The Evolution Of Central Banking: Credit, Gold, Fiat, Moral Hazard & Shadow Banks

Importance of Banking

A favorite media topic is the battle of main street versus wall street. For many main streeters, the latter is synonymous with greed, which is a group that includes banks. Before discussing modern issues with the banking system, noting that main street sometimes forgets the importance of banking throughout history is paramount. For the past 200 years, banking has provided extreme value to society by facilitating trade and credit transactions, which in turn fueled economic growth. Without banking, fundraising for infrastructure projects and costly machines would be near impossible, especially during the industrial revolution, as corporations often invested in long-term projects and therefore borrowed great amounts over long time periods. The business of lending money is risky and optimally banks invest in projects that have low risk with high expected returns. The problem is that extending credit in a digital world is so profitable, which is why shadow banks have multiplied in size almost to the point where they have replaced traditional banks. These shadow banks deploy a more complex lending process through structuring and off-balance sheet transactions, and they do it outside of the scope of central banks and regulators. Government experts that have pointed to the increasing reserves at large banks as a sign of economic health have failed to incorporate shadow banking in their analysis of credit. Given the vast amounts of credit circulating in the economy, the banking system is now so systematically important to society that governments and central banks will not allow banks or shadow banks to fail. This creates moral hazard, which means that banks and shadow banks are incentivized to invest in risky projects. There is no doubt that we need institutions that facilitate trade, monitor payments and handle credit extension, but in the digital world, society must solve the moral hazard problem to avoid future depression and perhaps even hot war.

Lorenzo De’ Medici, also known as Lorenzo De’ Magnificent. He was an influential banker in Florence that invested in the arts. “Masters of Florence” is a great tv show about him and his family spanning the 15th century.

Moral Hazard

The underlying cause of moral hazard in lending are information asymmetries. Borrowers possess an information advantage over lenders, as borrowers use money with a purpose. Before lending money, lenders must therefore monitor borrowers credit histories and previous investments. The borrower must sometimes also post collateral that is forfeited to the lender if the borrower is unable to repay the loan. For example, collateral for a mortgage loan is the borrowers house. With verification of the borrower’s trustworthiness and collateral, the information asymmetry decreases between lender and borrower to the point where the lender feels comfortable to transact. If the borrower defaults in a normal situation, the lender will lose money. However, banks today have the implicit full guarantee of the central bank, which means banks are invincible: either banks win by investing in risky projects or they receive central bank stimulus if the risky projects fail. Despite this government guarantee, the bank will still care about the borrower’s ability to pay back, but ultimately government insurance allow banks to engage in risky behaviors.

To exemplify moral hazard, Sven will invest in one out of two projects: project “risky” or “safe”. Project risky has a 50% probability of success, while project safe is guaranteed to be successful. There are no interest rate assumptions in this example.

- Risky: success = 30% return / failure down 30% (130% or 70%)

- Safe: success = 5% return (105%)

- Expected return of (Risky) = 0%

- Expected return of (Safe) = 5%

Clearly, project safe is a greater investment, as expected return (safe) > expected return (risky). However, investing in project safe only holds true if you risk your own money, as the risky project involves similar odds to betting on black in roulette. For example, imagine that Sven sets up a limited liability company called Sven INC with $2 in equity and $8 debt. As a result, Sven INC’s asset side then has $10 in cash. If Sven invests in project safe, he is guaranteed to make 0.5$, while the upside profit for project risky is 3$. However, if Sven loses 3$ on project risky, then he only loses 2$ in equity, as the remaining 1$ is covered by Sven INC’s lender (debt). The expected return on project risky for Sven in the limited liability example is therefore 1$, which is greater than project safe’s expected value of 0.5$. The structuring of the liability side of Sven INC’s balance sheet creates moral hazard, as the limited liability status protects against downside risks. Similarly, to the Sven example, governments protect downside risk for banks, which introduces moral hazard in banking. The difference between banking and the Sven INC example is that debtors investing in the latter understand the risks, while bank depositors might not. Even if depositors understand the risks, they do not care, as the government bails them out if the bank goes insolvent.

