Public Bank Lending

In my previous article, I discussed (traditional) postal banking, in which the central government manages a deposit-taking bank (which historically used post offices as “bank branches”). Postal banks offered basic payments and savings services for poorer people who were ill-served by private banks.

In my view, the usefulness of such banks depends upon conditions in the country. It may be just as easy to mandate private banks to offer minimal standards of service without the challenges of attempting to replicate the information technology investments required. In countries where private banking has spotty coverage, such banks may be useful.

Postal Savings Banks

Postal savings banks are a venerable form of public banks. They were traditionally aimed at providing payment and savings options for the broad public — they were not banks providing a full range of lending services. Instead, they recycled deposits into the bond and money markets, mainly investing in central government bonds. The “neoliberal” trends since the early 1980s resulted in these institutions being weakened or even privatised. In addition to the political shifts, the rise of digital computing raised the level of expected services in most countries.

This is an unedited draft section of my banking primer. My inflation manuscript is looking at Brent Crude price charts and sobbing.

Bond And Loan Financing

In an earlier article, I did an over-simplified discussion of how a local public bank would interact with municipal bond issuance. There was some ambiguities that I skipped over in order to keep things brief. This drew a variety of questions, and so it is clear that I need to expand on what I wrote.

Since these articles are expected to be bound into a banking primer manuscript, I was going to need to cover some of these basics long before I got to a section on public banks. But I will cover the basics herein, and not worry about the manuscript logic. There are also some assertions about technical issues which I would have to reconsider and dig into if they stay in the manuscript.

Public Banks And Municipal Bonds

Tyler Suksawat and Scott Ferguson recently published “Reclaiming the Public Interest: Cities Should Sell Municipal Bonds to Their Own Public Banks.” The lengthy title sums up the argument well. In this article, I want to offer my comments on this topic. My feeling is that the scope for such purchases are necessarily limited, and so one cannot expect an immediate revolutionary change. To the extent that sub-nationals can boost their finances, I think the model of la Caisse de dépôt et placement du Québec (“la Caisse,” disclaimer: my old employer) is more viable (at the state level in American terms).

Fed Balance Sheet Unwinding

I ran across this article by David Beckworth that discusses the issues with the reduction of the Fed’s balance sheet (called “Quantitative Tightening” or QT). The issue raised is not one that I spent much time thinking about: the previous expansion of the Fed’s balance sheet (“Quantitative Easing” or QE) has led to behavioural changes in banks (and their clients) as well as regulators.

The Credit Cycle

I finally have my kitchen back, and now can devote more time to writing and consulting. I am still pushing another project, so my output here will probably be limited. I have taken another look at my bank primer project, and realised that I have too much content — I will need to trim back the theoretical wrangling texts that I previously wrote. With today’s article, I think I have covered most of the content I want to be in the book, although I might stick in some cursory analysis of a few different banks’ balance sheets. For example, I might compare some teeny-tiny American bank versus larger European or Canadian banks as a way of indicating the dispersal of what “banks” are. This article has only been lightly edited.

If the economy was in a stable equilibrium dominated by agents forecasting their cash flows out to infinity, defaults would be a random process – defaults would occur, but without a pattern to them. Default risk would be an insurable risk (i.e., could be managed by actuarial calculations like life insurance). However, the existence and popularity of the term “business cycle” indicates that the flows of commerce are cycle – and defaults follow the business cycle. During an expansion, banks do face a persistent relatively low level of defaults and delinquent loans, which does accord with being a random, insurable risk. The problem is recessions – which see a spike in defaults. Although it is possible for there to be a recession without a default spike (as discussed below), the “interesting” recessions are the ones with default spikes. The “really interesting” recessions are the ones where the banking system itself joins in on the default trend.

Primer: Introduction To Credit Spreads

After a hiatus resulting from various disturbances, I am back with another book manuscript section. I just reworked this section, and hopefully did not introduce major issues into it. However, I wanted to get this out before next week. Right now, my main concern in life is getting my kitchen sink back.

