Nick Gruen Proposal

7/28/2019 Nick Gruen Proposal

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Central Banking for All: A modestproposal for radical change

April 2013


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Here I am back again in the Treasury like a recurringdecimal but with one great difference. In 1918 most

peoples only idea was to get back to pre-1914. No-one today feels like that about 1939. That will make anenormous difference when we get down to it.

John Maynard Keynes, 1942, (Moggeridge, 1992, p.

695)

Economic growth is held back by industries whereestablished interests are so powerful that disruptiveinnovation can be staved off forever. Financialservices is probably one.

John Kay, 2012.

The challenge for fiscal conservatives, then [is to]combine fiscal austerity with job creation?

Chris Dillow, 2013


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Overview

Introduction

Since the global financial crisis, debate has raged about the appropriatearchitecture for the monetary and banking systems, yet opinion remainsdivided as to what should be done, even amongst those sharing broadideological sympathies. Thus, some support narrow banking with strongseparation between banks utility role in facilitating payments andstraightforward lending from more speculative activities.1 Others dontthink this solves our problems.

This paper takes a different tack. We begin by asking questions fromfurther afield. We consider developments in other areas of the economythat have reflected the massive changes taking place in information

technology (IT) for banking is dominated by IT. We then ask whatmight be obstructing similar transformations in banking and whateconomic reform principles might guide our removal of those obstacles.This approach yields recommendations worth pursuing in their own rightas economic reform. But it also moves us towards a financial system inwhich the respective roles of private and public endeavour are bettercrafted so as to play to their respective strengths.

Fortuitously, it turns out that following this micro-economic formula yieldsthe system-wide benefit of making utility banking safer. It also provides apowerful new source of monetary stimulus to a depressed British macro-

economy. And not only can this be done without expanding the budgetdeficit, it will in fact generate substantial government revenue which willrise with economic recovery.

Competitive neutrality within a public-private partnership

New business models in IT, media, publishing, travel, entertainment andother industries have mostly come from the growth of new entrants,rather than the transformation of incumbents. Given that it is a soberingthought that all the major British banks today are the mergeddescendants of the major British banks of a century ago. New businessmodels are emerging, but they are not given access to the central

banking system and the liquidity it provides and so are at a perpetual

1http://www.johnkay.com/2009/09/15/narrow-banking


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competitive disadvantage against the official family of the banks andthe central banking system.

Further, within the banking system, larger banks enjoy fundingadvantages arising from market expectations that their creditors will be

bailed out if necessary. This too-big-to-fail subsidy which runsannually at tens of billions of pounds confers such advantages on thelargest five banks that competition from smaller banks cannot properlydiscipline the majors.

But governments will always be at the apex of the banking system determining the unit of account, vouchsafing price stability, supplyingliquidity to the financial system. And because the provision of liquidityundermines bankers incentives to be prudent, financial regulationcomes hand in glove with prudential regulation. Thus, banking isnecessarily a public-private partnership. Given this, the policy task is not

to minimise the governments role any more than one would minimisethe governments role in the provision of law enforcement as an end initself. Indeed, one could argue that such an approach helped generatethe financial crisis that plunged us into our current woes.

Rather, we must optimise governments role alongside the role of privateendeavour so as to play to the strengths of each. In this regard, theproposals set out in this paper are quite conservative in principle.However, because our current banking system strays so far from theprinciple of competitive neutrality, the benefits it can produce are large.

The motivating idea can be summarised as follows: modern technology

makes it possible to extend some important central banking services toindividual Britons and British businesses. Doing so would lead to abanking system that is more efficient and so cheaper, safer and morestable whilst generating a substantial new source of governmentrevenue as an engine of money creation alongside commercial banks.

Retail central banking services

Central banking evolved at a time when service provision in localbranches was integral to providing banking services. In this world itmade sense for the central bank to wholesale its core exchangesettlement and liquidity support services to banks which would thenretail them to individuals and businesses via their branches, passbooksand cheque accounts. It was impracticable for central banks services tobe provided to individuals. Yet this was also an age in which books andtickets for travel and entertainment were distributed through local retailoutlets whereas today much of this is being disintermediated by

wholesalers selling direct to consumers over the web. Today, for a substantial


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proportion of banks utility services involving lending, holding reservesand settling payments, the internet enables the central banking systemto wholesale directly to consumers.2

Savings and payments

Just as banks have exchange settlement accounts with the central bankenabling risk-free transfers between them, so all Britons who want themcould easily be provided with similar risk-free means of transferringmoney between one another electronically. They already have access togovernment savings accounts at National Savings and Investments(NS&I), and it would be straightforward to enable payments to be madebetween those accounts. Because, according to the principles ofcompetitive neutrality, governments should not be prevented fromcompeting against non-government service providers, those accountsshould be connected to the wider bank payments systems to enhance

their convenience and so attractiveness as a vehicle for Britons to saveand their government to borrow.