Figure 1

In Figure 1, Honest Abe has started a bank with 50$ in equity resulting in 50$ in cash on the asset side. Figure 1 demonstrates how a bank creates money from credit. Rose needs 30$ to purchase a camera for her influence business. As a result, the bank’s balance sheet increases from the initial 50 to 80. This process is not wholly bad because without borrowing money, Rose is unable to start her influencer business.

Why Banks Exist and Fractional Reserve Banking

Borrowing lots of cash spanning vast time horizons is a difficult goal to accomplish, as few lenders are willing to risk great sums of money for a single investment opportunity. Instead, most lenders prefer storing wealth safely with high liquidity, despite lowering their investment return. Traditional banks were therefore created as financial intermediaries to facilitate lending by transforming and pooling short-term deposits by private individuals into loans for long-term projects. Through these liquidity transformations, banks are indirect architects of electric grids, highways and schools in society. Unlike modern banks with a complex credit generation process, traditional banks create money out of credit as taught in schools, which means direct deposits are pooled for investment purposes. Banks can then lend out more money than is deposited by their customers. Lending out more money than exists is called fractional banking. While fractional banking has helped plenty of people from poverty, the weakness of fractional banking are bank runs. If all depositors withdraw money at the same time there will not be enough cash in a bank’s vault to cover the withdrawals. To remain in power, the bankers bank (central bank) and governments cannot allow these types of bank runs to occur so the role of the central bank has therefore shifted dramatically in the 21st century. Also, in the digital revolution, political interference in the banking system has increased.

Figure 2

Figure 2 demonstrates why a bank is able to extend another loan to Stan, which further expands both credit in the economy and the bank’s balance sheet. Stan is also purchasing a camera for an influencer business and the bank believes that the cash/equity buffer on the bank’s balance sheet is enough to ensure against a bank run. However, at some point the bank will feel that the cash/equity buffer is not enough. However, if there is no deposit insurance a bank will be more careful to lend money to stan, as bank run like Stockholm Banco can therefore occur.

Banks and Credit Extension

Before describing the role of central banks, discussing how corporate banks profit is important. With substantial funds, banks are able diversify their portfolio by investing in many large projects to avoid losing money on just one bet. The large banks today engage in many different activities, but traditional banking consists of two objectives; act as a custodian for client money and extending credit. Prior to the industrial revolution, extending credit was considered immoral and even illegal in many countries to protect people from debt burden. However, lending became more acceptable, as the industrial revolution increased investments in expensive machinery. As a custodian, banks stored currency in their vaults translating naturally to loans, which is the most common approach to extending credit. The term credit comes from the Latin word creditum and refers to the trust required between two counterparties to trade over time. For deferred payment transactions trust is necessary. The more credit created by banks, the more profit they are likely to earn. However, this leaves banks vulnerable to bank runs. As a result, governments have established deposit insurance to protect consumers and prohibit these bank runs.

Figure 3

Lending money to Rose for a social influence camera is an investment. If Rose purchases that camera, but fails to earn money, she will not repay her loan. If Stan is unable to repay as well, then the bank’s equity/cash buffer will not cover the withdrawals. If central banks do not bail out Honest Abe’s bank then the bank’s equity would be negative and the bank itself insolvent. This could happen if social media turns out to be a bad industry to invest in. With deposit insurance banks can continuously expand their balance sheets, which invokes moral hazard. In Figure 3, however, the store subscribes to Rose social media account and money is moved from store deposit back to Rose’s deposit. As a result, Rose repays her loan and the bank’s balance sheet is smaller, but the bank does not fail.

Beginning of Central Banking

Sweden’s Riksbank is generally considered as the oldest operating central bank in history. Prior to becoming a central bank, the Riksbank was founded as a joint stock company in 1657 by Johan Palmstruch under the Stockholm Banco banner. The bank first functioned as a private bank, but king Charles IX of Sweden had ultimate power of the bank’s management, so despite shareholders being liable for the bank’s debt, Stockholm Banco could still lend government funds and act as a clearinghouse for commerce. In 1668, the Swedish Riksdag (parliament) overtook Stockholm Banco after the bank failed to cover its customer’s withdrawals and its main shareholder Johan Palmstruch was jailed. The bank run on Stockholm Banco is a powerful lesson that issuing to many promissory notes without adequate capital is a dangerous game to play and yet the same game is being played today at the cost of taxpayers. After the foundation of the Riksbank, other joint stock central banks followed suit such as Bank of England, which was originally established to purchase government debt. Later on, the United States Federal Reserve Bank (FED) was established, which is currently the most powerful bank in the world. The FED arose from two separate U.S. central banks in 1913 and remains privately owned by a group of membership banks, which is unknown to the general public. These 12 membership banks include Goldman Sachs, Lazard and Rothschild Bank of London.

