Would the « sovereign money » system (on which we’ll vote on June 10) have allowed for a better handling of the UBS crisis in 2008? While some argue that it would have, this is not the case. The problem did not come from money creation by the bank, and the authorities would have had to step in anyway.
The multiple activities of UBS (and other banks)
In our everyday life we essentially deal with standard commercial banks where we have our deposit accounts, put our savings, and borrow for our mortgages, for instance. These banks create fiduciary money by granting loans: when my bank grants me a loan, it deposits the amount on my account and I become both its creditor and its debtor. It is precisely this mechanism that the advocates of the sovereign money system want to end, despite the fact that it is tightly regulated.
But the commercial bank is only one of the many facets of financial intermediations. Banks are far from a homogeneous block. In addition to commercial banking, the activities include wealth management, trade finance, investment banking, among others. Note that these activities are not based on the creation of fiduciary money. Some banks specialize in specific activities, while others including UBS offer a broader range of services.
As a large bank such as UBS covers many activities it is important to clearly identify where problems occurred in 2008. It was in the investment bank which had invested in toxic US assets. This unfortunate investment had not connection with the fiduciary money creation on which the sovereign money proposal focuses.
A public intervention would have been necessary anyway
What would have happened if the sovereign money system had been in place in 2008? Retail deposits would have been in a separate subsidiary of UBS which would have invested them entirely at the Swiss National Bank. The other part of the bank would have covered the remaining activities, including investment banking and lending to Swiss firms and households.
The loss on US assets held by the investment bank would have put into question the survival of thus second part of the bank. This would have created substantial problems for mortgage finance and lending to firms in Switzerland, with the risk of a major recession. The authorities would then have had to step in as part of their mandate to preserve financial stability. The form of this intervention would likely have been very similar to what actually happened.
Things have changed since 2008
It is important to remember that financial regulation has substantially evolved since 2008 and the authorities have clearly pushed banks to increase their ability to absorb losses. For instance the Swiss National Bank is not shy to put pressure on the banks. This unsurprisingly does not make them happy, as the case of Crédit Suisse in 2012 clearly illustrated.
In particular the structure of systemic banks has evolved with the aim to be able to insulate their activities in Switzerland from problems stemming from abroad. Is it enough? One can reasonably debate this and argue that an explicit and immediate splitting of these two fields of activities should have been put in place. Maybe, but such a split is not at all what the sovereign money proposal is about.
This is a strange way of looking at things. Imagine if UBS manufactured cars, rather than sold financial services. The story now sounds absurd:
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A public intervention would have been necessary anyway.
The “car-manufacturer-UBS” provides cars to Swiss firms and households.
The loss on US assets [e.g. car factories that turned out to be worthless] held by the “car-manufacturer-UBS” would have put into question the survival of this “car-manufacturer”. This would have created substantial problems for car-purchases in Switzerland, with the risk of major transport problems. The authorities would then have had to step in….
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Why should a bank receive State bail-outs any more than a car manufacturer? Of course there are times when there are cries for the State to take over an ailing company to avoid job losses or to ensure the continuation of service provision – but people mostly agree that private firms should be allowed to go bankrupt if they take bad decisions. Under these circumstances administrators come in and sell off the assets (in the case of UBS this would have been portfolios of mortgages and other “performing” financial assets). Other competing firms have a great time under these circumstances as their businesses can pick up new customers, and they can buy assets usually at a bit of a discount.
Note that for current-account holders at banks: in the case of a bank going bankrupt, the money in their current accounts is completely safe. They will be able to continue to receive their salaries and pay their rent etc.
Let’s re-imagine the story with story after a sovereign money reform:
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Banks now (after a sovereign money reform) look after their customers’ electronic money in the same way they would look after gold coins for their customers – paid for by account fees.
The investment banking departments of big banks are now (under the sovereign money system) mostly funded by «investment banking bonds » with different risk categories that banks sell to their customers, but they also have (potentially unlimited*) funds they have borrowed directly from the Swiss National Bank. Managers and employees in these departments know that if they make bad decisions first their bonds will become worthless, and then they risk bankrupting their bank. In this case, it is not just their bonuses, but also their jobs, that will be on the line.
Now imagine a new class of financial asset has emerged on the world markets – and prices are rising fast. The investment managers in a Swiss bank scrutinises these assets – but they cannot find anything of value in them. As the price rises yet higher, the managers decide to take a position. They either
a) Invest money they borrow from the Swiss National Bank in these new assets (potentially in unlimited amounts*), or
b) Invest some of the funds from the high risk bonds in these new assets – limited by the amount of high-risk bonds they have issued, or
c) Invest in some of the funds from high risk bonds in derivatives, so they will make money if the value of these new assets falls.
