Narrow banking with modern depository institutions: Is there a reason to panic? Hugo Rodríguez...

Narrow banking with modern depository institutions:

Is there a reason to panic?

Hugo Rodríguez MendizábalInstituto de Análisis Económico (CSIC), MOVE, and

Barcelona GSE

EUI, March 17, 2017

• What would be the effects of narrow banking?

Question

(i.e. 100% reserve requirement)

“(...) 100% reserve banking is a dangerous proposal that would do substantial damage to the economy by reducing the overall amount of liquidity. Furthermore, the proposal is likely to be ineffective in increasing stability since it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity. Fortunately, the political realities make it unlikely that this radical and imprudent proposal will be adopted.”

Diamond and Dybvig, JofB 1986

A LBank

DepositLoan

The traditional model (D&D , JPE 1983)

Reserves

NB advocates: fractional banking → risk of bank runs

• suspension of convertibility

• deposit insurance

borrower saver

NB detractors: narrow banking → huge efficiency costs

→ separation of financial instit.

cheaper alternatives to avoid bank runs

Question

• What would be the effects of narrow banking?

(i.e. 100% reserve requirement)

This paper: including a realistic description of modern monetary systems radically changes the predictions of the traditional model (at least regarding narrow banking)

• What are the effects of narrow banking?

Answer

• reserves are not competing with bank loans

• reserves have indirect effect on bank intermediation through cost of producing loans and deposits

• if central banks remunerated required reserves at refinancing rate (Eurosystem), then narrow banking would have no effecton liquidity creation and bank intermediation

• no need to separate financial institutions

• collateral at central bank’s OMOs? seigniorage?

• …Switzerland and Iceland are seriously considering introducing narrow banking in their monetary systems

By the way…

• The model

• Liquidity risks

• Calibration

• Conclusions

• Solvency risks

Outline

• Literature review

• Static general equilibrium model

• Continuum of risk-averse agents (workers & entrep.)

• Commercial banks

• Government sector (central bank and deposit insurance)

• Continuum of risk-neutral investors

The model

Economy consists of a continuum of identical islands

The economy

1

Labor market(competitive)

locations

Entrepreneurs

Workers

The real side

d

~ X(x)x = fraction of loans repaid to bank

Friction 1: market segmentationin banking services

Banks

Banks

time

A LBank

Banks

time

A LBank

Loan entrep. dLdL

: loan and deposit creation

dL

Deposit workerDeposit entrep.

• Banks as creators of money

Literature review

Federal Reserve

Holmes (FRBB, 1969), Keister & McAndrews (FRBNY, 2009)

Bank of England

McLeay et al. (BofE, 20014a, 2104b), King (2012), Turner (2013)

Financial sector

BIS

Borio & Disyatat (BIS, 2009)

Standard & Poor’s (2013), Pinetree Capital Ltd. (2012)

Banks

time

A LBank

Loan entrep. dLdL

: net worth

dL

Deposit worker

Net worth

NW

(1 + il)dL – (1 + id)dL

Banks

time

A LBank

Loan entrep. dLdL

: solvency risks

dL

Deposit worker

Net worth

NW

(1 + il)dL – (1 + id)dL

Solvency risk x ~ X(x) x [0, 1]

x(1 + il)dL – (1 + id)dL

Assets dQ Equity dQ

IOU

dQ

Investor

Capital constraint dQ ≥ k dL

x (1 + il)dL + dQ – (1 + id)dLx

Banks

time

A LBank

Loan entrep. dLdL

: liquidity risks

dL

Deposit worker

Net worth

NW

Solvency risk x ~ X(x) x [0, 1]

Assets dQ Equity dQ

IOU

dQ

Investor

Capital constraint dQ ≥ k dL

x (1 + il)dL + dQ – (1 + id)dLx

d

1 - d

For bank …

deposit outflow(1 – d)dL

deposit inflow

d(1 – d)L

net deposit inflow

(1 – d)d(L – L)dL

^

^

Banks: liquidity risks

t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dLDeposit entrep.dL

dQ

dL

OMO

M

Reserves M Loan from CB M

Net worth

x(1 + il)dL + dQ – (1 + id)dL – ioMx(1 + il)dL + dQ – (1 + id)dLx

NW


t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dLDeposit entrep.dL

dQ

dL

Flow of funds (deposits and reserves)

