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.

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