Further, the Bank of England pays banks Bank Rate on its reserves.3Likewise, users of what is proposed here as retail central bankingservices via NS&I or some similar agency would receive a similarinterest rate on sight deposits less some fee or interest margin to fundthe costs of running the system. Care should be taken to ensure thatwhoever is providing these services does not receive unfair advantagesregarding taxes and government charges vis--vis private competitors.However, because we want competition to provide a means by whichthe market searches to minimise its costs, this should not extend topreventing a government agency from providing products to the public atinterest and fee rates that reflect lower costs of operation.

Governments are likely to enjoy lower costs in the provision of someaspects of utility banking than private service providers. Indeed, it is thecentral banks lower cost of liquidity that has made it an integral part ofbanking in all developed countries.

2 In what follows, we refer to the central banking system to avoid prejudging the preciseinstitutional configuration best suited to implementing the banking architecture we propose.Suffice it to say that some or all tasks could be provided by the Bank of England but evenhere that might be subject to side agreements and guarantees provided by other arms ofgovernment as is the case with the Bank of Englands quantitative easing operations today.It may also be expedient to provide some or all services via other government agencies suchas National Savings and Investments (NS&I) which already provides services to the public.

3 Or in some circumstances Bank Rate less 25 basis points (Bank of England, 2010, p. 5).


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Lending against assets

In law, being unable to pay ones bills as they fall due constitutesinsolvency. However, banks regularly become illiquid, and so unable tomeet their obligations as they fall due. In this situation, central banks

supply liquidity against bank assets judged to be sound if carried tomaturity. This distinction between liquidity and solvency courts moralhazard and systemic risk. Big banks are complex to regulate. But ifliquidity and solvency can be distinguished on a bank balance sheet,they can also be distinguished regarding other assets.

A universe of common assets could be identified that could be acceptedas super-solvent or super-collateralised which involve negligible risk ofloss if held to maturity. This paper proposes that prime mortgages withloan to valuation (LTV) ratios below say 60 per cent meet thiscriterion, though the line between safe and super-safe assets might vary

through the cycle and by geography as occurs now in the commercialmarket. Be that as it may, such assets are immensely safe requiringboth falls in property prices of greater than 40 per cent and some loss ofincome from the borrower to generate any risk of loss. One could do thesame with mortgages against commercial property, though the loan tovaluation ratios would need to be lower to reflect higher levels of risk inthis market. For illustrations sake, we suggest a loan to valuation ratio of40 per cent. In each case, such assets are clearly much safer than A1and lower rated British banks to which the Bank of England currentlylends.

One could reconfigure a substantial portion of the central banking

systems liquidity support around the support of such assets themselves,rather than limiting that support to the same assets (usually with lowermargins for safety than are proposed here), but only where they reposeon bank balance sheets. The central banking system could offer toinsure such assets or a similarly safe pool of assets and to lend againstthem for cost and risk reflective fees and/or margins.


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National Savings and Investments (NS&Is) mission should be touse its resources in a cost effective way to provide basic bankingservices to the British public. Accordingly NS&I should removequantity restrictions on its accounts and establish facilities that

give its account holders direct access to pay each other and otheraccounts within the payments system.

Recommendation Two: The central banking system shouldguarantee and lend against super-collateralised mortgages. Thedemarcation between such mortgages and other collateralisedcredit should depend on the specific characteristics of borrowersand their particular collateral and should vary according to macro-prudential principles. Such services should be provided by agovernment agency that is at arms length from the government ofthe day.

Recommendation Three: The central banking system should takeBank Rate as the appropriate rate of return on sight or at calldeposits and on its own lending on super-safe assets withappropriate margins/fees to reflect residual credit risk and the fullresource cost of service provision.

It should be made clear that virtually all the additional work that would bedone by the central bank would be sub-contracted to businesses in theirvarious marketplaces. There are competitive markets in the provision ofsuch services as conveyancing, valuation, mortgage management and soon. It is not envisaged that the central banking system do more than

contract for the provision of such services, although, of course, someexpansion of operations would be necessary to manage the contracting ofsuch services.

Central bank loans would also be available on prime loans with LTVsabove the level of super-collateralisation. Thus, ,borrowers could fund an85 per cent or higher proportion of their homes value by raising the first60 per cent as a super-collateralised central bank loan as the senior orfirst mortgage debt with less senior or second mortgage rights for the restof the debt. In keeping with the principles of competitive neutrality,commercial banks and other lenders, and indeed other service providerssuch as supermarkets, telecommunications companies or ISPs would bepermitted to package central bank loans to their customers either withor without additional less senior debt from themselves adding their ownmargins to ensure there is a competitive market in the provision ofmortgage management.


