Rohan Grey’s ‘Banking Under Digital Fiat Currency’ Proposal – A Guest post by Richard Taylor

Rohan Grey, president of the US MMT supporting Modern Money Network, recently wrote a rather good article about why Facebook’s putative Libra currency is a bad idea.

In it he links to some proposals for future banking regulation.

In my view these proposals for “Banking in a Digital Fiat Currency Regime” are really interesting and highly relevant to Positive Money banking reform proposals. He discusses the opportunities to create a new plumbing for the banking system afforded by Digital Fiat Currency (DFC). DFC is the overarching term for forms of digital money issued by the state. Other possible sub-variants are Digital Cash or Central Bank Digital Currency (CBDC), when the central bank is issuer. These are areas where Positive Money also does significant work.

The paper describes what I would consider to be a type of Sovereign Money System (SMS), albeit built with a very different design to that proposed by Positive Money. To recap, in the full Positive Money SMS all bank account money would be in the form of a DFC. This “sovereign money” is a completely safe form of money issued by the central bank (Bank of England). Commercial banks may continue to administer access these funds, so to the general public the system would feel the same. But rather than this money being the private liability of the commercial bank, it is ultimately held by the central bank. The commercial bank is just providing the banking access portal. Commercial banks would no longer be able to create new money by making loans. They can loan out money but only from funds made available to them by depositors who are willing to risk their money for interest. There is no deposit guarantee in a full SMS system for those that chose to earn interest by allowing the bank to lend out their funds. Thus the shareholders of the bank and the depositors risk their money if too many loans default.

This is my interpretation of how Grey’s proposal works. It is rather different but still retains some of the essential characteristics and benefits of SMS, although continues to give commercial banks a full role in the system. In common with the SMS, all bank account money in circulation would be in the form of fully safe DFC. Again, commercial banks might be able to operate a portal to customer funds, but they would be held safely by the central bank. So in that regard it has the same positive characteristics of avoiding bank runs in a crisis and ensuring separation of the payments system from commercial bank loan operations.

In Grey’s proposal, however, commercial banks are still intimately involved in the loan and money creation process. A new step in the process is introduced which (arguably) provides much more direct control and oversight by the central bank in terms of money creation through loans. Firstly, a commercial bank would assess an application for a loan in much the same way as it does now based on the perceived risk and profitability. If it grants the loan then the loan agreement forms an asset to the bank in much the same way as today. However, it cannot just create a matching liability in terms of a deposit that the borrower can then spend. The customer needs DFC. So in order to obtain this the commercial bank must itself obtain a loan from the central bank using, as collateral, the loan asset that it just created. The central bank creates new DFC at this point to loan to the commercial bank, which is passed onto the borrower to be spent. In effect the commercial banks are franchised by the central bank to advance suitable loans that result in the central bank’s balance sheet being expanded. This franchising model is in essence the system we have today, but is obscured by the deposits being advanced by the commercial banks themselves. Ultimately though the state must support commercial bank deposits, bailing banks out if necessary if they risk insolvency. Grey’s approach makes this relationship much more explicit, ensuring that customer funds are always held in a safe form.

 

When the loan is paid back by the borrower (or in stages as the loan is repaid back over time), the commercial bank must pay back its loan of DFC. It obtains the DFC funds to do this (plus interest) from the borrower. When repaid, the DFC is destroyed along with the corresponding loan asset held by the central bank. So the supply of DFC is elastic depending on the demand met by the central bank. If the borrower defaults then the commercial bank will be left out of pocket (although of course covering this is part of their justification for charging interest) and this would reduce the shareholder equity. If the defaults are so severe that the bank becomes insolvent then the central bank may have to right off its asset, but the DFC liability is retained – so a loss must be recorded on its balance sheet. The point is that funds are never at risk since it is always the liability of the central bank. The commercial bank doesn’t need to be bailed out, its remaining assets would be transferred under administration to some other commercial bank with no risk to customers. In that sense the system provides 100% “deposit” guarantees to any level, but without the same level of moral hazard that exists in the current system which requires particular commercial banks to continue to operate no matter what (“too big to fail”). If customers transact their DFC through a portal of the failing bank then that can be easily transferred to another bank, without financial risk. All this is by virtue of the fact that this system separates the payment system and deposit holding away from the commercial banks, in common with the Positive Money proposal.

 

In Grey’s system the commercial banks quite explicitly don’t need customer deposits to make loans. That illusion would be well and truly fractured by such a system. The approach is bottom up, with the quantity of money directly impacted by commercial banks making loans and these loans creating safe DFC for the lifetime of the loan. In contrast, the SMS proposal is more top down with the overall quantity being determined explicitly by a committee of the central bank. In Grey’s proposal, commercial bank regulation would be much more focused on the asset side – i.e the quality of the loans being made. Much less regulation around the bank’s liabilities would be required, since customers would no longer be depositing their money with the bank and their money would always be safe. However, since the central bank is more intimately involved in the loan creation process I would speculate that more direct shaping of credit allocation by the central bank could be enabled. In other words such macroprudential policies might limit the amounts loaned to certain sectors, or charge different interest rates on the central bank loan to modulate the lending behaviour. This isn’t anything that couldn’t happen today (the central bank is meant to be regulating commercial bank behaviour, after all!) but somehow it feels that the central bank being more explicitly in the loop might make such control more likely.

