Saturday, June 18, 2016

How to Build a Banking System, Part 2: A New Hope

When we left off, the FRED stock banking system was on the verge of collapse. Continental Freebank of Illinois had failed, their depositors had lost money, banks which had provided short-term loans to Freebank had lost money. Panic loomed among fear that depositors would withdraw their money from other banks on the brink, causing a chain reaction of bank failures.

Against this backdrop, a light bulb goes on for someone at Front and Rear Entry Doors. Not only can FRED prevent the collapse of the entire system, they can make money doing it.

That afternoon, an executive at Jean-Paul Organs and Savings Company gets a call from FRED. The voice on the other end explains that FRED is now offering insurance for deposits. In the event of the bank's failure, FRED's newly formed deposit insurance subsidiary will see to it that any of the bank's depositors get all of their deposited stock back. FRED will also issue short-term emergency stock loans, if needed, to prevent or at least ease bank failure. The executive immediately requests full insurance for all of J.P. Organs' deposits, forgetting in his excitement to ask about the cost.

The FRED Deposit Insurance Company ("FDIC" for short) is an instant success, insuring almost all outstanding FRED stock deposits by the end of the week. The secret to the FDIC's success is simple: it's a subsidiary of FRED. Unlike any other insurance company, FRED can never go bankrupt by insuring deposits of its own stock. FRED can always just issue more stock! The FDIC's insurance is the ultimate insurance.

With FDIC insurance in place, no depositor ever needs to withdraw their FRED stock deposits for fear of bank failure. Banks no longer need to worry about customers withdrawing when things get tight. Now, banks only need to worry about long-term solvency. Never again will a bank go under because their depositors were worried about a rumor! Of course, banks do still make bad long-term bets and go bankrupt from time to time, and the FDIC then must pay off the depositors. But the FDIC constantly monitors insured banks for any untoward risks, and insurance premiums more than cover costs. Soon, the FDIC is a major new source of profits for Front and Rear Entry Door.

As the FDIC becomes a major source of profit, the FOMC (FRED Open Market Committee, FRED's stock issue and buyback department) shifts their attention in a new direction. The FOMC is able to exert considerable influence over short-term interest rates on FRED stock by issuing or buying back stock, thereby increasing or decreasing the amount of stock available in the market. When more FRED stock is available, more banks have extra deposits to lend and rates are low. When less FRED stock is available, more banks need to borrow and rates are high.

High rates tend to be bad for the banks, leading to more defaults and higher costs for the FDIC. On the other hand, low rates lead to devaluation of FRED stock, potentially even runaway inflation if things go bad. The FOMC tries to maintain a middle ground, controlling interest rates by issuing stock when rates get too high and buying back when rates get too low. This activity also generates profits in its own right - the FOMC ends up issuing stock at higher prices and buying it back at lower prices. In the process, the FOMC also holds many other profitable financial assets. For example, when issuing new FRED stock, the FOMC might trade that stock into the market in exchange for mortgage securities or government bonds. Later, if the FOMC needs to buy back some FRED stock, it sells those assets back into the market in exchange for stock.


So there we have it. A monetary and banking system, with a central bank, deposit insurance and oversight, lender of last resort capabilities, and no required reserve ratio, built from scratch using only the standard laws of property and contract.

There's a lot more that could be said. Thinking about building a monetary system this way illustrates inefficiencies in our current system, opportunities which will likely be exploited some day in the future, and dangers which will likely crop up along the way. It illustrates how broad the idea of "money" can be, and part of why the Fed (excuse me, FRED) has historically had difficulties quantifying the money supply. And of course we could introduce another company, Bonnet, oil & Engine (BoE), and delve into the interplay between the two companies' stock prices.

But I leave all that on the table. If you're new to this sort of thing and like it, I recommend Marcia Stigum's book "Money Markets". Also, while linking above to the home pages of various major financial institutions, I found that every single one of them features reports from their in-house economists on the front page, and most of it is pretty good.

How to Build a Banking System, Part 1: Doors, Shutters, and the Freebank Era

There's a saying in synthetic biology: "If you can't build it from scratch, then you don't understand it." With that in mind, I want to outline how to build a monetary and banking system from scratch, using only the standard legal apparatus of property and contract. Everything I outline here could actually be done today in most first-world countries without any special approval or government oversight.