In case (a), if the asset price falls then the bank will suffer, and could possibly go bankrupt.
In case (b), if the asset price falls then the bonds will collapse in price and the bond-holders will suffer (but not the bank directly, although their future business could suffer if they get a bad reputation).
In case (c) the bond-holders will profit.
None of these scenarios will involve the State using taxpayers’ money to bail out the banks, as is the situation now and actually occurred for UBS in 2008.
Under the Sovereign Money system, the threat of bankruptcy will be a driving force for banks to deeply scrutinise assets before taking too large a position in them – unlike the present situation when they know they will be bailed out by the State. This will lead to better decisions, and ultimately a banking sector that better serves its customers.
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*Can banks borrow money from the Swiss National Bank (SNB) in unlimited quantities? This will form part of the SNB’s monetary policy: the SNB could offer unlimited funds at a particular interest rate – or funds could be limited in some way. The SNB can decide – but it must act in the interest of Switzerland as a whole.
Dear Ms Dawnay,
Thank you for your comment. Actually there is nothing strange in the story. Let me follow on your comments along 3 points:
– Are banks special?
– It’s about size.
– Monnaie pleine does not help.
Are banks special?
Yes, even though it’s not the main issue.
You make the parallel with car manufacturers. But if the manufacturer of my car goes bankrupt, my car will still start in the morning. I may have issues of spare parts when I need to fix it, but this will happen gradually. If a bank goes under, firms and households that rely on its services are immediately stuck.
In addition banks (and financial intermediaries) are more exposed to panics and runs. This is by the very nature of financial transactions where information is imperfect (if information was perfect, lenders and borrowers would not need intermediaries).
It’s about size.
This is the key point. The bankruptcy of a small firm is an unpleasant part of economic daily life. The bankruptcy of a large firm can have systemic consequences. This is why the US authorities stepped in to shore up the Detroit car manufacturers in 2009 (so after all car makers are not that different from banks).
The intervention of the authorities in the case of UBS (and other banks in other countries) is about its size. That’s’ the “too big to fail problem”. To be clear, I am not happy that this had to be done, and neither are the regulators (even though the operation turned up a nice profit for the Swiss taxpayer in the end) and would like bankruptcy of imprudent banks to be feasible.
So what can regulators do? They can improve the banks’ solidity (that’s what higher equity cushions are all about), they can make it easier to liquidate a bank if we get to that point (that’s what the split of Swiss and foreign activities in case of bankruptcy is about), they can limit size so banks can die without doing damage. While size is not directly limited, it is taxed. Regulators require systematically important financial institutions to have equity cushions that are larger than other banks. Equity is an expensive form of financing, and more equity mechanically reduces the return on equity (profits are divided across a broader equity base). The higher equity cushions amount to a tax on size.
Monnaie pleine does not help.
Your point that deposit accounts used for everyday payments would be protected. I agree, but the issue is not about deposit accounts. What about lending to firms and households? Lending is a function at least as important as the payment system, and the initiative is only about the later.
The lending part of the bank under monnaie pleine would face exactly the same problems, and the same incentives for policy intervention, as banks currently do. In fact, the scenario you describe under monnaie pleine with the new asset class is pretty much how things work currently in investment banks. In that scenario you implicitly assume that the bank can fail. Fine, but that amounts to assuming the size problem away. If UBS had been small, it would have failed and the deposits would have been covered by the guarantee fund (and by an extra from the authorities if needed, as it is hard to imagine they would have stayed put).
You point that the lending bank could be funded by term deposits that couldn’t be withdrawn. This does not help that much however. First, would households be so keen to hold term deposits knowing that they could get stuck in times of crisis? There is a reason why households currently hold a lot of their assets in sight deposits. Second, term deposits have to be rolled over. Let’s say that terms deposits have to be held for a year. If they are evenly distributed, this means that every month 1/12th of funding needs to be renewed. All it takes then to put the bank in trouble is for the rollover not to happen. This is not so different from people pulling out their sight deposits.
One last word about the role of the central bank. You indicate that it can lend (potentially unlimited amounts) to the banks. That is its role of “lender of last resort”, which is already done. This is fact is what central banks were originally built for. Notice though that such lending is not without conditions, and is backed by collateral. This is because the central bank is fine helping with a liquidity problem, but does not want to bear the cost of a solvency problem (rightly so). And yes, the SNB does conduct its policy in the interest of Switzerland as a whole.