The Swedish Riksbank, which is the oldest bank in the world.

History of The Federal Reserve

Prior to FED’s creation in 1913, it was hard to separate certain physical commodities from money, as commodities such as gold or silver served as economic monetary anchors for paper money. Until 1971, FED kept the dollar value relative to the price of gold constant. This meant that the amount of money and credit in the system was constrained by gold reserves. In the 1920s, the central bank mandate expanded, as politicians became worried about real economic stability and unemployment. FED’s objective then evolved to also promote a smoother US economy by providing services such as supervising the banking system, acting as a monetary regulator and conducting monetary policy. Even with a role expansion, FED’s main focus remained on managing gold reserves, which led to lax monetary policy and excessive speculation in equity markets through cheap loans provided by banks. When FED closed the speculation loophole with the Real Bills doctrine in 1928, interest rates increased due to monetary tightening and the markets came crashing down in 1929. The ensuing bank runs between 1929-1933 resulted in the necessary yet dreaded deposit insurance with the creation of the Federal Deposit Insurance Corporation (FDIC). The creation of FDIC in 1933, was necessary for people to trust the banking system, but the FDIC creation has some really long-term consequences that governments are still fighting today, especially because the FDIC incentivizes bank consumers to remain ill informed.

Jerome Powell is the current Federal Reserve chief and is the 16th person with the job. He is in a difficult position, as he must navigate the toughest crisis since World War 2.

Problems with Deposit Insurance

If bank consumers are not worried about their bank deposits, they do not research how banks invest their money. As a banking supervisor and regulator, FED therefore monitors banks and set reserve requirements so that banks are unable to overextend credit to risky counterparties. In 1944. Bretton Woods of monetary management agreement was established to organize the western financial system. The agreement tied western currencies to the US dollar, which was ultimately tied to the gold price. However, to spur on economic growth and prevent unemployment, central banks printed more money than there was gold supply. In 1971, the Bretton Woods agreement was therefore terminated by the Nixon administration. By removing gold as a nominal anchor, the dollar became a fiat currency without intrinsic value and currency became worth what people think it is worth. Starting in 1971, the FED is now able to create money from thin air by pressing a button. The termination of Bretton Woods in combination with digitalization has allowed shadow banks to emerge and circumvent banking rules through regulatory capture.

Deposits in banks for US customers are covered up to 250K by the FDIC

Shadow Banking

Not printing money to solve problems is emotionally difficult for central bankers, especially when the purpose is to avoid economic disasters such as the Corona Crisis. To prevent politicians from impacting monetary policy decisions, the FED therefore established itself as an independent institution. The US President is, for example, unable to fire the FED’s chief executive, but the rules do not prevent the FED chair from political pressures and tweets. Political pressure often forces central banks to conduct bank friendly monetary policy, which in combination with fractional banking and fiat money allows shadow banks to extend massive amounts of credit through regulatory capture. To avoid banking regulation, banks move packaged loans from their liability side on their balance sheet to off-balance sheet legal entities called special purpose vehicles (SPVs). Creating credit through SPV’s is a complex process, but the end result is the same as for traditional banking; moral hazard. If shadow banks are not allowed to fail, then they will lend money to risky projects. There is no direct deposit insurance for off-balance sheet products like SPVs, but the growth of SPVs and other financial derivative innovations is massive and the derivatives industry is now so systematically important that SPVs have their own implied deposit insurance. Imagine running a business that cannot fail. That is precisely what is happening to our banking system.

