A brave new world of banking

The idea that a bank's lending function must be separate from its monetary function is gaining traction in the US

If President Joe Biden has his way, the US will have as head of the Office of Comptroller of Currency (OCC) a lady who intends to change the very nature of banking. The US has multiple regulators for banking. The OCC is, perhaps, the most important one.

Consequent to the global crisis, the pendulum has swung in the US away from the market and towards a greater role for regulation and state intervention. That Saule Omarova, a law professor at Cornell University, has even been nominated for the post of OCC is evidence of such a swing.

Ms Omarova belongs to the school that believes private banking today is fundamentally flawed. Banks are supposed to intermediate between savers and investors.  They do so by taking deposits and making loans — that’s the theory. In practice, banks don’t wait to collect deposits before making loans. They make loans and have a corresponding entry for deposits against the loans they have made. As bank deposits count as money, banks have the facility to create money out of thin air. 

That is where, according to the Omarova school, the mischief lies. Bankers can make loans at will and they have incentives to do so — more loans spell bigger bonuses. Credit bubbles are thus inherent in banking. Bankers couldn’t care less whether the credit is for productive economic activity or for speculation. 

When you combine credit booms with the fact that banks operate at crazy levels of leverage —under Basel 3 norms, banks can operate at a debt to equity ratio of 33:1 — you have a recipe for recurring banking crises that wreck economies and create social instability.

Illustration: Binay Sinha

Central banks try to curb the ability of banks to create money through cash reserve requirements, the interest rate, capital requirements for banks, etc. These tools, we have seen, are limited in their effectiveness. As long as we have “fractional reserve” banking whereby banks have to park only a small portion of their deposits with the central bank, banks will not be confined to channelling savings to investor. They will retain their money creation function. And banks can be as irresponsible in creating money as governments are.

Ms Omarova thinks the time has come to separate banks’ lending function from their monetary function. Banks should lend without creating money. The way to do so, she reckons is to take deposits away from banks. Deposits should be moved to the Federal Reserve. She spells out her ideas in a paper. (The People’s Ledger, Vanderbilt Law Review, October 2021).

The idea that individuals should have some deposit accounts with the central banks had already been mooted in the discussion on central bank digital currency (CBDC). These would be similar to the digital wallets that individuals have with banks or payment providers for the purpose of transactions. Most people see CDBCs as co-existing with commercial bank money.

Ms Omarova proposes something more radical: Moving all deposits to the Fed (FedAccounts).  The FedAccounts would earn interest just as deposits do. This interest rate would set an effective floor on the interest rate structure in the economy. It would dramatically increase the Fed’s capacity to manage interest rates —the familiar “transmission” problem would disappear. It would also enable the Fed to manage money supply by directly crediting and debiting the FedAccounts. The bottom line: The Fed no longer needs to conduct monetary policy through banks.

Two questions arise.  One, what happens to banks if they lose their deposits to the Fed? What does the Fed do with all the deposits it acquires? Ms Omarova addresses both the questions at length. 

Banks don’t have to close shop when they lose access to deposits. The Fed will make funds available to them at a subsidised rate against collateral in the form of qualifying securities. By specifying the collateral eligible, the Fed can nudge banks to lend in preferred ways. To finance activities that do not qualify for funds from the Fed, banks will have to raise funds through costlier debt or equity securities as corporations do. 

Once banks lose access to deposits, bank runs and the fragility inherent in banking will end. So will the need for deposit insurance and reserve requirements and bank capital requirements. The whole complex structure of bank regulation can be dismantled. Banks’ asset side remains unchanged except that it is financed in a different way. Ms Omarova does not touch on the point but it is likely that Fed funds will be more expensive than deposits, so banks will have to live with lower net interest margins.

That is on the liabilities side of the Fed’s balance sheet. It is the asset side transformation that Ms Omarova proposes that is proving even more controversial. If the liabilities side of the Fed expands through access to public deposits, there has to be a huge expansion on the asset side. How will this happen? 

One way is through the Fed’s new discount window loans to banks mentioned above. Another would be buying securities issued by the proposed National Investment Authority. The NIA is envisaged as a public infrastructure agency that would finance infrastructure projects. Public-private partnerships involve public capital and private management. The NIA, in contrast, envisages public-private capital and public management. It rests on the idea that infrastructure is primarily a public sector responsibility. A third deployment of funds would be expanded open market operations aimed at market stabilisation.

Ms Omarova’s scheme, as she makes clear, is not just about stability in banking or making monetary policy more effective. It is about democratising the financial system by giving ordinary citizens access to the Fed’s balance sheet instead of limiting the access to banks. It is also about altering the balance of public and private power in the financial system decisively in favour of the former. 

It is anybody’s guess whether Ms Omarova’s nomination will go through. Critics have pounced on the fact that she grew up in the erstwhile Soviet Union and her college thesis was about Karl Marx. They have denounced her as a socialist who wants to bring back central planning. What the critics will not do is engage with the issue she raises: How do we make finance the servant of the economy instead of the other way round. 

Ms Omarova’s ideas should make us here in India sit up and think. At a time when we are talking about monetisation of public assets, the idea the public sector should have primary responsibility for infrastructure has the backing of the US President, no less. And even as we seek to reduce the role of the public sector in banking, the idea that the private sector’s role should be curbed is gaining traction in the land of the free market. 

ttrammohan28@gmail.com