Best regards
Cédric Tille
Dear Ms Dawnay,
One more point pertaining on the role of size.
Small can go bankrupt, and do. Consider the case of the United States. Many local and regional banks have gone under in the crisis. Why did we not read a lot about it in the press? Simply because the agency in charge (the Federal Deposit Insurance Corporation) handles the process efficiently. In a nutshell, the bank is taken over during the weekend and on Monday it is operating under new management. In fact, depositors and borrowers would hardly notice the difference.
Best regards
Cédric Tille
Dear Prof Tille,
Thank you for your reply. Of course I agree that banks are special and that when they fail the whole economy suffers – that is why we are bringing the sovereign money or “monnaie pleine” initiative.
Elaborating on your points, I think you’d agree there are two reasons a big bank may need to be saved:
1) To avoid whole transaction-payments system from failing
2) To enable households and businesses to continue to borrow money – businesses especially as they often have roll-over loans.
If banks know they are too big to fail, we have a system where private interests profit when such a bank does well, but taxpayers bear the price when things go badly. This does not benefit society.
The question is: when is a big bank sure that it is too big to fail (so managers can safely assume it will be bailed out if it gets into problems)? I would argue that if (1) above is true, then managers can be certain it will be bailed out. If only (2) is true, managers cannot be absolutely certain that it will be bailed out, and the pros and cons of bailing out might be hotly debated by the authorities. This uncertainty is healthy, as managers are likely to be more cautious, knowing that they personally might be affected if they take bad decisions.
If monnaie pleine (= sovereign money = vollgeld) had been implemented just before the financial crash of 2007/8, you may be right – the authorities may have decided it would have been necessary to save UBS. However, like the Detoit car manufacturers, economists would not all have agreed that this would have been the correct course of action (hence the uncertainty).
If monnaie pleine had been implemented some time before the crash, managers and/or the SNB and the banks’ customers might have behaved differently, reducing the need for a bail-out:
1) Managers, knowing they could lose their jobs (as they are not certain of a bail-out), might have taken a more cautious approach to speculative investments in general.
2) Managers in the investment banking department would have had to find the funds for their speculative investments before investing (unlike the case now, when they can create money to invest). They could do this in several ways: borrow it from the SNB; use customers’ savings deposits; issue bonds; use their own profits; etc. It is very possible that with the monnaie pleine system the different sources of funding would either have had the effect of reducing funds available for speculation or passing the risks of speculation on to investors (so they would not be borne by the bank):
– the SNB: the SNB might notice “imbalances”, e.g. an asset bubble developing, and raise interest rates (perhaps just for financial speculation, but not for lending into the real economy)
-customers: they might not want to put their money at risk – which would also have the effect of raising interest rates on savings accounts. Banks may well react by having different savings instruments with different interest rates – a lower rate for safer investments and higher rates for speculative investments etc., thereby passing the risks directly on to their customers.
– The bank’s own profits: funds are limited to the amount of accumulated profit; also, managers would know their bonuses are on the line, so are likely to be more cautious.
This means that the chance of needing to be bailed out would have been reduced significantly compared to what actually happened under the current system.
Monnaie pleine would work!
Capital buffers and banking regulation:
Increased capital buffers may well also help, but I don’t believe that they’re the answer. I’ve also heard from insiders that even as the next round of Basel rules is being drawn up, big banks are finding ways of circumventing them. An ever more complex rulebook makes for costly enforcement and huge entry costs for new entrant-banks, which inhibits entrepreneurialism which is sub-optimal for society.
About the SNB:
Instead of being the “bankers’ bank” and “lender of last resort” as it is now, under the monnaie pleine system it would become a bank supplying legal tender into the economy in the best interest of Switzerland, and lending money to banks would be a normal event, happening all the time (not only a “last resort”).
Best regards,
Emma Dawnay
Board member of MoMo, the association bringing the monnaie pleine initiative
Dear Ms. Dawnay,
Thank you for your constructive comments. I agree with the two main reasons that you point for banks being “too big to fail”, i.e. protecting transaction deposits and avoiding disruptions in lending to firms and households. I also fully agree (as do the vast majority of economists and regulators) that too-big-to-fail entails a cost to society.
If we take the assumption that the authorities are less concerned about avoiding disruption in lending than about protecting deposits, then a bailout in case of trouble is more uncertain, and yes it follows that sovereign money helps along this dimension as it removes the first reason for bailouts (that leaves the question of how the cost of credit moves in equilibrium, but let’s focus on your points). In fact the conclusion that monnaie pleine helps follows automatically from the assumption.
