A Regulatory Design for Monetary Stability

In the paper, A Regulatory Design for Monetary Stability, which was recently made publicly available on SSRN, I seek to make the case that our financial regulatory apparatus is ill-designed to address what is, arguably, the central problem for financial regulatory policy. That problem is the instability of the market for money-claims—a generic term that denotes fixed-principal, very short-term IOUs. The money-claim market is vast, and it is dominated by financial issuers. Building on prior work, the paper contends that the money-claim market is associated with a basic market failure. It further suggests that our current regulatory approach, even as modified by recent and pending reforms, is unlikely to be conducive to stable conditions in this market.

The paper offers an alternative regulatory framework to address this market failure. Specifically, it proposes that the issuance of money-claims be permitted only within a public-private partnership (“PPP”) system. Unlike our existing financial stability architecture, the proposed regulatory design embodies a coherent economic logic. Furthermore, the paper argues that the proposed regime would be more readily administrable than our current system, in part because it would rely on more modest regulatory capacities.

The elements of the proposal can be described succinctly. Under the PPP regime, the government would:

• Establish licensing requirements for the issuance of money-claims. (Logically, this would mean disallowing unlicensed parties from issuing these instruments, subject to de minimis exceptions.)
• Require licensed firms to abide by portfolio restrictions and capital requirements. (In effect, adherence to these risk constraints would be the “eligibility criteria” for the regime.)
• Establish an explicit government commitment to stand behind the money-claims issued by licensed firms—making them default-free.
• Require licensed firms to pay ongoing, risk-based fees to the government in exchange for this public commitment.

Those who are familiar with the modern regulation of depository institutions will observe that these are precisely the core regulatory techniques that have been used for the depository sector since the establishment of the FDIC in 1933. Specifically: (1) the federal government and state governments issue special charters to depository banks, and unlicensed firms are legally prohibited from issuing deposit liabilities; (2) depository banks are constrained to a narrow range of permissible activities and investments and are subject to capital requirements; (3) the federal government explicitly stands behind (most) deposit obligations through the deposit insurance system; and (4) depository banks pay ongoing, risk-based fees to the government in return for this explicit commitment. In short, U.S. depository banks operate under a public-private partnership regime.

Conceptually, then, the PPP proposal is modest, even conservative. It envisions the modernization of an approach that has been used in the United States for many decades, arguably with reasonable success (albeit with some notable lapses). Importantly, the proposal is not that deposit insurance be “extended” to cover institutions that are currently ineligible for depository licenses. Instead, the argument begins at an analytically prior position. It starts by revisiting banking law’s foundational prohibition: existing law forbids the issuance of deposit obligations without a special license, but this prohibition does not apply to other categories of money-claim. This distinction, it is argued, is both formalistic and anachronistic. In our modern financial system, deposit obligations—once the predominant cash-parking contract—have come to represent only a small fraction of outstanding money-claims. Other money-claims serve a function substantially similar to that of deposit instruments, and they raise the same basic policy problem.

Accordingly, the paper proposes that the existing prohibition on unlicensed deposit issuance be updated to encompass the broader universe of money-claims, functionally defined. Firms would need a special license to issue money-claims, whether or not those money-claims were styled as “deposits.” The natural question is what types of firm should be eligible for licenses—equivalently, what asset portfolios should be permitted to be financed with money-claims (including deposits). The paper offers a set of functional parameters to govern this determination. It is possible that the application of these parameters would yield an asset profile that is coextensive with—or conceivably narrower than—the range of currently permissible investments for depository banks. Firms meeting these criteria would be allowed (if they chose) to issue money-claims, so long as they agreed to abide by capital requirements and pay the ongoing fee. Unlicensed firms would be denied access to money-claim financing, subject to de minimis exceptions. The PPP regime, then, represents a unified regulatory approach to money-claim issuance. There would be no separate “depository” regime; deposits are just a variety of money-claim.

The paper compares this PPP proposal to the available alternatives and traces some of its implications.

The full paper is available for download here.