Why the Fed Denied the Narrow Bank - Keith Weiner (10/09/2018)

Sept 10, 2018
It’s not every day that a clear example
showing the horrors of central planning comes along—the doublethink, the
distortions, and the perverse incentives. It’s not every year that such an
example occurs for monetary central planning. One came to the national
attention this week.
A company called TNB applied for a Master
Account with the Federal Reserve Bank of New York. Their application was
denied. They have
sued.
First, let’s consider TNB. It’s an acronym
for The Narrow Bank. A so called narrow bank is a bank that does not engage in
most of the activities of a regular bank. It simply takes in deposits and puts
them in an account at the Fed. The Fed pays 1.95%, and a narrow bank would have
low costs, so it could pass most of this to its depositors. This is pretty
attractive, and without the real estate and commercial lending risks—not to
mention derivatives exposure—it’s less risky than a regular bank. According to
Bloomberg’s Matt Levine,
saving
accounts for large depositors average only 0.08% interest
.
So it’s easy to see why many believe that the
Fed’s reason to refuse an account to TNB is unsavory: to protecting the crony
too-big-to-fail banks. That is a plausible explanation for sure, but there is
much more.
The Bank: Spindled, Folded, and Mutilated
There has been a long, slow
process—punctuated by big changes in responses to crises—of perverting the
banks. Before the first world war, when a retailer received consumer goods he
would sign a bill acknowledging delivery. Typically, he had 90 days to pay,
which was enough time to sell the goods through to the consumer. The wholesaler
could endorse this and pass it to his creditors. The bill traded at a discount
to its face value.
The creditor—perhaps the wholesaler—could
endorse it and pass it to his supplier. The supplier could bring it to a bank.
Banks were happy to discount a bill, because bills earned the discount rate and
they were very liquid. The bill was the perfect asset to back demand deposit
accounts.
Banks also engaged in lending. They bought
loans and bonds. A loan is not a good asset to back a demand deposit account,
as it is not liquid. A bond is slightly better, but the problem is that the
bond market can go “no bid” at times of stress. Which is precisely when
depositors are demanding their money back, and hence banks need to sell.
So the government had a solution: create a
rediscounter of bills—the Federal Reserve. Today, economists say the Fed was
created as
lender of last resort with
an important caveat. It would only lend on quality assets. Well, bills are not
lending, but clearing. If you had a $2,000 (100 ounces gold!) bill drawn on a
baker for his flour delivery, you did not have much worry that the demand for
bread would disappear (the commodity was insured).
So in its inception, the Fed was
purportedly supposed to rediscount these bills. That is buy them, and provide
the gold unexpectedly needed by the banks. They needed the gold because they
backed demand deposits with loans or bonds. They didn’t expect the need,
because they assumed that the bond market cannot become illiquid and did not
understand that they caused the illiquidity by mismatching the saver’s demand
deposit with the borrower’s long-term project. The saver said “I might want my
money back by next Tuesday” and the bank said “right, 10-year railroad bond!”
Anyways, the theory was that banks could
bring in some bills to get some gold, to pay redeeming depositors. The practice
was that the Fed began buying Treasury bonds, thus distorting interest rates
(which was illegal in 1913 and retroactively legalized in additional
legislation many years later).
And the Fed did not just distort the
interest rate. It distorted the very business model of the banks. Consider the
so called open market operations. The Fed is prohibited from buying new bonds
directly issued from the Treasury. So it buys them in the “open market”, which
in practice means it buys from the big banks. The big banks now have a business
that never existed in a free market—knowing the coming bond purchase schedule,
buying those bonds for inventory and then unloading them onto the Fed a few
ticks higher in price.
Another example is that the big banks sell
various products to hedge the artificial and unnecessary risks created by a
central bank. One is interest rate moves. A free market has a stable interest
rate, and there’s no need to hedge. Once the Fed is created, the interest rate
is destabilized. Another is currency exchange moves. Gold is universal, but
when each country imposes its own irredeemable paper, the value of one currency
in terms of another can move all over the map. So businesses seek to hedge
these risks, and the banks find themselves in the business of manufacturing
hedging products to sell.
Last week, we wrote about the business of advance
refunding bonds
, created by the long-term falling interest rate trend.
Or there is the government-guaranteed loan
for housing, college education, and small business. This distorts the price of
credit to these markets—the interest rate is lower, and hence the price of the
asset is higher. It also distorts the banking business. The government is, in
essence, giving banks a license to make risk-free profits by finding borrowers
upon whom to dump cash.
