Archives for posts with tag: Banking

I’ve had three working papers made available on SSRN recently. One is economic history, another one is political economy, and the third one is contract theory. Two of them are related to free banking, and two are related to insolvency. In order of pre-publication:

  1.  Free Banking and Economic Growth in Lower Canada, 1817-1851, with Vincent Geloso

    Generally, the historical literature presents the period from 1817 to 1851 in Lower Canada (modern day Québec) as one of negative economic growth. This period also coincides with the rise of free banking in the colony. In this paper we propose to study the effects of free banking on economic growth using theoretical and empirical validations to study the issue of whether or not economic growth was negative. First of all, using monetary identities, we propose that given the increase in the stock of money and the reduction in the general price level, there must have been a positive rate of economic growth during the period. We also provide complementary evidence drawn from wages that living standards were increasing. It was hence impossible for growth to have been negative. Secondly, we propose that the rise of privately issued paper money under free banking in the colony had the effect of mitigating the problem of the abundance of poor quality coins in circulation which resulted from legal tender legislation. It also had the effect of facilitating credit networks and exchange. We link this conclusion to the emergence of free banking which must have been an important contributing factor. Although we cannot perfectly quantity the effect of free banking on economic growth in Lower Canada, we can be certain that its effect on growth was clearly positive.

  2. Robust Political Economy and the Insolvency Resolution of Large Financial Institutions

    This research applies the robust political economy framework to a comparative institutional analysis of large US financial institutions insolvency procedures. The regimes investigated will be the bailout of financial institutions, Dodd-Frank Act’s Orderly Liquidation Authority, both through procedures that follow original intent and through a ‘bail-in’ route, and 3 bankruptcy possibilities including Chapter 11, a so-called “Chapter 14,” and a mandatory auction mechanism used as a benchmark. We study the robustness of these regimes’ procedures through 5 criteria, both ex ante and ex post. These are the initiation of insolvency procedures, Too-big-to-fail moral hazard, the filtering mechanism, the allocation of resources, and their alleged systemic externalities containment abilities.

  3. In Which Context is the Option Clause Desirable?

    The option clause is a contractual device from free banking experiences meant to prevent banknote redemption duels. It has been used within the Diamond and Dybvig [Douglas W. Diamond and Philip H. Dybvig. 1983. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy 91 (3): 401-419] framework to suggest that very simple contractual solutions can act as an alternative to deposit insurance. This literature has however been ambiguous on whether the option clause can replace deposit insurance outside of those two contexts. It will be argued that the theoretical clause does not generally affect the likelihood that a solvent bank goes bankrupt because of a bank run, as empirical evidence suggests it is already near null, and that the exercise of the clause will have the effect of diminishing the size of creditor claims on bank assets because it exacerbates the agency problem of bank debt. It will therefore be argued that the clause is only desirable in (a) free banking systems that are historically devoid of bank runs in the first place and have other means of managing debt-related agency problems, and (b) under the unrealistic assumption that bank runs are self-fulfilling prophecies. It will be argued that the agency problem of bank debt make the option clause undesirable outside of free banking systems.

There’s more where those came from, I might add another one soon, on bankruptcy theory.

For an Institute for Humane Studies program I wanted to participate in you had to write a short essay on how a famous article or book is misguided and inimical to liberty. I wrote the essay below for the occasion, and I’m pretty happy of how it turned out, so I’m sharing it here. Some readers will instantly recognize the heavy influence of chapter 6 of Lawrence H. White’s Theory of Monetary Institutions—get this book.

The seminal paper by Diamond & Dybvig (1983) on bank runs is misguided and inimical to liberty. It suggests that banks are inherently unstable, always on the verge of suffering a “redemption run” at any unrelated ‘sunspot,’ and that it is absolutely necessary that bank runs be suppressed, and that deposit insurance is the most effective way to do it. In their model, if banks ought to survive it has to be through intervention into the financial system. The basic features of this model are still present in most publications on financial stability to this day.

First, unlike the model would suggest, bank runs are generally not responsible for the initial shock. Gorton (1988) studies the National Banking Era in the US, and finds that for each of the 7 crisis he identifies, bank runs were rather the result of a previous event announcing a possible depreciation of banking assets. Likewise, Calomiris (1991) finds that over 1875–1913 all banking panics (generalized run on all banks) happened within the quarter following an abrupt increase in business failures. Mishkin (1991) studies bank panics from 1857 to 1988, and finds that for all but that of 1873, panics occur well after the recession has started.

