2023-03-22 11:32:16 ET
Summary
- The current banking system combines both the functions of financial intermediation and the payment system.
- This combination has resulted, over time, in many banking problems including bank runs, financial crisis, and more and more bank regulation.
- The world is becoming digital, and this evolution will impact the banking system and the regulatory process.
- Many now believe that the credit function in the banking system should be separated from the payments system.
- One suggestion is that the government produce a Central Bank Digital Currency which would allow the banking system to separate the credit function from the payments system.
Modern commercial banks, fundamentally, are a combination of two functions: the credit function and the payments function.
On the one hand, commercial banks attract funds and then loan these funds out to people and businesses that want to borrow money.
On the other hand, commercial banks provide a place, hopefully, a safe place, for people and businesses to store money and then provide a "transfer" process for customers to move their funds from place to place.
Historically, these two bank functions have not always been combined.
The lending function is not always connected to the payments function.
Historical development and evolving technology always seem to play a role in just how the banking system is constructed.
The basic point is, however, that the two functions do not have to exist within the same organization.
Current Revelations
Current events have revealed that the combination of the two in one organization can lead to financial difficulties that can be quite disruptive to the financial system.
Problems from the "credit" system, the management of money, can result in behavior from the "payments" system that can put a bank out of business.
Rapid flows of money out of a bank can be destructive if the bank experiencing the outflows must draw on funds sources that are not immediately available at the book values.
Losses may be sufficiently large so that the bank experiencing the outflow of funds must close.
This would not be the case if the intermediation the bank created in the firm's business model did not include assets that were associated with another function of the financial institution.
That is, the combination of the "credit intermediation" function of the bank and the "payments" function of the bank can be in working to achieve different goals.
Bank failures can arise, banking authorities produce bailouts, kicking the can down the path a little further, and new banking problems evolve over time.
Niall Ferguson and Moritz Schularick provide us with a picture of how combining these two functions work out in the Wall Street Journal .
The title of the article is "Life's Certainties: Death, Taxes and Bailouts."
Their point out:
"((O))ver the longer run...(t)he historical record...shows that providing a financial safety net invites riskier behavior in the period after the financial crisis."
"((A))nother boom-bust episode in the future rises significantly after central banks have come to the rescue with their expanding balance sheets."
"Bankers conclude that the central bank can always be counted on to bail them out."
"In other words, bailouts and loose monetary policy prepare the ground for the next crisis, but this time with even more leverage."
"((I))t isn't only death, taxes and bailouts that are inevitable--the next financial crisis is, too."
The Problem
It appears that combining the two functions mentioned above results in a combination of forces that, over time, can be destructive of one another.
Maybe the two functions need to be separated.
Over the past year or two, I have alluded to this possibility.
My argument has been this: the payments system, to most banks, has really been secondary to the credit function. Most banks, especially the smaller ones, buy into a payments scheme, whether through correspondent banks or other financial institutions, they are related to and just live with the payments system they choose.
These banks have neither the knowledge nor the resources to really do anything else about the payments system they are connected with.
Even the bigger banks have not, over time, given their attention to the payment systems that they incorporate into their business model.
Lending has always been the major focus of these organizations.
It has only been in recent years that any of the major banks have started to get more interested in their payment system.
The reason?
The change in information technology and the success of organizations like PayPal, Apple Pay, and Amazon Pay.
It has only been with the recent turn of some major banks to pay more attention to their payments system that I started to write about how meaningful controlling their own "advanced" payments system would be to the place of these banks in the industry.
The future is digital. To control their future, the banks, especially the larger ones, need to play a role in their destiny and build their "bank" around the payments system.
This, to me, is the future of the banking system.
Decentralized finance and the further spread of the "credit" function are going to evolve in their own technological way, a way that can be gained even without paying attention to the "payments" function.
The Payments System
The government cannot be ignored in how this evolution might take place.
The government is going to be all "digital" as well and they must play a big part in moving forward.
The future of central bank money lies in the realm of Central Bank Digital Currency ((CBDC)).
I have suggested in another post that we look at something called "the Chicago Plan" for ideas about how the government might get into the picture.
In essence, the Chicago Plan is that the Federal Reserve provide 100 percent reserves on deposits subject to check so that "the creation and destruction of effective money through private lending operations would be impossible."
This could only be achieved by separating lending operations from the issuing of money.
One benefit of this approach would be that money would be more under the control of the monetary authorities, whereas lending would still be free to function as a market operation.
Although the original idea of 100 percent banking came about as a response to the Great Depression in 1933, the latest attention to the possibility came in 2012, following the Great Recession. The International Monetary Fund produced a working paper to support this initiative.
The conclusion is that this plan would result in a more balanced economy without the booms and busts of the current system, the elimination of bank runs, and a drastic reduction of both public and private debt.
The major concern that people have with this plan is that it poses a real threat to personal privacy.
Most discussions of the Chinese effort to produce a CBDC is the ability it would give the Chinese government to gain more information on individual citizens.
This is a problem area that must be overcome.
But, many changes are coming to the world's payment systems and, one way or another, the government is going to play a major role.
it does seem time, however, since the technology is now available, to separate the credit system from the payment system in the financial markets.
I would only add that the intrusion of information technology into the process is going to happen. The evolution will not be stopped.
Therefore, it is important for us to work with it and its ramifications rather than fight it.
For further details see:
The Transformation Of The Banking System