The government needs to make sure that the
borrowers are creditworthy (or at least politically eligible). So a major part
of bank operations becomes compliance. Especially because the bank itself has
various forms of government guarantee, including deposit insurance and bailouts
for so called too-big-to-fail banks. Imagine if you could walk into a casino,
and start betting on roulette and blackjack, with a guarantee that the
government would cover your losses.
So after more than a century of creeping
change, the big banks today have become distorted beyond recognition. Keynes
and Friedman shared the same great vision (though we expect they would not
agree with this statement, nor our summary of the vision itself). They believed
you can boost economic activity by increasing the quantity of dollars.
Sometimes this causes rising prices of consumer goods, but since 1981, we’ve
had rising asset prices. Rising asset prices is a process of conversion of one
speculator’s wealth into another’s income, to be spent. Which adds to GDP.
The banks today have balance sheets,
workforces, business activities, and revenues derived from such
money multiplier effects. This is
completely perverse, completely destructive, completely unsustainable, and
completely popular. From Wall Street to Left-leaning academia, from Republicans
to Democrats, from property and business owners to homeless advocates, everyone
loves Plank #5 from the Communist Manifesto and its modern manifestation—the Fed
which presides over the falling interest rate, cheaper financing for the
deficit spending of the welfare state, and endlessly rising asset prices. From
2009 to 2017, Obama supporters pointed to rising stocks, employment, and GDP as
proof of his good policies. Since 2017, Trump supporters point to the same
trend as proof of his.
Monetary Policy
Continuing to apply steady perverse incentive
pressure on a dynamic economy demands a complex array of institutions and so
called
policy tools. The goal is to
incentivize behavior A, but not allow B and C to creep into the system. There
must be sticks of course, but carrots work better.
One such carrot policy tool is that the Fed pays interest on so called excess reserves (remember, earlier we
touched on government guarantees and the compliance this brings?) The banks are
required to have cash reserves. Cash above this threshold is deemed to be
excess, and the Fed pays the banks 1.95%
on
excess reserves at present.
This is not a free handout for the sake of
a free handout. It is there, because the Fed relies on those
excess reserves to fund its portfolio of
government bonds. The Fed ballooned this portfolio in the various so called
quantitative easings imposed in reaction
to the financial crisis of 2008. It has to fund this portfolio by borrowing.
The bank’s
excess reserves are one
and the same with the Fed’s borrowing.
That is true, by the way, for every
financial asset. One party’s asset is another’s liability. What you think of as
your
money is what someone else
thinks of as his debt. Which he borrowed in order to fund the purchase of his
asset in turn.
We don’t know what, precisely, would happen
if the banks attempted to withdraw over $4 trillion and the Fed were forced to
sell over $4 trillion in Treasury bonds. The Treasury bond is the central asset
in the system. If its price collapsed, in the face of such selling (and the
front-running that every trader with access to the Internet would do), then that
would bankrupt the banks.
The Fed hopes never to find out, and so it
offers interest to keep its funding in place. This is just like ordinary banks
raising the rate for deposits, when they want to retain or grow their deposit
base.
It is also a component of monetary policy, central planning of
money and credit. The Fed obviously can’t just let any Tom, Dick, or Harry mess
up their intricate and brittle plans for our economy.
The Narrow Bank
Enter: The Narrow Bank.
The Narrow Bank intends to raise deposits,
but instead of using them as a conventional bank to prop up the entire asset
price syndrome, multiplying the Fed’s
magic
money woo
and boosting GDP, TNB just wants to deposit the funds at the Fed.
Earlier, we referred to the Fed’s planning
as both complex and brittle. Now TNB wants to start pumping cash into the Fed’s
hands, forcing the Fed to buy more Treasury bonds, bidding up the price and
hence pushing down the interest rate. To the monetary mandarins who centrally
plan our little economy for us, this is most unwelcome meddling.
Last week, we discussed how municipal
governments may get a lower interest rate than Treasury bonds, because munis
are tax-exempt to the investor. We described the trade of selling a lower-rate
bond to fund the purchase of a higher-rate Treasury. We called this
illicit arbitrage.
TNB wants to perform a different kind of
illicit arbitrage. The Fed has set the rate it pays on excess reserves at 1.95%
in response to a complex array of parameters. These are all based in the conventional
models and cost structures of the big banks.
For a lean and mean TNB, the rate is far
too high and presents a fat opportunity. So naturally if the market is offering
a risk-free opportunity, someone will take it. Which is what TNB intends.
The Fed said “no.”
