because it seems to me this is counterproductive and deflationary, so separating money from some intrinsic worth would seem to be a step in the right direction.

    Saving for the future is far different from hoarding and it is imperative that we encourage one while discouraging the other.


    warren mosler Reply:

    the currency/monetary system is the tool that supports the public purpose of moving real goods and services from private to public domain.

    without it the public sector would have to find some other means of provision, such as a command economy.


    Curious Reply:

    Or a different currency/monetary system.

    The US states, counties and cities have no problem moving real goods/services from the private to the public sector and yet, none of them issue any currency.

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