Well the simple
answer is to regulate shadow banks!! Or in the words of Lord Turner (head of
the UK’s Financial Services Authority) "If it looks like a bank and quacks
like a bank, it has got to be subject to bank-like safe-guards."
However,
DD seem to think it would be impossible to regulate shadow banks. They say “…it
will be impossible to control the institutions that will enter in the vacuum
left when banks can no longer create liquidity”.
Exactly
where the difficulty is, DD don’t say. But there is a good reason for thinking
it would not be too difficult, as follows.
The
larger a shadow bank, the more difficult it is for it to escape being noticed
by the authorities and thus being regulated. On the other hand the smaller it
is, the more difficult it is for it to create money.
To illustrate,
any self-employed plumber or electrician with a turnover of say £100,000 who tries
to avoid being noticed by the tax authorities is liable to be caught out. And
£100,000 a year is a minute turnover for a bank (shadow or formal). Thus
keeping tabs on shadow banks, with the possible exception of the very smallest
ones, should not be difficult.
As
readers will have noticed, DD imply that small banks (particularly small shadow
banks) can create liquidity with much the same ease as large banks. Not true.
Small
shadow banks have no problem in competing with large banks when it comes to
what is perhaps the main activity of all banks: connecting borrowers to
lenders. But that of itself does not create money.
Creating
liquidity, or at least one form of liquidity creation is the bog standard money
creation business which commercial banks carry out: lending money into
existence. Or as Mervy King put it, “When banks extend loans to their
customers, they create money by crediting their customers’ accounts.”
Money
creation consists of persuading one’s creditors to accept one’s liabilities and
pass them from hand to hand in payment for goods and services or anything else.
A Minsky put it, “everyone can create money; the problem is to get it
accepted”. And the smaller a bank, the less easy is it for the bank to “get it
accepted”. To illustrate, everyone in the UK has heard of say Lloyds bank and
readily accepts a cheque drawn on Lloyds (assuming they trust the drawer), and
readily accepts plastic cards with “Lloyds Bank” or “Visa” imprinted on the
card.
In
contrast, small shadow banks just don’t issue cheque books or plastic cards: if
they did, they would not be readily accepted.
And as to
other liabilities that banks issue and try get accepted as money, the smaller
the bank, the more difficult it is for it to get its liabilities accepted as
money.
Conclusion.
The basic flaw in the DD idea that shadow banks can create money is thus. The
larger a bank the more readily it can create money, but the less easy is it for
the bank to escape being noticed by the authorities and being regulated. On the
other hand small banks MAY BE ABLE to escape being noticed, but small banks
have problems creating money.
Maturity
transformation.
Another
form of liquidity creation is maturity transformation (MT), that is “borrow
short and lend long”.
But that
is another area where size pays. MT relies on calculating what proportion of
depositors are likely to withdraw their deposits in the next week or month, and
keeping that money available for those depositors, while lending on the rest of
the money.
Now a
bank with hundreds of thousands of depositors can calculate very accurately
what proportion of depositors are likely to withdraw in the next month. But the
same does not apply to a very small bank with say ten depositors (or similar
types of bank creditor). The latter sort of bank would probably run a risk if
it engaged in any MT.
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