We'll start off with a corporation. This corporation is publicly owned, i.e. its stock is publicly traded on exchanges. Like any publicly owned company, it already serves some useful economic role and is profitable. For concreteness, let's say it's a door company called Front and Rear Entry Doors (FRED for short). Clearly, this is all straightforward (though not necessarily easy) within the standard legal framework.

FRED reserve assets
Now, our hypothetical corporation makes three unusual announcements:
1. FRED will no longer issue either bonds or dividends. It will borrow only by issuing new stock, and it will distribute earnings only by buying back stock. (Issue and buyback is handled by the finance department, internally called the "FRED Open Market Committee" or "FOMC".)
2. FRED introduces a system for transferring shares of its own stock between other individuals and companies (including itself), quickly and easily. (They call it "FREDwire".)
3. FRED will accept its own stock as payment for goods and services, and its employees and contractors have the option of being paid in stock.
These are the key pieces for Front and Rear's stock to begin functioning as money. Technically, not all of these are necessary. (2) could be implemented by any third party (i.e. a clearing house). (1) and (3) are really equivalent, since the company or its employees/contractors can immediately trade any revenue for stock in the open market. But practically, these steps would spur people to start thinking of and using the stock as a currency in its own right.

Let's say this goes on for a while. The FRED sells lots of doors, and starts expanding into shutters. Many employees and contractors seek payment in stock, the company's revenue drives aggressive buybacks, and the stock price generally fares well. Local shopping centers begin to carry gift cards for FRED stock (called "FRED notes" after the cute messages on the cards). In fact, things go so well that some new home buyers want to finance their doors and shutters by borrowing shares of FRED's stock with which to make their purchases.

Along comes some enterprising fellow who says "Hmmm. There's a bunch of home buyers looking to borrow FRED stock, and there's a bunch of contractors with their FRED stock savings just sitting around. What if I pay the contractors some interest to lend me their stock, and then loan that out to the home buyers at a slightly higher rate of interest?" So begins the FRED home loan bank.

The FRED banking business goes well, competitors spring up, and soon there is a dynamic FRED banking business. The banks take in stock, for which they issue interest-bearing "deposits". They then lend out most of the stock to borrowers. Loans quickly extend beyond home loans into business loans, inventory finance, and short-term loans to other banks.

The short term interbank loans are of particular interest, since they facilitate deposit withdrawal. When a customer wants to withdraw a deposit, they are always paying it to someone else, who in turn typically deposits it in their own FRED bank. So whenever one FRED bank loses deposits, another bank gains deposits. Typically, the bank which lost deposits will borrow some FRED stock from the bank which gained deposits. In this way, every bank only needs to keep a very small amount of FRED stock on "reserve" to cover deposit withdrawals. All the rest of the FRED stock can be loaned out to consumers and businesses for a profit.

Everything goes well right up until it doesn't. A bad month for FRED mortgage defaults causes interest rates to rise. One bank, Continental Freebank of Illinois, had made many long-term mortgages at low interest rates in previous years. Unfortunately, Freebank is low on deposits, and has to borrow funds using interbank loans. As rates increase, those short-term interbank loans grow more expensive, until eventually the interest on the short term loans is almost as high as the long-term mortgages Freebank had issued. Between the interest rate hit and mortgage defaults, Freebank is losing money.

Fearing the loss of their deposits, Freebank's customers panic and withdraw their stock deposits. As Freebank's deposits dwindle, it is forced to take on even more short-term loans at high interest to pay off its customers. Soon other banks begin to worry, and they refuse to lend to Freebank. With customers clamoring for deposits and nobody willing to loan, Freebank's stock pile runs out. Deposits can no longer be paid, and Freebank goes into bankruptcy.

Shocks run through the system.  Some of Freebank's customers' deposits are lost. All the other banks which had made short-term loans to Freebank now also have losses on their books. Panic sets in among consumers, realizing that further bank failures could threaten their own deposits. Banks worry that their depositors will also withdraw their stock, causing further failures. Disaster looms.


Will the catastrophic bank failures run through the the entire Front and Rear Entry Door banking system? Will the Freebank era come to an end? Can the system be saved without introducing a new legal framework? Tune in next time for "How to Build a Banking System, Part 2: A New Hope".