Economics and Banking – James Tobin 1963 (Redux)

By JKH (Cross posted from Monetary Realism)


This essay (unlike the previous) is an unfiltered look at the famous 1963 James Tobin paper on banking:

Commercial Banks as Creators of “Money” (1963)

The Tobin paper has been the subject of recent vigorous blogosphere discussion. Steve Waldman has included a list of links at the conclusion of his own excellent post on the subject:

I have included links to several additional Tobin papers at the conclusion of this essay which may help round out the context. But the focus here is on the 1963 paper linked above.

Tobin’s essay revolves around the idea that banks are a type of financial intermediary. His generic description of bank balance sheet management holds up reasonably well today. Curiously, there has been some resistance from heterodox economics types to the idea that banks are financial intermediaries. Why has there been such resistance to this idea?

First, heterodox likes to focus on the notion that banks are “special”, as reflected in the idea that “loans create deposits”. This seems to be a pivot point for a kind of reflexive rebellion against mainstream economics and its analysis (or not) of banking. In fact, while Tobin focuses on the intermediary character of banking in his 1963 paper, he does not deny that banks are special. He does examine their special nature more intensively in a 1982 essay (noted further below), but the two perspectives are entirely complementary.

Given a set S = {e1, e2}, the element e1 is special in that it is not the same as the element e2, but general in that both e1 and e2 are members of S. Both characteristics are true, and the only question is the qualifying criterion for membership in the set S. And in this case, that qualification has to do with a Tobinesque portfolio management approach as it pertains to both bank and non-bank financial intermediaries, notwithstanding the special characteristics of banking within the intermediary group. The common intermediary quality is the focus of his 1963 essay.

Second, failure to see how banks are a type of intermediary flows from what might be described (somewhat tongue in cheek) as “deposit origination myopia” (DOM), an especially exuberant attachment to the mantra “loan create deposits”. Tobin’s 1963 essay is a 50 year old barometer of this syndrome. I think this was roughly Paul Krugman’s interpretation in the context of earlier blogosphere discussions.

(Krugman has faltered tactically in a number of exchanges with heterodox bloggers because of his apparent dismissal of the relevance of bank accounting. Perhaps there is a potential middle point between presbyopia and myopia in this regard – although positions in some cases appear to beentrenched.)

Neither mainstream nor heterodox economic schools offer a very refined analysis of banking operations. But Tobin’s essay, 50 years old, is insightful on the general framework of banking – certainly more so than “loans create deposits”.

Reserve management is one of many critical functions in banking. The role of bank reserves complements the “loans create deposits” perspective – in that reserves are used for interbank payments, not for deposit creation. That said, heterodox insight on the issue of bank reserves, while constituting a degree of forward progress, is hardly the decisive qualification for understanding what banking is about. This is inherent in the message of Tobin’s 1963 essay. His framing of banks as a type of financial intermediary is a more complete conceptual framework. In that context, the fact that loans create deposits is a minor operational detail that is of very little significance to the strategic management of banks.

Banks are financial intermediaries. So are insurance companies. Banks are special. So are insurance companies. Banks are special because they issue deposits. Insurance companies are special because they issue actuarial claims. Recent blogosphere discussion seems skewed toward the special part in the case of banks. And so the phrase “loans creates deposits” seems to have produced a fresh generation of corresponding banking experts.

Tobin focuses on the set of financial intermediaries and how its constituent members – banks, insurance companies, mutual fund companies, investment firms, etc. – are similar as a group. (Tobin also reveals a great deal in the 1963 paper about how banks are special, without dwelling on this aspect as the main theme.) These similarities have nothing to do with the way in which deposits are issued by banks or used by non-bank financial intermediaries.

Tobin starts his essay with a trifecta – dismissing the false money multiplier story of banking, acknowledging that loans create deposits, and recognizing that banks obtain required reserves after the fact of related deposit creation. These are standard heterodox claims today. Tobin pointed out these facts 50 years ago! But he then sets these observations aside, and moves on to describe banking as a type of financial intermediation.

Before moving further into Tobin’s paper, it may be worthwhile to explore the idea of media of exchange.

