Free Banking
Private banks issued their own money (banknotes) redeemable in a homogenous unit of account (Dollar or pound on the gold standard)
Along with deposit banking and transfers, issuing redeemable paper banknotes lowered transactions costs
Costly ways to increase demand to hold a bank’s notess
- Attract more depositors
- make redemption easier
- Advertise
- Anti-counterfeiting measures
- Make the currency more attractive (aesthetics)
What happens if the system overissues?
Direct effect:
- extra spending due to the increase in the money supply
- gets funneled into imports which exports specie and drains bank’s reserves
Indirect effect:
- increase in money supply raises domestic price level higher then the post price level
- depressed exports and stimulates imports
- precious metal flows to where it has a higher purchasing power (foreign countries)
Bank Runs
occure when depositors fear that they won’t be able to access they money at the bank
Illiquid
Assets>Liabilities, but does not have liquid assets (cash) on hand at a specific time
Illiquid banks can be saved.
Insolvent
Assets<Liabilities. “Underwater”
Most often happens when loans are defaulted on.
If saved through a bailout, an insolvent bank cannot pay back the loan.
Sunspot Theory
Depositors run because others run
Bad News Theory
Depositors run on a banks that are insolvent. Depositors watch bank activity to make sure their deposits are safe. If they think the bank is in a risky position (Too many bad loans, not enough reserves), they run.
Problems with DD Model
- debt-equity hybrid. Real-world banks have equity owners
- non-spendable deposits
- DD model imposes first come first serve redmeption
Costs of Bank Runs
- Depositors lose deposits
- Shareholders lose out
- After the run, banks liquidate assets quickly to try and stay liquid.
- Assets are sold at low prices to move them quickly. “Fire sale losses”. - To Borrowers
- Interrupts bank-borrower relationship - For banking panics
- Money supply contracts
- Can cause recession in its own right
Benefits of Bank Runs
- Runs on insolvent banks stop a “wealth destroying machine”
- The threat of runs encourages banks to run a sound operation
Fire Sale Losses
A fire slae describe the vicious circle during which the forces sale of a financial asset drives down the price of related assets forcing more sales further driving down the prive
Arguments for Regulated Banking
1) An unregulated banking system is inherently run prone and open to contagion.
2) Runs have negative spillover effects (externalities)
3) Regulations can reduce runs and panics, and cost less than the benefits they provide by mitigating panics.
Why are banks run prone?
The expected payoff of arriving earlier to remove your deposit is higher than when arriving later
Solutions to being prone to runs
1) Equity claim (like shares in a MMMF)
- bad news reduces the price of all assets. Each depositor only has claims to a limited number of shares. Value of shares moves together. No incentive to run
2) Conditional redemption
- notice-of-withdrawal and option clauses. Avoids fire sale losses
3) Solvency Assurances
- advertised capital. Diverse portfolio of safe assets. Extended liability for shareholders
The role of government and banking regulation
- lender of last resort (FED)
- Deposit Insurance (FDIC)
- Various restriction
- minimum equity ratio
- equity restriction
- reserve requirements
- asset portfolio supervision
- activity restriction (Glass Steagall)