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The division of assets into those that central banks regard as sufficientlysafe to underwrite repo activity between themselves and banks,4 andthose that can be regarded both as super safe and as implicitlygovernment guaranteed in any event, opens up two avenues forefficiency gain.

Firstly, however safe assets are, for the private sector to fundthem, it must fund a vast series of market connections whichbegin with individual lenders and end with individual borrowersbut which must be aggregated and disaggregated as they passthrough the banking and wider financial systems often betweendifferent firms which must bear the costs of due diligence oneach transaction. Such costs include marketing, accountmanagement, audit, custodianship, insurance, legal costs andthe management of liquidity. By contrast, as an integrated entityand the issuer of legal tender, the central banking system can

simply issue liquidity against an asset, up to the point at which itceases to regard it as presenting negligible credit risk. Thepotential efficiency gains over this being done by multiple firmswithin a market are large.

Secondly, it makes sense for the government to offer to explicitlyinsure or lend against super-collateralised assets for cost or riskreflective margins because the circumstances in which it wouldbe called upon to make good on the risks it is thus taking on arethose in which the governments implicit guarantee of thefinancial system would be drawn on in any event. Yet, where

such guarantees are implicit, they are unpriced, which is bothinequitable as taxpayers get drawn into bailing out bank funders,and inefficient because the margins at which banks provide theirproducts are not reflective of the risks they are drawing thecommunity into. And this implicit subsidy is enjoyeddisproportionately by large banks judged too-big-to-fail and soremains largely with their shareholders rather than beingcompeted away and so recycled to their customers as lowerfees and margins.

4 In this paper, in the absence of the contrary intention, the expression banks will be takento include all firms providing loans which are supplied liquidity by and prudentially supervisedby the central banking system.


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Micro-economic impacts

The central micro-economic impacts of these recommendations wouldbe to displace a substantial portion of private banking with utility centralbanking services providing finance at substantially lower resource cost

to the economy and so to borrowers. Other things being equal, theprovision of extended retail deposit services by government would tendto somewhat lower the cost of debt to governments and to reduce banksaccess to such deposits while a substantial portion of lending currentlybeing underwritten by banks would be underwritten by the centralbanking system. This would reduce employment in banking, thoughsome of this would be offset by additional employment in both the publicand private sectors in delivering utility central banking services.

In addition to on-selling central bank services to their customers,commercial banks would migrate to taking a higher risk part of the

market in higher LTV mortgage lending. This would be a riskierproposition than is currently the case because the less senior tranche oflending would no longer have super-collateralised lending to cross-subsidise its costs and reduce its risk. With such cross-subsidies beingremoved, one would therefore expect the cost of that debt to rise aswould the returns required to attract deposits and wholesale funding.However, the former margin reducing effect would outweigh the lattermargin increasing effect because falling margins for services nowprovided by the central banking system would reflect lower resourcecosts as the central banking system simply supplied liquidity to super-collateralised loans rather than having to raise it on the market with all

the attendant costs of doing so. The market financing of the higher, lesssenior tranches of loans would likely require higher interest rates but,with the possible exception of some additional credit enhancement suchas private mortgage indemnity insurance, the provision of such fundswould have similar resource costs as they do now.

Macro-economic impacts and implications for macro-economic

management

These proposals come with additional large benefits, particularly duringthe current sustained downturn, for they represent a powerful and very

direct form of quantitative easing. With Bank Rate close to its zerobound, bank margins hold their borrowers to variable interest rates onhome loans which are mostly over two and often over three per cent. Inthese circumstances, the Bank of England has described its quantitativeeasing policies its creation of new money to purchase high quality


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assets like gilts from private investors such as pension funds andinsurance companies as designed to circumvent the banking system.5

Yet it has also found itself pursuing quantitative easing through thebanking system with the Funding for Lending Scheme (FLS). This has

lowered lending rates, yet it is unclear how much of the benefit is beingpassed on and how much is being captured by the banks themselves.FLS appears to have brought down the cost of super-collateralisedhome loans somewhat by up to 50 basis points in some cases. But thishas been nowhere near enough to make large inroads into the obstaclesthat bank margins impose on the operation of monetary policy near thezero lower bound. And because of their lower resource cost, the kind ofproposals set out here would achieve substantially greater marginreductions. Accordingly, in the present circumstances, the introduction ofthe proposed central banking services for citizens would engineer a newand much more direct front of quantitative easing.