This section introduces credit spreads from a bond pricing perspective. Looking at bonds is not completely inappropriate, as banks do hold bonds in their liquidity portfolio. The illiquid loans on bank balance sheets can be analysed in the same way, albeit bankers might use different terminology.

Wholesale Payments Systems and Bank Reserves

Status update. I had to take an unplanned trip, while at the same time starting a new consulting project. I focussed on the project before I left, and I now have some time to do some writing while away from home. This is the latest instalment of my draft manuscript, which is a brief discussion of wholesale payments systems. I might beef up the discussions further. International payments is another variant topic, but I may shy away from opening that can of worms.

Wholesale payments systems are the glue that ties the banking system together. These systems allow banks to make monetary transfers to each other – either on their own account, or on the behalf of clients – quickly and more importantly, safely. The payments system allows bank clients to transfer money electronically to one another without worrying about the exact mechanism for the transfer.

Bank Credit Risk Management

This article is an unedited draft section from my banking manuscript. It finishes off the chapter on risk management.

The focus of this book is on how bank lending and liquidity flows interact with the wider economy. So long as credit losses remain at acceptable levels, they do not interrupt those flows. Given that the focus is elsewhere, this section will just offer a high-level perspective on how banks manage credit risk, without attempting to discuss what strategies individual banks use to analyse credit risk. Although this section will mainly refer to lending decisions, liquidity provision to capital markets participants also requires credit risk analysis.

Primer: Bankruptcy

This article is a draft section from my banking manuscript. It fits into a chapter on bank risk management. This article is an introduction to basic bankruptcy procedures, which needs to be understood before worrying about how banks manage the risk of their customers defaulting. This version of the section includes some text about bank resolution procedures that was previously published (but modified here).

Primer: Currency Risks For Banks

Yet another unedited section from my banking primer manuscript. My feeling is that this section is packing in too much information, and might be trimmed. The technical appendix may be too technical, but I will look at that later.

Although the major banks have global operations and currency trading is a massive financial market, this book largely ignores the complications created by banks operating in multiple currencies. The first reason is that the author has no useful experience in that area. The second is that currency risk is not a significant source of risk for well-managed banks. If a sensible bank is operating in two currencies, it is best understood as two banks operating in one currency, with one bank acting as parent. (From a regulatory perspective, the fact that the home base is in a different jurisdiction matters, but this text is not delving deep enough into details for that to be a concern.)

Currency risk is defined as the risk of generating losses based on changes to the exchange rate between two currencies (i.e., the price of a currency in terms of another). Currency risk is not the risk associated with a bank relying on transferring funding from one currency to another. This cross-currency financing risk was a major factor in the 2008 Financial Crisis, but it is not “currency risk” as it understood from a risk management perspective. This distinction matters because there is considerable folklore about banks running currency risks, and the people spreading that folklore make the mistake of treating the cross-currency financing risk as being a currency risk.

Primer: Bank Interest Rate Risk

Interest rate risk refers to the potential for losses due to the movement of the risk-free curve, which is largely driven by the central bank policy rate and its expected future path. One might also use a yield curve based on the main banking reference floating rate used in the jurisdiction. When LIBOR was the reference rate, the curve would be derived from LIBOR fixes, short-term interest rate futures and LIBOR swaps. This curve traded relatively close to the governmental yield curve (e.g., U.S. Treasurys), but there was a spread between them. Regardless of which curve is used, changes in the spread between those high-quality curves is dominated by the changes in the level of either curve.

Primer: Bank Liquidity Risk

This article is an unedited draft from my banking primer manuscript. It probably needs more work, but I will not be able to look at again for awhile.

One of the main economic functions of banks is providing liquidity to other actors – i.e., ensuring that clients can get funding on short notice. Banks are only able to do this by themselves carefully managing liquidity risk. Although the central bank can bail out the banking system if something goes horribly wrong, the expectation is that private banks should manage liquidity risk on their own.

