A Simpler Approach to Financial Reform

There is a growing consensus that new financial reform legislation may be in order. The Dodd-Frank Act of 2010, while well-intended, is now widely viewed to be at best insufficient, at worst a costly misfire. Members of Congress are considering new and different measures. Some have proposed substantially higher capital requirements for the largest financial firms; others favor an updated version of the old Glass-Steagall regime.

In A Simpler Approach to Financial Reform, forthcoming in Regulation, I suggest a different and simpler strategy. This simpler approach would be compatible with other financial stability reforms. However, in the first instance, it is better understood as a substitute for Dodd-Frank and other measures. The simpler approach would require new legislation. It consists of the following specific measures, starting from a pre-Dodd-Frank baseline:

• Prohibit the use of short-term debt funding by all financial firms other than deposit-banks (for reasons described in the paper, I refer to the financial sector’s short-term debt, inclusive of deposits, as “broad money”—a conventional term in the monetary context);
• Apply reserve requirements to all of the broad money issued by deposit-banks, thereby giving the Federal Reserve the power to cap the quantity of broad money outstanding;
• Fully insure (i.e., with no coverage caps) all of the broad money issued by deposit-banks, and phase out insurance of long-term certificates of deposits;
• Charge risk-based fees to the deposit-banking sector for this public backstop, and keep charging fees even if the FDIC’s insurance fund is fully funded—at which point the fees would become a fiscal revenue item (in the central banking context, this is called “seigniorage”: fiscal revenue from money creation);
• Tighten up existing deposit-bank portfolio constraints—most importantly, implement a swaps push-out rule along the lines of Dodd-Frank’s; and
• Replace the Basel Committee’s new liquidity standards with an international accord that prohibits financial institutions from issuing broad money denominated in nondomestic currencies (in short, wind down the so-called “Eurocurrency” markets).

The simpler approach—which we can call the “licensed money” approach—obviously centers around the financial sector’s short-term debt, or broad money. The approach confines the issuance of broad money to the existing deposit-banking system; it gives the Fed the power to cap the quantity of broad money outstanding through reserve requirements (not to be confused with capital requirements); it wraps broad money with a public backstop, making it sovereign and default-free; and it charges the banking system a fee for this public commitment.

The licensed money approach is designed to render the financial system panic-proof. The term “panic” is used here in a specific sense: to quote Ben Bernanke, it is “a generalized run by providers of short-term funding to a set of financial institutions.” The licensed money system is based on the idea that, when it comes to financial stability policy, panics are “the problem” (or the main one anyway). The paper expands on this claim.

Notice what is not included in the licensed money approach. There is nothing here about “systemic” or “macroprudential” oversight of the financial system; no designations of nonbank financial firms for special regulation; no new resolution authority for nonbanks; nothing about the securitization markets; nothing about derivatives (apart from the push-out); no proprietary trading limits; nothing about breaking up the banks; and no Glass-Steagall-type limitations on affiliations between banks and nonbanks. Again, the licensed money system would be compatible with these other measures, but it should reduce the perceived need for them.

The sketch above is silent about what activities can take place outside the licensed banking sector. It only says that those activities must be financed in the capital markets (with equity and/or long-term debt), not the money market. In principle, the licensed money system would allow for a very wide degree of latitude for nonbank financial firms, subject of course to appropriate standards of disclosure, antifraud, and consumer protection. So nonbanks might be given free rein to engage in structured finance, derivatives, proprietary trading, and so forth. But they would not be allowed to fund short.

Deposit-banks, on the other hand, would continue to be subject to strict limitations on their activities and investments, just as they are today—though these portfolio constraints could use some tightening up, particularly in the derivatives area. And of course deposit-banks would continue to be subject to capital requirements, though these too might warrant some tweaks. The need for such risk constraints obviously stems from the moral hazard that accompanies a public backstop of broad money.

It may be useful here to visualize, at a very high level, what the licensed money approach would mean for a giant financial conglomerate—like J.P. Morgan, Bank of America, or Citigroup. In simple terms, we can picture the conglomerate as consisting of a holding company with two subsidiaries: a big deposit-bank and a big securities firm. Under the licensed money system, the securities firm would be required to “term out,” that is, end its reliance on short-term funding. Nor would the conglomerate be able to simply move its securities business into its deposit-bank: deposit-banks have long been expressly prohibited from engaging in securities dealing (with very narrow exceptions). [1] Nor could the conglomerate use its deposit-bank to fund its securities business: the Federal Reserve Act already imposes strict limitations on such affiliate transactions. [2]

Legal limits on the issuance of “private money” are nothing new. At the risk of stating the obvious: current law prohibits the issuance of deposit instruments without a special license. In a prior era, similar prohibitions applied to the issuance of circulating bank notes. In other words, the law has long made money creation a privileged activity. It is widely acknowledged that the financial system’s short-term wholesale debt obligations are functional substitutes for deposits. Yet they have no legal-institutional status as such. Hence the short-term wholesale funding markets today represent a form of “free banking”: money creation without a license, and outside the purview of money and banking authorities.

The licensed money system is not exactly a method of “financial regulation.” It is better understood as a modernization of the monetary system. Implicit in the approach is a counterintuitive idea: that financial instability is, at bottom, a problem of monetary system design. In fact it always has been. This recognition brings a great deal of clarity to the task at hand, and it points toward a far simpler approach to reform.

The working paper is available for download here.

Endnotes:

[1] See Section 24 (Seventh) of the National Bank Act, 12 U.S.C. § 24 (Seventh).
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[2] See Sections 23A & 23B of the Federal Reserve Act, 12 U.S.C. §§ 371c–371c-1.
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