The ‘finance franchise’ and fintech (Part 1 & 2)
To the contrary, as a new paper in the Cornell Law Review by Cornell lawyers Robert Hockett and Saule Omarova argues, some of them see finance as more akin to a public-private partnership “most accurately, if unavoidably metaphorically, interpreted as a franchise arrangement.”
Here’s the crux of the argument:
Pursuant to this arrangement, the sovereign public, as franchisor, effectively licenses private financial institutions, as franchisees, to dispense a vital and indefinitely extensible public resource: the sovereign’s full faith and credit.It’s brave theory, not least because the view that the loanable funds theory is absolute is still being hotly debated.
In the United States, public full faith and credit flows through the financial system in two principal forms. The first form comprises directly-issued public liabilities: mainly Federal Reserve notes and U.S. Treasury securities. The second, quantitatively more significant yet less commonly recognized form is publicly accommodated and monetized private liabilities. What we call “accommodation” occurs when a public authority—typically, the Federal Reserve (the “Fed”)—takes on a privately-issued debt liability as a liability of its own. “Monetization” occurs when the ultimate beneficiary of accommodation is then able to spend the proceeds thereof as if they were currency. When a public instrumentality directly or indirectly accommodates or monetizes a private liability, it effectively extends the full faith and credit of the sovereign—in this case, the United States.
Nonetheless, the three-pronged approach to understanding the financial system they propose is interesting. At a minimum it encapsulates — or at least in part offers explanations — some of the weirder things that have been going on post crisis that can’t necessarily be explained by the orthodox model alone.
To the authors, there are three ways finance operates through the economy: 1) credit intermediation 2) credit-multiplication and 3) credit generation.
Credit intermediation follows the standard view. This suggests that which is lent or invested is always something that has been previously accumulated, “hence is limited both by the finite stock of the latter and by the willingness of its private accumulators to invest it.”
If it’s been accumulated and not consumed, meanwhile, it must be intermediated because S=I.
“Credit-multiplication” they note is the most familiar counter-example. This encapsulates the theory of fractional reserve banking, the idea that the banking system lends out more than it receives in investor deposits and holds only enough of the latter to handle anticipated daily withdrawals. The rest is continuously lent out.
According to the authors, however, these two theories aren’t enough to satisfy how the banking system actually works. The third model of ‘credit-generation’ also needs to be factored in.
What they observe is that because the reserve can be preposterously small in the credit multiplication model — even sitting at zero if the fluidity of the system is continuously kept in check via a robust and continuous form of real-time clearing — the idea that any form of loanable funds are vital to the system may be an incorrect assumption. “Instead, it might be more accurate to view lending institutions as generating finance capital, rather than simply intermediating or even multiplying it.” That’s the none-to-many model.
If banks are free to create money from thin air, what then are the limitations?
The authors argue since credit outstanding is not fundamentally dependent upon—or, therefore, limited by— pre-accumulated investment capital, it must be limited only by investment opportunities which are viewed as potentially profitable. “In other words, credit is endogenous rather than subject to exogenously given, pre-accumulated funds.” If the opportunities are there, banks will generate the funds (on effectively maximum leverage by way of an accounting trick) to find ways to finance them.
“Where credit flows conform to the multiplication or generation models, as they do in all modern financial systems, the public inevitably becomes the financial system’s principal protagonist.”Effectively the public sector ends up being responsible for both authorisation — including any associated supervisory responsibilities — and for guaranteeing the intrinsic value of these magically constructed liabilities, especially when banks are unable to honour them (due, let’s say, to a breakdown in the clearing mechanism and/or a failure in their investment strategies at a systemic level).
That, in any case, is how the public-private franchise evolves. Banks operate as agents of the sovereign balance sheet, creating money — via the creation of assets, simultaneously with the creation of liabilities — when they believe the investment cases justify them. These asset/liabilities need only to be funded on a holistic basis to the extent that regulations require them to be funded.
Our take would be, yes — yes it does. If shadow banking liabilities are accepted by the wider banking system as cash or a cash equivalent (indistinguishable from bank-generated cash liabilities) there isn’t necessarily a guarantee the shadow bank in question — whether unwittingly or purposefully — is properly funding those liabilities (since it’s outside of the supervisory loop). If they’re not properly funded, or if there’s excessive margin lending going on, they’re either credit multiplied or credit generated.
The difference is, the public balance sheet is not theoretically supposed to be on the hook for guaranteeing such liabilities if and when things go wrong.
The problem is… even if the public balance sheet is not theoretically responsible for defending shadow banking liabilities, the revolving door between the shadow-banking sector and the official sector by way of liability transfer opens the “authorised system” to contamination.