Ever since 1960, the amount of shadow banking liabilities have increased drastically

Further Problems with Shadow Banking

Shadow banks extend credit through SPVs based on semi scientific gaussian statistics such as normal distributions, correlations and standard deviations, which convinces regulators that SPVs are safe. In normal markets, the statistical approach to lending functions well, but in extreme market conditions, statistical relationships break down and fat tail catastrophes transpires. The SPV is usually a limited liability company without employees. The equity and junior tranche owner of the SPV is usually a sponsoring entity such as a bank. If the SPV loses money, the sponsoring entity takes the first hit, so when banks establish these SPVs, their balance sheet risks are transferred to the SPV, but the risks are not removed. Currently, the amount of credit circulating in the economy is massive and the fat tail problem increases exponentially with credit extension. For example, the Corona Crisis has caused significant unemployment. Without central bank stimulus, people might default on their mortgages, which increase the odds of mortgage SPV defaults. Just like traditional banks lend out money deposited by their customers, the SPV issues debt by pooling together millions of mortgages on the liability side of the balance sheets. The SPV debt is then backed by a diversified portfolio of loans on the asset side. If only a few mortgages fail then the SPV survives, but if most mortgages default, then the SPV is unable to repay loans on its issued debt. An increase in mortgage defaults leads to house price declines and the SPV sponsors must then cover losses by fire selling mortgages at discount prices. This process then turns into a liquidation cycle, as defaults spread systemically through the economy like the corona virus itself, which is similar to a traditional bank run. In 2008, the TARP bill created by President Obama prevented the subprime liquidation cycle from destroying the economy. However, the TARP bill further increased moral hazard because it sent a signal to shadow banks that when shit hits the fan, the government prints money and bails them out.

Inflation and The CARES Act

Despite a ten-year bull market, the US passed the CARES act to prevent record unemployment from destroying the economy. The CARES act provides businesses and consumers with economic stimulus payments and unemployment checks. Ultimately, these payments equal an FDIC type of insurance to shadow banks, as people continues paying down mortgages. As a result, house prices remain high and business insolvencies are prevented. The CARES stimulus also incentivizes shadow banks to extend more risky loans on the asset side, which then increases the systemic importance of the SPVs. Loans on an SPV’s asset side is payed for by its liability side and if the asset side decreases in combination with mortgage defaults an economic depression will occur. However, this crisis is prevented if the FED and governments decides to print money. The problem with a printing approach is currency debasement. The value of the dollar will perhaps decrease relatively to fixed assets such as gold and consumer products, which leads to inflation. Given the divergence between the real economy and the stock market during the middle of 2020, asset inflation is already taking place. The question is when prices on consumer goods starts to increase.

Conclusion

The first central bank was created in Sweden to lend government money. The institutions chief officer, Johan Palmstruch, was jailed because the bank issued to many promissory notes. When the inevitable Swedish bank run occurred, Stockholm Banco was unable to cover withdrawals. Ever since this “central” bank insolvency, the banking system has evolved to prevent future defaults. The current US banking system has ruled since the creation of the FED in 1913, which has resulted in enormous absolute life improvements for US persons. However, in the last 30 years massive money printing by central banks have created record levels of wealth inequality. Up until 1913, the main objective of central banks was to maintain price stability, but since then many steps have been taken to stimulate the economy at all costs. In combination with information asymmetry between lenders and borrowers and digitalization, the FED, FDIC, and US government have created enormous moral hazard problems in the global economy. The drop of the gold peg and increasing political interference in central banking policy further increased the moral hazard problem during the 1970s, as the termination of the Bretton Woods system lead to a faith-based fiat currency system. Ever since 1971, shadow banks have gathered massive amounts of debt through financial innovations such as packaged mortgage obligations, which has increased shadow bank balance sheets to record levels. These shadow banks use SPVs to extend credit much like a bank uses fund deposits to make a profit. There is currently a high appetite for borrowing money, as interest rates are kept artificially low by central banks. Despite low returns from lending, shadow banks have an incentive to lend as much as possible because of the implicit guarantee from the central bank. This was demonstrated both in 2008 with the TARP bill and in 2020 with the CARES act. The cycle of money printing will end when inflation takes place. My worry is that inflation is not a question of if, but when.

Thanks for reading!

Cheers!

/Adaptivealph