Whatever you think about the Bank of England’s behaviour over the crisis, the quality of its publications and speeches has been exemplary.  The Financial Stability Report and Inflation Report are essential reading, while the speeches tend to highlight important and often complex issues better than I have read elsewhere.

For those of you who like to see the Financial Crisis in Manichean terms*, such publications are bad news: they show you so much about the systemic fragilities that the soaring language of good, evil, injustice and so forth can seem somewhat silly afterwards***.   For example, ‘The Role of Macro Prudential Policy’ has a wonderfully succinct taxonomy of the ways that rational economic activity can sum up to systemic fragility; how we can all be doing our jobs correctly as we see things, and yet the whole caboodle** can be tottering on the edge of disaster.   Finding a single bunch of CEOs who between them crashed the car is futile.

Paul Tucker, who is particularly responsible for Financial Stability, has made some ‘remarks’ on shadow banking, an essential component of this crisis.  As a relative novice to banking, I have been puzzling over how it works, and found his speech useful – because it highlighted the very blurred lines between something acting like a bank and something that IS a bank.

Consider a primitive economy.   Larry the Lord has £10 worth of Land.    Peter the Peasant has £10 worth of Corn.  Barry the Banker has £10 of gold.   Now imagine Larry wants to dig a well, and needs £5 of corn. Now, if a land-corn market does not exist, he has a problem. If neither Larry nor Peter trust each other enough, and absent some sort of financial system, no well is dug, economic activity is lower.  Shame – because Larry is a useful entrepreneur, and rich enough, but just not liquid enough.

Stage 1: banking solves the problem

But Barry is a banker.  He offers to lend £5 of gold to Larry on security of half his land.  Larry then buys £5 of corn off Peter by paying that gold to him.  Peter deposits the £5 gold back with Barry

–          Larry’s balance sheet is then: £10 land; £5 corn, £5 owed to Barry.

–          Peter’s is:  £5 corn; £5 of ‘M’, which signifies a deposit with Barry.

–          Barry’s is: £10 gold, £5 owed by Larry; £5 owed to Peter in the form of deposits.

Because this is a static example, everyone is as rich as before – they are each worth £10.  But because deposits with Barry are counted as money, there is now more liquidity – another £5.  If Peter wanted to buy something for £1, he could say to the seller “transfer £1 from my name to yours with Barry” – issue a cheque.  This has huge advantages over having to haul the gold over to the right person – particularly if they inhabit an economy with zillions of economic transactions to carry out, and not much gold.

Stage 2: shadow banking takes over?

OK.  Now take this position as a starting point. Imagine, too, that Barry is now as exposed to Larry as he feels comfortable with.  But  Larry wants another £5 loan against the rest of his land, having decided to make the well deeper.  In comes Danny the dealer.  He promises to get the money for him.  He issues a bond, which promises to repay £5 in a few years’ time.   Peter buys the bond, by which we mean, transfers his deposit at Barry’s bank over to Danny.  Danny then offers to lend this to Larry, who buys more corn off Peter, by transferring that deposit all the way back to Peter.

Now what do we have?

–          Larry: £10 of land, £5 owed to Danny, £5 owed to Barry, £10 of corn

–          Peter: £5 in terms of a bond, £5 ‘M’ deposit at Barry Bank

–          Barry:  £10 gold, £5 owed by Larry, £5 deposit owed to Peter

–          Danny: £5 bond owed to Peter, £5 loan owed by Larry.

The money in the system has NOT gone up.  In those strict terms, we are not more liquid. Money at Barry has not gone up, and gold has not been created.   But like in the first stage, the resources have been transferred to Larry to get started on some economically useful activity.

You can see that in many ways these two stages are similar.  They both seem to achieve the same things.  But the distribution of risks is different; in stage 2, Danny has the risk that Larry digs a stupid well.  Peter is still at risk if Larry screws up, but in Stage 1, he is owed by Barry, who has a fat buffer of gold; in my example, Danny has nothing, and might pass over a heap of losses to Peter if Larry screws up.

It is impossible, in the abstract, to say which of these ways of doing things is necessarily less risky.  It depends on how much capital each actor has.  If Danny set out on his business with £10 of gold, he might be safer, for example.  The phrase ‘Shadow’ awakens the suspicions of those determined to see things in terms of good and evil, or sneakiness and honesty.  Paul Tucker’s message seems to be that we need to consider all banking-like risk profiles – maturity and liquidity – and not just the formality of whether they are real banks.

On my part, such examples increase my scepticism about the obsession with increasing M4 or M4x or whatever else, that so motivates the pure monetarists.  You can increase lending in an economy without touching that particular measure. Congdon is dismissive of ‘lending’, but in my example, resources shifted to he who had the best use of them, without Money being created.

It is possible over the next few years that economic activity will not track Broad Money so surely, as alternatives to banking come forth.  Given how money growth is still disappointing (ht Bond vigilantes), we had better hope so . . .

*I appreciate that like GW Bush I am simplifying the implications of being like this particular cult.

** a technical financial term for “everything you need to keep working”

***if you want a great example of the sort of boneheaded moralistic explanation for why things went wrong, go to Rob Arnott in today’s FT (FM).  In his version, everything went wrong because people did things that were de jure OK but against ‘moral ethics’.

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2 thoughts on “Banking, shadow banking, money

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