The rule of law does not govern where
central planning occurs. The central planner needs discretion, precisely
because his schemes become complex and brittle. He needs to be able to react to
changes swiftly, otherwise illicit arbitragers will hoist the central planner
by his own petard, and bring crashing down his brittle system.
If TNB were allowed to do this, and if TNB
grew big, the outcome is certainly unpredictable. But one thing is for sure. If
depositors have a choice between 0.08% with unknowable risks vs, say, 1.45%
(giving TNB a gross spread of 50 basis points) and only the risk of the
Fed/Treasury, then they will choose the latter. Deposits will be pulled from
the big banks. Economists have a technical term to describe the trend that results.
A run on the bank.
Also, the banks do have an important
activity mixed in with all the perverted activities in the current mix. They do
lend to businesses, who need cash to finance inventory, buy tools, plant
fields, etc. TNB would suck the capital out of the banks, and hence out of
these not-politically-favored but vitally important activities.
The Fed cannot allow this, obviously. They
must stop it, no matter what the law says. The law be damned, the Fed is not
going to allow a new business model to collapse the banking system and the
dollar.
Conclusion
To recap, this system is perverse, complex,
brittle, and it makes it profitable to consume capital. It will come to an end
one way or the other. If we don’t do it sooner and voluntarily, it will collapse
in the end involuntarily.
The path out of this is to replace dollar
debt with gold debt. Dollar debt is irredeemable. That is, someone must borrow
more so that all debtors can make the payments on their debts.
Gold debt is redeemable. That’s because a
lump of gold is not someone else’s liability, the way a dollar is. A lump of
gold just is. When you hand it to someone, then that is final payment on the
debt. By contrast, when you hand someone a dollar, then you merely shift the
debt to the Federal Reserve.
Keith is working with Nevada, to help them
issue a gold bond. He has put up a petition to show the state government that
there is support for their move forward, and demand to buy it if they sell it. Please click here for the
petition at Monetary Metals, especially if you would consider
buying a gold bond. If you’d like to sign, but prefer not to give us your
email address, please click here for the
petition at Change.org.
Supply and Demand Fundamentals
The price of gold dropped five bucks, and
that of silver 40 cents this week. But let’s take a look at the supply and
demand fundamentals of both metals. Also, we continue to follow the development
in the gold-silver ratio.
First, here is the chart of the prices of
gold and silver.
here for an explanation of bid and offer prices for the ratio). It rose to a decade highthis week.
Here is the gold graph showing gold basis, cobasis and the price of
the dollar in terms of gold price.
The October contract is under selling
pressure, as longs must close their positions in the next few weeks before
First Notice Day. The Dec contract shows rising scarcity, but not this much and
not close to backwardation.
This, by the way, is one proof that there
is no massive naked short selling of futures. If there were, the banks would be
buying the expiring contract with urgency. They would be pushing its price
up. Instead, we see its price
going down. The banks are arbitragers, happy to make their small spread without
betting on price. It is the naked longs who must sell the contract with
urgency. Thus the expiring contract always has a falling basis, which means a
falling price relative to spot (basis = future - spot).
This week, the Monetary
Metals Gold Fundamental Price
fell $5, from $1,376 to $1,371.
Now let’s look at silver.
Not a lot of change in the scarcity of silver.
The
Monetary
Metals Silver Fundamental Price
fell $0.22, from $16.08 to $15.86.
Last week, we said:
This is the best
time to trade gold for silver in the last three months, alright. But if basis
ratio gets over 1.05 then it will be the best time in the last three years
(this ratio hasn’t spent more than two weeks or so above 1.05 since 2009).
This time, the
gold-silver ratio is higher, currently 82.7 as of Friday’s close.
Correction: the above should have said
1.005.
This week, the ratio of gold to silver
closed at 84.65. And the ratio of the gold basis to the silver basis hit 1.0054
on Wednesday, and closing the week over 1.005.
Is now a good time to trade silver for
gold? Well, you’d have to go back to October 2008 to the last time the ratio
was higher than this (it only got above this level on four days, the most
notable being Oct when it spiked to 87.88 intraday, only to close below 84).
Before that, was Feb 1993. The ratio got above 85 from Oct 1990 through Feb 1993,
peaking at 100 in Jan 1991.
We don’t have basis data going back prior
to 1996. We can say that the ratio of the gold basis to silver basis hit over
1.019 in October 2008. There were a few other instance of spikes in this ratio.
The balance of upside to downside would
seem to favor silver at this point.
Originally posted at Monetary Metals
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