As the authors note, this revolving door is in part fuelled by the presence of leveraged investors in capital markets:
….capital market investors—not only financial institutions but also ordinary investing individuals—are able to finance their purchases of securities in capital markets by borrowing (directly or indirectly) from banks, in accordance with the model in Part II above. To the extent such levered investing is a basic fact of the capital markets, it defies the fundamental assumption that “accumulators” of scarce funds directly finance issuing firms. It shows that capital market investors themselves often act as the true “intermediaries” in the process of transferring capital from banks—the ultimate “investors” in securities purchased with the money borrowed from them—to firms.Nevertheless, the shadow banking sector — since it does not on the surface have access to a lender of last resort — still attempts to regulate itself by using government paper as its equivalent of “base money”. This, as the 2008 crisis shows, de facto extended the public guarantee since only the government can create more of its own public debt. If the cost of not supplying high quality public debt to the shadow banking sector is potential systemic contamination of the official sector (due to the intermingled state of respective liabilities), as it was in 2008, chances are the state will act to defend the unofficial system. Its choice from then on is whether to extend the public-private franchise, in exchange for the right to supervision, or not.
Doing so ex post facto, however, doesn’t set a good precedent for the shadow banking systems of tomorrow, which can then assume they can operate according to their own non-supervised terms in a risk-inducing way until something goes wrong and they are forced to become supervised entities.
That, in a nutshell, is the theory of the financial franchise: even those institutions which are not officially franchised may be implicitly franchised because nobody can be sure if their collapse will or will not pose a systemic threat for the official sector in the long run.
What this has to do with fintech is coming up in our next post. (below)
In the first part of this two-parter we explained how the “financial franchise” theory of finance works, as thought up by Cornell lawyers, Robert Hockett and Saule Omarova in a new academic paper in the Cornell Law Review. (It should be noted, the theory isn’t necessarily unique as much as combinatory since it channels both Chartalist thinking and shadow banking collateralist thinking.)
What’s really interesting, however, is how it applies to the budding fintech sector, which aims to increase its independence from the official sector by recreating models based on loanable funds (credit intermediation) assumptions. These models, most famously, include peer-to-peer systems and cryptocurrency.
The authors imply these institutions will learn the hard way that once a credit generation model backed by a public-private franchise is in play in the economy, it’s almost impossible to go back. The reason being: all exclusive loanable funds systems carry a major competitive disadvantage on cost of funding vs established public-private franchise systems, and are hence likely to be outcompeted.
In its aspirations to render both the banks and the central banks redundant, this new-century fintech sector portrays itself as a revolutionary alternative to the existing financial system. Ironically, however, despite its disintermediation rhetoric, what this currently unfolding “fintech revolution” seeks to create in practice is a pure form of the orthodox “one-to-one” intermediation model of finance, as described in section I.A.1 above, in which traditional intermediaries such as banks or securities broker-dealers are replaced by electronic peer-to-peer transaction platforms.While the authors note it’s probably too early to decisively write off fintech, the way things are proceeding seems to support their theory. In short, they believe that if these systems are to expand beyond their peripheral place, they will have to reintegrate into the core finance franchise system eventually:
Fintech enthusiasts view modern technology as the magic key enabling the flow of pre-accumulated capital among freely-contracting private parties, on a scale sufficiently large to obviate the need for publicly sanctioned and supported credit-generation. In that sense, fintech revolutionaries are essentially envisioning a sort of financial “return to Eden”—or, at least, to the putatively peer-to-peer origins of finance.
Without sustained direct access to the ultimate public resource flowing through that system—the public’s full faith and credit—alternative finance is not likely to outgrow its present fringe status. In fact, as this Part shows, marketplace lending is already effectively re-integrated into the core financial system, if only as a new variant of shadow banking. Cryptocurrencies may be moving in the same direction.For more on how peer-to-peer is already turning into a conventional banking model see Kadhim’s work on the likes of Rate Setter and Zopa.
On cryptocurrencies, specifically, the authors note:
…the value of cryptocurrencies is tied fundamentally to their convertibility into conventional currencies, such as U.S. dollars backed by the full faith and credit of the United States. Cryptocurrencies are therefore likely to remain on the fringes of the financial system. Not surprisingly, startup cryptocurrency firms have reportedly been looking for partnerships with banks that have the resources and scale to reach mainstream audiences.For more on that last part see Dan McCrum’s latest on Goldman Sach’s recent foray into investment advice on bitcoin “as an asset class” in which they predict the price will surge in a frenzy of speculation, before going on to halve — while simultaneously disclosing that the Goldman Sachs trading desk “may have a position in the products mentioned that is inconsistent with the views expressed in this material”.
The second implication is that bitcoin’s high volatility as a store of value makes it an attractive underlying commodity for derivatives trading. In September 2014, TeraExchange established the first regulator-approved U.S. bitcoin derivatives trading platform. It may be only a matter of time before large U.S. FHCs enter this market and turn virtual currencies into the raw material for derivatives trading. The emergence of a deep market for hedging—and speculating on—bitcoin risk would, in turn, enable growth in the bitcoin acceptance rate in commercial transactions. Thus, as in the case of marketplace lending, the most likely mechanism for the success of cryptocurrency, ironically, involves its integration into the existing financial architecture—again, through the familiar channels of shadow banking, described above.
Related links:Goldman’s sketchy case to buy (and then sell) bitcoin – FT Alphaville
The finance franchise – Cornell Law Review
Nessun commento:
Posta un commento