Governments could finance super-collateralised mortgages either withinthe traditional disciplines of fiscal policy by borrowing money which isthen re-lent to mortgagees. (The development of NS&I proposed abovewill assist in this process.) However, in the current circumstances, thecentral banking system could also fund mortgages by the creation ofnew money as it is doing with existing quantitative easing exercises.Where it did so, this would mostly displace existing money previouslycreated within the fractional reserve banking system. However, the lowerinterest rates charged on the super-collateralised portion of mortgageswould stimulate borrowing. It would also generate revenue as borrowersinterest payments would be paid to the central banking system ratherthan to banks and their funders. Unlike other quantitative easingmeasures, the quantitative easing described here does not involvepurchasing interest-bearing assets, which could be expected to suffercapital losses for governments as interest rates rose to more normallevels. Rather, Bank Rate increases would produce large increases ingovernment revenue that could fund services, obviate the need fordistortionary taxation elsewhere and/or retire debt.

It is beyond the scope of this paper to elaborate in detail, but under thenew regime proposed here, to the extent that the central banksadditional lending against super-collateralised mortgages is financed by

money creation, the relationship between monetary and fiscal policy

5 Bank of England, Quantitative Easing Explained, accessed athttp://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx on Sept 16, 2012.


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would change in important ways. Changes in Bank Rate would generatesubstantial corresponding changes in government revenue. If thesewere not sterilised from the domestic economy with correspondingchanges in the fiscal stance possibly involving sterilisation via foreignfinancial markets they would dilute the macro-economic effect of BankRate changes. Once recovery is underway, it may also be necessary tosoak up additional liquidity via varied reserve requirements forcommercial banks or by fiscalising any central bank money creationwith additional borrowing. Further work would be necessary to sketchout alternative scenarios in this regard.

Existing central banking retail services

As Shiller (2008) points out, the centrality of government to banking hasmeant that many of the most important financial innovations in modernbanking have fallen to governments. One innovation stands out. Amid

the Opposition warnings that anything that tends to connect the statewith banking has always been productive of disastrous consequences,6the Banking Charter Act of 1844 moved to freeze existing English privatenote issue and so to ultimately phase in the monopoly of note issue ofthe Bank of England, something realised in 1921 with the last noteissued by Fox, Fowler and Company when it was acquired by Lloyds.

In some respects it is to be regretted that the transition was made bylegislative fiat. For it might have been made in the way proposed in thispaper, by allowing the Bank of England and private banks to competewith each other as far as possible on a level playing field. For it canhardly be doubted that, at least if the central bank is soundly governed,its notes offer a superior technology for storing value and effectingpayments in everyday situations than private notes. Why did this methodof physical settlement come to replace all private bank notes? Becausethe involvement of parties other than the guarantor of the monetarysystem the central bank system simply injected additional complexityand counterparty risk into the transaction without commensurate gain.

Remarkably, more than ninety years since the Bank of Englandsmonopoly over English bank notes was consummated and over forty

6 Mr. Benjamin Hawes, a Whig politician, in the House of Commons on 13th June, 1844during the second reading of the 'Bank of England Charier Bill'. HC Deb 13th June, 1844 vol75 cc777-871, accessed at http://hansard.millbanksystems.com/commons/1844/jun/13/bank-charter-the-currency on 10th February, 2013.


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years since the birth of the internet, there exists no simple and easilyaccessible electronic analogue of this process. Yet it could be built, fromthe existing infrastructure of NS&I, relatively quickly and cheaply.

It is quite true that the proposals set out here involve substantially

greater government involvement in banking than is the case today. But itis greater government involvement in precisely the way the Bank CharterAct of 1844 contemplated greater government involvement in theprovision of the most utility-like aspects of banking. And as in 1844,they do so by extending to citizens the services the central bankingsystem currently provides to banks. They also generate governmentrevenue by capturing seigniorage in money creation previously enjoyedby private banks. This paper does not propose the establishment of agovernment owned bank to compete with private banks. To do so wouldinvolve governments in the provision of services such as local bankbranches which can be competitively and competently provided by the

private sector. One might surely wonder why governments establishenterprises to provide services to the community only to charge themwith acting in essentially the same manner as private businesses.

Summary and conclusion

The proposals outlined in this paper:

Use existing infrastructure;Achieve their objectives simply by enabling government agencies

to compete in the marketplace on their own merits rather thanby preventing or impeding competing private service providers;

Involve no subsidies; Preserve the important principle that government agencies

commercial dealings should be at arms length from thegovernment of the day; and

Generate a powerful new form of direct quantitative easing and anew source of revenue for the future.

All this from simply building the means by which individual Britons canaccess the central banking services already provided to British banks.

Nick Gruen Proposal

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Transcript of Nick Gruen Proposal