M

Reserves M Loan from CB M

FF = (1 – d)d(L – L)^

FF

Reserves M + FF

dL + FFDeposit worker

e ~ Y(0, se)

Net worth

x(1 + il)dL + dQ – (1 + id)dL – ioMx(1 + il)dL + dQ + FF – (1 + id)(dL + FF)– ioM

e

x

NW


– edL

t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dL

dQ

dL

Interbank market

M

Loan from CB M

FF

Reserves M + FF

I

Reserves M + FF – I

Loan interb. I

Net worth

x(1 + il)dL + dQ + FF – (1 + id)(dL + FF)– ioM

riskpremium

x

NW

e


+ i × I(I > 0) + (i + s)× I(I < 0)


t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dL

dQ

dL

M

Loan from CB M

FF

I


Loan interb. I

x

NW

e

Net worth


Remuneration of required reserves


+ i × I(I > 0) + (i + s)× I(I < 0) + ir rdL

reserve requir.


t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dL

dQ

dL

M

Loan from CB M

FF

I


Loan interb. I

x

NW

e

Net worth



+ i × I(I > 0) + (i + s)× I(I < 0) + ir rdL

Banks: role of cash?

So expost net worth is

e ~ Y(0, se)

LiIIsiIiIMiFFi od rd-- r)0()()0(

Reserve position

LLLLM rd-ed--d-d )ˆ)(1(

LLLFF ed--d-d )ˆ)(1(

> 0 excess reserves

LLLLM rd-ed--d-d )ˆ)(1( < 0 reserve deficit

LLLLMI rd-ed--d-d )ˆ)(1(

LiQLix dl d-dd )1()1(


So expost net worth is

LiQLix dl d-dd )1()1(

e ~ Y(0, se)

LiIIsiIiIMiFFi od rd-- r)0()()0(

LLLFF ed--d-d )ˆ)(1(

LLLLMI rd-ed--d-d )ˆ)(1(

I >< 0 e <

> er-d

-d-d

L

LLM )ˆ)(1(

LiIdsiIdiMiFFiL od

MrdeYeY-- r

e

e

-

)()()( max)(


LiIdsiIdiMiFFiL od

MrdeYeY-- r

e

e

-

)()()( max)(

)(1 eY- siio

e--d-d-rd )ˆ)(1( LLLM Ls

isiLLL

o

d

-Y-d-d-rd -1)ˆ)(1(

LI de-e )(

e

r eYed-rd---d-d- )()()ˆ)(1()()( dLsLiiLLiiL odo

FOC


Ls

isiLLLM

o

d

-Y-d-d-rd -1)ˆ)(1(

LI de-e )(

e



General result on the role of reserve requirements

• risk averse investors

• lack of bank segmentation

• dynamics

Interbank market clearing → i

Nominal side (solvency risk) based on Bernanke, Gertler and Gilchrist (1999) for the relation betweenbanks and depositors (DI)

- Friction 2: realization of x is private information of banks (investors)

- CSV setup between banks and depositors(standard debt contract)

Banks: solvency risks

t = 0 A LBank

Loan entrep.

Assets dQ Equity dQ

dL

dQ

dL

M

Loan from CB M

FF


I


Loan interb. I

Net worth

x(1 + il)dL + dQ + (L) – (1 + id)dL


t = 0

dQ

dL

M

FF

I

Net worth (solvent bank)

x(1 + il)dL + dQ + (L) – (1 + id)dL ≥ 0


xLi

LQLix

l

d

d

-d-d

)1(

)()1(

xx xx

monitoring

cost f(1 + il)dL

depositors take everything

no monitoring

(1 + id)dL

(insolvent) (solvent)

Given il, dQ, and the risk-free rate, if, the problem of thebank is to choose loans dL (leverage), and thresholdrepayment ratio x to maximize equity premium

subject to participation of depositors (DI)

