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Prudential banking versus real bills doctrine

November 4, 2015
in Blog

Should banks adhere to the Real Bills Doctrine (RBD)? This is an old question that, from time to time, resurfaces.

So what then is a real bill? A real bill is a bill that is backed by a real good. If I produce bread, for instance, then as a producer I can issue a bill payable on a date after I expect to have sold the bread, which is still under production. Banks, under such a doctrine, should then constrain themselves to invest in this type of bills. In so doing, they would only offer credit to real market activities.

Following a recent interview, Juan R. Rallo and Lawrence H. White engaged in an interesting exchange about this issue (see herehere, and here.) Rallo argues that the RBD is a prudential banking policy- in short, that banks under free banking should follow a version of the RBD to maintain monetary stability or, more precisely, to avoid discoordination by borrowing short and lending long. This is problematic, the argument goes, because the market loses liquidity: one bank can gain liquidity by selling a long-term mortgage, for instance, at the expense of someone else losing liquidity as well.

Let me offer a few critical comments to what is my best understating of what is being argued.

First, banks do not manage stocks of deposits or stocks of loans. Banks manage flows of deposits and loans. Therefore, maturity mismatching is not an issue in itself. Banks do not go bankrupt just because of maturity mismatching, but because they engage in mal-investment (save for government interferences and regulation that could produce a crisis or trigger a general bank run). It seems to me that the argument implicitly assumes that what is being managed are stocks, rather than flows, and therefore the maturity mismatching seems to be more of a problem than it actually is.

 

Second, I don’t see why maturity mismatching amounts to discoordination. What type of discoordination is taking place? In the discussion, the ABCT (Austrian Business Cycle Theory) is mentioned, but the discoordination that occurs in this theory is due to a change in the relative price of time with respect to goods- namely, a change in interest rates (and therefore in discount rates.) This means that projects that are more forward looking see the present value of their expected cash-flows increase more than shorter term projects (think of Macaulay and modified duration). The ABCT is not about maturity mismatching, which may or may not affect interest rates. Interest rates depend on the demand and supply of credit, while the maturity of the loan is a particular point in the yield curve. For the ABCT story to kick-in, maturity mismatching should push the discount rates below their natural or equilibrium levels.

 

Third, maturity mismatching is not just a banking phenomenon; all industries deal with the same issue. When a new project is started, a producer promises to pay wages and suppliers against the promise that eventually he’ll receive a cash-flow at some point in the future. In the meantime, the project manager relies on an investor that advances funds because the maturities of the project are mismatched. The producer does not say to his employees that they will get paid whenever he starts to receive revenue. Maturity mismatching is part of economic activities across the market, not just banking.

 

Fourth, since RBD are short-term bills, this doctrine seems to minimize maturity mismatching. Why stop there and not push it to a 100 percent reserve requirement if the problem is maturity mismatching? The RBD seems to be presented as a corner solution among all the possible loans that a bank can perform. But if RBD is an acceptable investment, then the question of the optimal composition of the bank portfolio rises. Bankers optimize the use of reserves in at least three dimensions: (1) keep liquid reserves, (2) chose the optimal weighted average maturity of the loans granted, and (3) chose the optimal weighted risk of the loans granted. There are two ways we can understand prudential banking. As the rules and institutions that minimize business fluctuations and as the business plan that maximizes economic profits. The former is an institutional, i.e. policy, issue beyond the banker as a banker discretion. The second issue is up to the banker to sort out. This is not more general or abstract than saying that is up to Toyota to decide which portfolio of cars to produce and sell in the market. Arguing that RBD is the prudential banking behavior is like arguing that producing only Toyota Prius is the prudential Toyota policy because the Prius is the most liquid car they produce.

 

It seems to me that the RBD argument is trapped between being too specific in telling bank managers how they should run their business or in folding back to be substantially the same than free banking but losing the RBD nature.