Balance Sheets Of Financial Firms

This article is an unedited draft of a section that would go into the introductory chapter of my banking manuscript. It is somewhat of a placeholder, and I may want to add more information (e.g., have a table that is an actual balance sheet). Given the nuisance value of setting up tables, I will not worry about that until much closer to publication.

This section is an introduction to what balance sheets are, with an emphasis on financial firms. It will also cover some of the jargon used in this text. If the reader is completely unfamiliar with accounting, it may be necessary to supplement this material with other primers. The focus on this text is the economic principles of banking, and not the highly specialised accounting used in the industry.

Self-Funding And Financial System Fragmentation

This is an unedited draft for my projected banking manuscript. It might be an idea to embed some of this content into earlier articles that discussed the self-funding nature of the banking system. Although I planned to do a different article first, I decided to add this discussion in response to some reader feedback.

When discussing the self-funding nature of the banking system, the risk is that my arguments may suggest to some readers that a bank can make whatever loans it wishes without ever worrying about funding. I was conscious of this comprehension risk when setting out my examples — I tried to emphasise the practical limits of what the bank can do. However, readers might skip over the numbers, or might just see out-of-context quotations of what I write. Rather than bury everything I previously wrote under a layer of waffle, I want to break out the concerns herein into a stand-alone discussion.

Self-Funding And Deposit Hoarding

Once again, this is an unedited draft of a section that would go into my banking manuscript. It follows onto the previous example.

In the extended example of how new bank loans are self-funding when we look at the entire financial system (including bond markets), one might attempt to critique it based on the idea that the depositors that are the recipients of spending that is financed by new bank loans (which creates deposits that are transferred) might hoard the deposits — preventing re-circulation back to the bank that extended the loans. (Alternatively, recipient banks might hoard reserves.) Such criticisms might seem plausible since the example uses convenient numbers to make life easier for the writer/reader — what happens if behaviour is different?

Bank Self-Funding Example

This is a potential section for my banking manuscript. It probably needs some diagrams, but I do not want to spend too much time on them if they end up not being used.

One way to get a better handle on the mechanics of the overall banking system is to work through an example that includes some of the important features we want to capture, but avoiding extraneous details. The example I am using has the following features.

Banks, Intermediation, And Pass-Throughs

This is a topic that is of interest for my book on banking. It may overlap some existing texts written some time ago (which is creating a future editing problem). Note that I refer to “this book” which should be read as “previous articles scattered around on my Substack.”

A somewhat arcane point of debate is whether banks are “(financial) intermediaries” or not. The reason why this is supposed to matter is whether banks exist to match savers or borrowers, or whether they “create saving.” From my perspective, the problem is the term “intermediary” as it is too vague, and should be replaced by the somewhat less common term “pass-through entity.” This is yet another example of how heterodox/orthodox economic debates have drifted into terminology disputes over decades. I will first explain the debate as I see it, then touch on the debate as framed by others.

Asset Allocation And Banking

Note: This article would hopefully be worked into my banking manuscript. I think it overlaps other article(s), but I wanted to see how this line of argument looks. Needless to say, I have no put the articles into a single document…

One of the difficulties with understanding banking is that one needs to use relatively complex macro models to see how the formal banking system interacts with the non-bank financial system. Analysis based on looking at the motivations of a single bank or based on models where only the formal banking system exists will be misleading. Stock-flow consistent (SFC) models are one of the few attempts at such a modelling framework.

The Central Bank And Government Finance

This article continues the sequence of articles on central banks as banks. This article was as brief as possible since it overlapped my book Understanding Government Finance (available for sale cheaply at online bookstores, and I emphasise that it would be an amazing Christmas present for friends and/or enemies (depending on what you think of my writing)). I might need to expand upon the less obvious points herein if this text does get into my book manuscript.

Central banking largely evolved the way it did due to the exigencies of wartime finance. The central government needs control over its financial operations in wartime, and any attempts to interfere by the private sector would be viewed as akin to sabotage. For a free-floating sovereign (and currency pegs are typically broken during major wars), the system guarantees that the financial flows will continue to flow.