 

Another nice characteristic of the proposal that Grey points out, is that the loan asset from the commercial bank will necessarily already by collateral for the loan of the DFC from the central bank. Therefore it shouldn’t be used again as collateral for anything else. This may lead to much better control of the shadow bank shenanigans that is enabled by using loan assets as collateral, specifically for securitization or rehypothecation.

 

This enforced valuation of commercial bank loan assets bears some resemblance to Mervyn King’s Pawnbroker for all Seasons proposal (https://positivemoney.org/2016/03/mervyn-kings-pawnbroker-for-all-seasons-explained/ ) and the ECB’s LTRO’s (https://citywire.co.uk/funds-insider/news/what-is-ltro-and-how-does-it-work/a569758), although the intention with Grey’s proposal is that the process of issuing DFC is presumptive on the basis that the bank is following regulations. Thus any loan would be converted into DFC, with the focus on overall regulation to ensure continuing compliance, but not requiring specific oversight a loan by loan basis.

 

This seems like a really interesting approach and proposal. It seems very elegant. As with much MMT thinking it places the commercial banks inside the domain of the state, and assumes that they can be regulated sufficiently for public purpose. Of course, it can be argued that this doesn’t quite reflect reality today.

 

Personally the aspect I find most problematic compared to the SMS proposal is that it continues to give commercial banks great power in determining loans to be made, and to profit from those from charging interest. But certain aspects of the design make me think that it might be easier to design a regulatory regime with this approach that may provide a trajectory to more controlled lending for public purpose. Ultimately it may make it easier to argue for greater regulation and specific credit guidance for the type of loans that can be created. Moreover, it avoids the criticisms levelled at SMS in terms of over centralisation of monetary control and fundamentally seems more politically achievable.

 

Overall this seems like a refreshing new perspective and I’ll be really interested to see how these ideas develop. I’m very grateful to Rohan Grey for comments on an earlier draft.

 

 

Richard Taylor is a member of Positive Money Edinburgh

Comments

  1. Peter May -

    I think this is an excellent scheme.
    I have never liked Positive Money’s idea that the Monetary Poilcy Committee of the Central Bank would have the additional task of creating all the money for an economy, which I always considered far too over centralised, top-down (as pointed out above) and in fact very likley to be an impossible task.
    This proposal at least puts the private banks in the driving seat, which I’m rather surprised to hear myself saying, but with the best will in the world they are locally more in touch than the Central Bank and this would also work equally well with the up and coming local mutual banks.
    http://www.progressivepulse.org/economics/real-progress-on-real-local-banking/comment-page-1
    It is also a good point about the lack of ‘tradability’ of the loan book. That would certainly help to reduce shadow banking but I’m not sure it would shut it down entirely as lots of it seems to be engaged in by people other than banks.
    But it would be a good start.

  2. Peter May -

    I feel it worth noting, too, that Fran Boait, Positive Money’s Director is speaking at the third MMT conference
    https://www.mmtconference.org/
    I think previously they have sent only observers.

    1. Peter May -

      I agree – I think it is the only way for Positive Money to go… Indeed Positive Money is a better marketing title than MMT!

  3. Andrew (Andy) Crow -

    “They [private sector banks] can loan out money but only from funds made available to them by depositors who are willing to risk their money for interest.”

    I don’t think that bit makes sense. That is not actually how banking works, that’s how Building Societies work.

    ‘Positive money’ may be a better marketing title than MMT, but the philosophy behind it is deeply flawed from what I can gather.

    It’s stuck in the mindset that believes money is a real commodity. Proxy gold. I smell a rat.

    1. Andrew (Andy) Crow -

      I think maybe I missed the point and that that describes ‘orthodox’ positive money theory. (?)

      1. Peter May -

        Yes. I think Positive Money have realised that their original idea of letting the Monetary Policy Committee of the BoE decide on all money creation is just putting the bankers in charge, and takes no account of money creation by the government, which they have supported through people’s QE.
        They seem to now take a peculiarly disinterested view, concentrating on specific campaigns but not promoting directly any overall plan. Perhaps they could be descibed as MMT lite?

    2. Richard Taylor -

      This is a description of how the system would look if the full Positive Money Sovereign Money system were to be implemented. In that case banks could only lend out customer deposits – i.e. the loanable funds model would become true and all banks would act like Building Societies used to. You’re right, this isn’t how the system works right now.

      I don’t think there is any disagreement between Positive Money and MMT about how banks operate today. It is a question of how to improve or reform them. Part of the motivation for reform is to get banks to make better lending decisions for public purpose. Another motivation is to ensure the payments system and deposits are resilient under bank failure (so that they can be allowed to fail, and some moral hazard is removed from the system). What is interesting about Rohan’s proposal in my view is that it is able to neatly separate these two concerns.

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