Secondly, banks that do go bankrupt because of a bank run are those that are pre-run insolvent. Banks that are solvent can generally borrow from other banks and other institutions, historically clearinghouses, have a large repertoire of possible solutions to help banks is crisis. While bank runs and associated liquidity problems can be aggravating factors, even in the worst bank panic episodes they are causes of bank failure only in exceptional circumstances (Kaufman 1987, 1988). Even in the most fruitful historical era in terms of banking panics and runs, the American National Banking Era, runs were a primary cause of failure in only one case out of 594 bank bankruptcies (Calomiris 1991, 154). Calomiris & Mason (1997) study the banking panic of June 1932 in Chicago and find that no pre-run solvent banks failed. Reviewing this literature, Benston & Kaufman (1995, 225) conclude that “the policy implications of the Diamond & Dybvig (1983) model are not very useful for understanding the workings of the extant banking and payments system.”

A third reason is that most runs have in fact been partial “verification” runs. Depositors eventually figure out that the bank will likely survive the crisis, and runs stop. This is impossible in the Diamond & Dybvig (1983) framework; once initiated the run must always go through and make the bank fail. Ó Gráda & White (2003) study a single bank from the 1850s. They investigate depositor behavior through individual account data, and particularly through the panics of 1854 and 1857. The bank survived both. They find that runs are not sudden, but involve a learning mechanism where random beliefs are progressively dropped, while behavior motivated by legitimate signals become more important over time. Panic does not displace learning in the market processes of bank runs.

Finally, if Diamond & Dybvig (1983) is correct, it should apply to all fractional-reserve banking systems without deposit insurance. But, as evidenced by the US-centric literature cited, bank runs are much more common in U.S. history than elsewhere, and bank panics are specific to the American National Banking Era and attributable to bank regulation of that era, such as the ban on branch banking that made mergers with insolvent banks impossible, and the bond deposit system that limited emission at a critical time (Smith 1991). Bordo (1990, 24) compares bank panics internationally and comments that “the difference in the incidence of panics is striking.” While over the 1870–1933 the US had four panics, there were none in Britain, France, Germany, Sweden, and Canada despite the fact that “in all four countries, the quantitative variables move similarly during severe recessions to those displayed here for the U.S.” Table 2-1 in Schwartz (1988, 38–39) report that from 1790 to 1927 the U.S. experienced 14 panics, while the Britain, the only other country with as many observation, experienced 8, all of them before 1867.

Not only does Diamond & Dybvig (1983) suggest bank runs have much higher costs than evidence does, but it also shrouds its benefits. My research suggests that bank runs could play an important role in initiating insolvency procedures earlier, before the bank can enlarge its losses, and therefore limit systemic externalities.

Over at Punto de Vista Economico Nicolas Cachanosky has a very enlightening post on the debate hosted by the Online Library of Liberty about Ludwig von Mises’ Theory of Money and Credit that I posted about earlier. The whole thing is worth reading, as well as Nicolas’ various essays on the topic (here and here for example).

In this post I’m going to go further than I did the last post. I am going to claim that there might actually might be room for a reconciliation in the debate over the convergence to 100-percent reserves in free banking. That is, with a small concession one-hundred-percenteers might be able to salvage the idea that competition among free banks would lead to something close enough to a reserve ratio of 100%. This position was argued by Antoine Gentier in his 2003 book “Economie Bancaire: Essai sur les effets de la concurrence et de la réglementation sur le financement du crédit,” but you might also find it elsewhere in English. A short version of the argument is present in Gentier’s forthcoming paper in English in the JEEH.

He argues that in practice both positions are very close to another, because in the end what matters is not a snapshot or an average of reserve ratios, but the marginal reserve ratio. Indeed, “[p]ast money creation is not the main problem because it has already disrupted the economy by changing relative prices. The main problem relies in the ability of the banking system to create new currency now, and further distort the structure of production.” Over the period studied by Gentier (2003), and myself with Gentier (unpublished), while competing banks’ reserve ratio was very low, their marginal reserve ratio was close to 100%. Because of the phenomenon of adverse clearing, competing banks of issue are incapable of wildly expanding their circulation of banknotes. If they did they would be quickly drained of specie, much like was the case of the Ayr Bank in free banking era Scotland (See White 1995, 27-29). This is something Mises agrees to. It means that free banks could not create credit “out of thin air” like it is sometimes claimed, but had to do it almost entirely through accumulation of prior savings. This is one of the reasons that free banks have very high capitalization levels. At the margin, reserve ratios in free banking would indeed be “up very high and possibly close to 100 percent,” to use the words of Hummel.

White, L. H. 1995. Free Banking in Britain: Theory, Experience, and Debate, 1800-1845. 2nd ed. London: The Institute of Economics A ffairs.