Qi

xdLiLQLix

f

x

dl

d

Xd-dd

)1(

)()1()()1(

1

LixdLQLixxLi f

x

ld dXddf-X-d )1()()()1()1()(1)1(0

and capital constraint

Q ≥ k L


subject to

Qi

xdLiLQLix

f

x

dl

xL d

Xd-dd

)1(

)()1()()1(

max

1

,

LixdLQLixxLi f

x

ld dXddf-X-d )1()()()1()1()(1)1(0

→ L, x

Q ≥ k L


Determine s from

)(1)1(1 xsii X-

Determine il from arbitrage condition

1

)1(

)()()1()1(

1

d

Xd-dd

Qi

xdLLiQLix

f

x

dl


As long as reserve requirements (r) do not affect (L), they do not have an effect either in bank intermediation

siiiIMxL dl , , , , , , ,

Determine id from

xLi

LQLil

d

d

-d-d

)1(

)()1(

• Parameters: d, f; io, ir, if; r, k; X(x), Y(e)

Calibration

→ size of banks: d

→ monitoring costs: f

→ policy rates: io, ir, if

→ regulation: r, k

Data (FDIC): average share of loans and leasesd = 0.0001

Data (FDIC): average losses from bankruptcy over depositsf = 0.22

Data (Fed.): average refinancing rate average 3-month T-bill rate

Data (BIS): capital requirement Basel I & II

ir = 0

io = 0.0278

if = 0.0257

k = 0.08r = 0

Calibration

→ distribution of performing loans: X(x)Match: mean and standard deviation of NPL ratio


Lognormal(mx = 5.8606; sx = 0.3595) truncated at x = 1

0

0.2

0.4

0.6

0.8

1

0.5 0.6 0.7 0.8 0.9 1

x

X(x) and empirical distribution of performing loans

Calibration

→ distribution of performing loans: X(x)

→ distribution of liquidity shocks Y(x)

Match: interbank trade over loans

Lognormal(mx = 5.8606; sx = 0.3595) truncated at x = 1

Normal(me = 0; se = 0.2131)


KS test at 10% wrt empirical distribution of NPL

Match: mean and standard deviation of NPL ratio

8.5

8.6

8.7

8.8

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

r

BANK LEVERAGE (ir = 0)

0

0.02

0.04

0.06

0.08

0.1

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

r

Lending rate and deposit rate (ir = 0)

• Nominal model with…

Conclusions

• …endogenous bank leverage (solvency risk)

• …demand for reserves (liquidity risk)

• …instruments of MP (official rates, reserve req.)

• …interbank market

• …bank regulation (capital requirements)

• In the model…

Conclusions

• …flexible prices

• …only important frictions

• …MP has real effects in the short run (changes in io)

• segmentation in bank loan market

• information frictions

Conclusions

• Effects of reserve requirements

Realized net worth after realization of x

)()1()1( LLiQLix dl d-dd

e


• if io = ir no effect on equilibrium no matter what r is

• for 0 ≤ r < 1 DI needed to prevent bank run equilibrium

A LBank

Loan entrep.

Assets dQ Equity dQ

dL

Loan from CB M



Loan interb. I

• Role of collateral

• M < dQ may not be enough to support narrow banking

Ls

isiLLLM

o

d

-Y-d-d-rd -1)ˆ)(1(

• M < dQ + dL (securitization)?

Conclusions

• Role of collateral

Conclusions

• Seigniorage

A LCentral Bank

OMOs

Assets

Required

Reserves

Currency

Excess

• The model could incorporate…

Conclusions

• …heterogeneous banks

• size (money market dichotomy)

• …unconventional MP (QE)

• …DSGE + endogenous risk cycles

• risk profiles (solvency and liquidity)

• …

• Banks as creators of money

Literature review

Goodfriend & McCallum (JME, 2007)

Bianchi & Bigio (NBER, 2014)

Chari & Phelps (JME, 2014)

Jakab & Kumhof (BofE, 2015)

Disyatat (JMCB, 2011)

Benes & Kumhof (IMF, 2012)

Thanks for your attention

Narrow banking with modern depository institutions: Is there a reason to panic? Hugo Rodríguez...

Economy & Finance

Transcript of Narrow banking with modern depository institutions: Is there a reason to panic? Hugo Rodríguez...