But is the assumption warranted? I am very skeptical. I think that disruptions in credit are a deal of much concern for the authorities, so having only this motivation for too-big-to-fail would only marginally help at best. We would still be in a game of chicken with bankers that would take risk a play the usual game of “heads I win, tails the taxpayer loses”. So the whole apparatus of monitoring banks’ actions, imposing equity limits, imposing liquidity rules, etc.. will remain as it does today.
You point that bankers would “have had to find the funds for their speculative investments”. But under monnaie pleine they will have to find the funds for any risky investment, including lending to firms and mortgages. Risk does not just reflect speculation. It also comes from honest business activity. I find that the supporters of monnaie pleine often distinguish between safe deposits and speculative activities, and ignore that a large share of risky lending is not speculative.
You indicate that “with the monnaie pleine system the different sources of funding would either have had the effect of reducing funds available for speculation or passing the risks of speculation on to investors (so they would not be borne by the bank)”. Thus it would raise the cost of funding for speculative activities, but also for honest lending as it now would rely on uncovered deposits. This is precisely what the opponents point when they say that borrowing costs for firms would increase. I don’t see how you would increase the interest cost of funding speculation without touching the indirect cost of funding honest lending. The current regulation by contrast can do so, for instance by asking for higher capital requirement for investments in some activities than in others.
I agree that the capital buffers and other forms of regulation are difficult, and yes there is lobbying going on (regulators are well aware of this). But the same would still happen under monnaie pleine. In fact, if only the second reason for bailouts remain (avoiding lending disruption) I can see lobbyists putting a lot of energy to ensure that the probability of bailout remains high by weakening the rules. In fact if I were them I would argue that as deposits are fully safe the regulator can go easy on the rules. I could then take more lending risk on my balance sheet and when things go wrong turn to the regulator and point that my backruptcy would not be more costly for the economy.
I disagree with the view that the SNB (or the Fed, BoEngland, ECB, etc…) are bankers’ banks. As monetary policy operates via financial markets, central banks unsurprisingly keep a close eye on them. But their mandate of price and financial stability for the entire economy is not just for show. It is truly what they care about.
Best regards
Cédric Tille
PS: Allow me to remind the readers that the intervention for UBS in 2008 did not cost the taxpayer anything but in fact ended up generating a nice profits for the taxpayer and the SNB. Also the interventions by US authorities in the banks during the crisis netted a profit. This is not at all to say that we should welcome such cases, far from it, but the statement that “the taxpayer bailed out the banks” is not true. Of course this does not remove the fact that the consequence of the bubble burst led to losses in growth and jobs.
Dear Prof Tille,
I do indeed believe that an event whereby a significant proportion of the population could no longer access their bank accounts would be far more drastic than a big bank no longer being able to offer (or roll over) loans. If people and firms couldn’t access their bank accounts, how would people buy food, or firms pay employees? Whereas if firms could no longer access credit from one bank, wouldn’t other banks step in to profit from this business? Or couldn’t the administrators of a big bank that goes bankrupt manage it somewhat like “Swissair”?
At the very least, it is absolutely clear to all systematically important Swiss banks that they will be bailed out if necessary under the current system – the UBS case has proved this beyond doubt. This is a problem.
Under the monnaie pleine system, big banks would not know they would get bailed out for sure. This uncertainty would mean they are likely to act differently, thereby making a bail-out less likely.
I think we are going to have to agree to differ. Thank you for the interesting debate.
Best wishes,
Emma Dawnay
Dear Ms. Dawnay,
Thank you for your message. It is reasonable to expect that the probability of bailouts is lower if “only” the lending to firms is jeopardized than if the lending and the payments are. The question is by how much the probability is affected. I think that the difference would be minimal. After all credit also covers lines of liquidity for firms to run their routine operations and not just funding for capital goods. Firms could in theory switch to another bank, but the massive shift that would follow the collapse of a large bank would overwhelm the other banks’ ability to absorb and screen all the new customers. As for administrators managing the big bank like “Swissair” (not a reassuring parallel by the way) would precisely amount to a bailout to keep the bank going.
I fully agree that too big to fail is an issue, and so do regulators. I would have welcomed a vote on whether large banks should cleanly split their Swiss and foreign operations (instead of just having a plan “just in case” that will only be tested in crisis), or on whether equity ratios should be much higher. But this is unfortunately not what monnaie pleine is about.
As you point out, we’ll agree to disagree. Nothing wrong with that, and I thank you for a constructive and courteous discussion.
Best regards
Cédric Tille