The Online Library of Liberty’s Liberty Matters debate forum just hosted a very interesting discussion on Ludwig von Mises’ Theory of Money and Credit (1912). The lead essay is by Lawrence H. White, with comments by Jörg Guido Hülsmann, Jeffrey Hummel, and George Selgin, and a final reply by White.

It contains, among other things, an enlightening reply by White on Mises’ purported disapproval of free banking, and free banking’s supposed procyclicality. Other topics includes a reassessment of the original contributions of Mises’ book and how his “regression theorem” holds up with the emergence of bitcoins.

This passage in Hummel’s comment was of particular interest to me;

[W]e must carefully distinguish between favoring free banking as a legal regime and predicting how it would operate in practice. I think Larry goes too far when he seems to imply that Mises had in mind the kind of free banking that he (1999) and George (1988) predict would emerge without regulation: that is, a system in which reserve ratios are extremely low and banks adjust the money supply to demand in a way that stabilizes velocity. As much as I may agree with their prediction, I can assure them that Sennholz repeatedly affirmed his belief that unregulated competition among banks would drive reserve ratios up very high and possibly close to 100 percent, and he left the impression that such was Mises’s opinion as well.

Of course Hummel knows that both White’s and Sennholz are equally predictions, and admits his own support for the idea that reserve ratios would be extremely low. But what I want to get to is that Sennholz’s predictions are much less supported than White’s are. They are not equal predictions. This is important because elsewhere one-hundred-percenteers have suggested that the market would favor 100% reserves anyway.  White replies to this passage;

Mises in Human Action (p. 446) does quote Cernuschi to the effect that free banking would have narrowed the use of banknotes considerably, and in other ways suggests that reserve ratios under free banking would be, as Hummel puts it, “up very high and possibly close to 100 percent.” If that is Mises’s prediction, then on this point I do depart from Mises. In my 1992 essay that Hummel cites, I criticized Mises for suggesting that free banking would produce reserve ratios close to 100 percent. The best historical evidence we have, from the Scottish free-banking system and other mature systems, shows reserve ratios below 10 percent.

The historical evidence is one way of answering this. In my own research with Antoine Gentier (unpublished) we found that New England’s freest banking systems in terms of both freedom of entry and banking regulation (ie not in the “Free Banking Laws” sense) had similarly low reserve ratios. But there are also theoretical reasons.

Competition over bank’s financial stability does not only occur over reserve ratios. In our study, for example, banks competed over capitalization levels to prove their resilience. But they could also be competing over the liquidity of their assets, their demand debt to total debt ratio, or a variety of  “living will” arrangements (liability regime of shareholders, option clauses, clearinghouse memberships, etc.) just to name a few. I’m going to conjecture (and derogate from Selgin’s comment on the use of statistics), and say that given the prevalence of banknote circulation as a source of banking profit in free banking systems relative to the costs of these other ways banks can prove their financial stability, it is not at all a blind prediction, or one merely supported by historical anecdotes, to say that reserve ratios would be closer to 1% than they would to 100% under free banking. In fact, it would take a particularly unfree institutional environment for competition between banks to lead to 100% reserve ratios.

In this video Larry White of George Mason University covers deposit insurance and bank run literature.

“Practically all the discussion on the relative merits of a centralised monopolistic banking system and a system of competitive banks all possessing equal rights to trade, took a place in a period of some forty to fifty years in the nineteenth century, since when it has never been reopened. In that period, however, the subject was one of the most keenly debated of its time. This is especially true of France, and indeed the period of about twenty years during which French thinkers occupied themselves with this problem is perhaps the most productive of any in French economic literature, both from the point of view of output and from the standpoint of its quality in comparison with that of other countries in the same years.”

Smith, Vera C. (1936) 1990. The Rationale of Central Banking and the Free Banking Alternative. Reprint, Indianapolis: Liberty Fund.

A widely held belief in the United States and the world financial community is that the default of major debtors-whether companies or municipalities or sovereign countries-could lead to bank failures that would precipitate a financial crisis. The remedy proposed by those propagating this view is that major debtors therefore must be rescued from the threat of bankruptcy to avert the projected dire consequences for banks and for the stability of the financial system. I shall argue that (a) a debtor whose affairs have been mismanaged should be liquidated or reorganized under new management; (b) default by major debtors need not result in bank failures; (c) if defaults do result in bank failures, so long as the security of the private sector’s deposits is assured, no financial crisis will ensue. The bugaboo of financial crisis has been created to divert attention from the true remedies that the present financial situation demands.

Schwartz, Anna J. (1987) “Real and Pseudo-Financial Crises,” in Schwartz, Anna J. (ed.) Money in Historical Perspective, University of Chicago Press, p. 271-288.

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