Wednesday, 28 June 2017

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Polycentric banking and financial resilience

May 4, 2016

In my previous post, I argued that the institutions underlying laissez-faire banking systems, as approximated by historical cases in Scotland, Canada, and Sweden (among others) provided market actors the incentives and information necessary to maintain aggregate demand stability.  This also means a laissez-faire banking system does a good job of maintaining short-run macroeconomic stability, although this is not an intentional result.

Today, I will argue these same institutions contribute to a high degree of financial resilience.

A system is resilient if it is both robust and adaptable.  The former means it can absorb shocks without much harm, and that it can recover from shocks quickly.  The latter means it is not overly-calibrated to solving existing problems at the expense of qualitatively different problems that may arise in the future, that it does not fall prey to ‘slippery slope’ degradation, and that it permits a healthy degree of creative destruction.  It is important for financial systems to be resilient so they can facilitate the efficient allocation of scarce capital, while also coping with well known difficulties, such as balance sheet shocks.

Again, the same institutions that contributed to short-run macroeconomic stability also contribute to financial resilience in laissez-faire banking systems.  These institutions are:

  1. Inside-outside money distinction.  With multiple banks of issue contributing to the general stock of generally accepted exchange media, they are able to meet short-run changes in money demand without significant changes in reserve medium (historically, gold or silver) inflows or outflows.  Since money is both a medium of exchange for the public and instrument of financial intermediation for banks, unexpected money demand shocks can ‘spill over’ to impugn the quality of banks’ balance sheets.  Since banks can adjust liabilities without selling off assets in the event of money demand shocks, thanks to the inside-outside money distinction, they can minimize the effects of money demand shocks on their balance sheets.
  2. Interbank clearinghouse.  The clearinghouse facilitates a limited degree of cooperation (not collusion!) among banks for governing mutual concerns.  Historically, clearinghouses have facilitated emergency loans between banks, maintained minimum quality/capital standards, conducted audits to ensure irresponsible banks were not free-riding on the reputational capital of responsible banks, and shared information regarding potential counterfeiters.  Today, many of these activities are performed by central banks and executive regulatory agencies, but historical experience with the clearinghouse in various banking systems shows public intervention is not necessary to ensure these functions are performed.
  3. Legal embeddedness.  Banks in laissez-faire systems were not a law unto themselves.  They operated within particular legal systems that enforced contracts and upheld the rule of law.  Because no bank was above the laws of property, contracts, and torts, one of the most pernicious features of modern systems—the soft budget constraint—did not exist in laissez-faire systems.  In addition, banking was typically characterized by some form of extended liability.  Bank shareholders were liable, not just in proportion to their initial investment in the bank, but in proportion to their personal wealth as well.  Some systems even had unlimited liability for shareholders, meaning if the bank failed, shareholders’ personal wealth could be used to pay back depositors and bondholders up until all claims were met.  Hard budget constraints for individual banks, and for the financial system as a whole, combined with extended liability, incentivized banks not to construct overly-risky portfolios, because those in control of bank behavior knew they would bear significant costs if this strategy failed.

In modern banking systems, the above features are typically performed by a central banks and regulatory agencies.  As recent years have shown, they do not perform them very well.  This is largely because bankers, financiers, and regulators have bad incentives and information.  Financial resilience must be a bottom-up result of institutional quality, not a top-down result of bureaucratic control.