Media of Exchange

Commercial banks are “special” at the very least because they issue demand deposit liabilities. Demand deposits are a core medium of exchange for customers of banks. We can think of the medium of exchange for bank customers as a complex of related things: demand deposits, cheques, electronic transfers, banknotes and coins. This may be insufficiently precise for those with more refined sensitivities about definitions, but it suffices here. The instruction to effect an electronic transfer from one demand deposit to another blurs the distinction between deposit and the instruction itself as the medium of exchange. (Marshall McLuhan said the medium is the message.) Is the medium of exchange the demand deposit, the electronic transmission, or the instruction? Are these things in combination a substitute for the physical transportation of central bank money from one bank account to another? To simplify these issues, we’ll refer to bank demand deposits as the core medium of exchange for commercial bank customers, with central bank money, cheques, and electronic instructions affixed to that concept.

Central Banks are “special” as well, for at least the reason that they issue reserve deposits for use by commercial banks in making payments to each other. These reserve balances are the core medium of exchange for commercial banks. Central banks and government treasuries also issue banknotes and coins, which commercial banks hold as inventories in order to satisfy customer demand. Commercial bank customers hold a mix of government money and commercial bank money according to their liquidity preferences.

Commercial banks are in general the only institutions that both use and issue different media of exchange in stock form.

(One interesting exception to this rule occurs within the Euro system. The European Central Bank (ECB) issues TARGET2 balances to the national central banks (NCBs) of the Eurozone. The NCBs use TARGET2 balances as a medium of exchange and issue reserves to commercial banks. Commercial banks use reserve balances as a medium of exchange and issue demand deposits to their customers.)

There is an important parallel to be drawn between central banks and commercial banks as issuers of media of exchange. Both issue media of exchange to their respective clientele using asset swaps. For example, central banks can issue new reserve balances to commercial banks through asset repurchase agreements or by lending directly to banks. (In recent years, with quantitative easing, the US Federal Reserve has issued additional reserves by acquiring bonds originally held mostly by non-banks. Credits to commercial bank customer accounts are accompanied by an increase in bank reserve balances at the Fed.) Commercial banks typically issue new deposits by lending directly to customers or acquiring other market assets (usually liquid securities of third parties). While the process of medium of exchange creation is sometimes described as “ex nihilo”, both entities – central banks and commercial banks – expand their balance sheets by exchanging the medium of exchange for an asset of equivalent deemed value.

Customers of commercial banks can disburse funds from newly acquired deposits in order to pay for things by using cheques, electronic transfer, or conversion to central bank money. The creation, destruction, and transfer of bank deposits works according to the rules of accounting. Individual banks issue new deposits in conjunction with the transfer of funds from other banks. The deposit at the origin of the transfer is destroyed as the new one is created. The issuing bank receives central bank reserve credit as payment from the counterparty bank. System deposits remain unchanged in this type of transfer. This is perhaps the most basic of all banking transactions, but it is interesting because the medium of exchange (the source bank deposit) is being used to acquire the medium of exchange (the destination bank deposit). Indeed, it is reflected this way in macro flow of funds accounting.

A financial intermediary category is defined according to the kind of liability business it is in. Banks are allowed to create the medium of exchange as a liability. Other intermediaries for example offer insurance or pension policies or mutual fund shares.

The core asset business of a bank is lending and the core liability business is deposits. The core asset business of an insurance company is a financial asset portfolio of securities and the core liability business is the issuance of insurance policies and pension promises. The core asset business of a mutual fund company is investment in financial securities and the core liability business is mutual fund shares. And so on. (We use the term “investment” here in its vernacular meaning of financial investment in stocks, bonds, and money market securities.)

The banking system as a whole expands its balance sheet in a single step. The coincident swapping of a newly created demand deposit liability for a new loan asset is the iconic example of such system expansion. This produces new medium of exchange.

By contrast, the NBFI system (non-bank financial institutions) as a whole expands its balance sheet in two steps. An insurance company can swap an insurance policy liability for a demand deposit asset. Using the same demand deposit, it can subsequently acquire a corporate debt or equity security as an addition to its portfolio of assets, which in total “hedges” the actuarial claims it has issued. The net result is that the NBFI balance sheet will have expanded by the value of the insurance policy as a liability and the matching value of the financial asset. No new medium of exchange is produced in these two steps.

The net effect in the case of both banks and NBFIs is that balance sheets are constructed according to asset swaps. That is the essence of financial intermediation.

Financial Intermediation

In the case of both banks and NBFIs, the role played by the medium of exchange in balance sheet expansion is just the beginning of the story. It is the operational front end of a larger and more complicated management process. That process is inherent in Tobin’s portfolio management paradigm. It is the theme of his 1963 paper.

Tobin views those who acquire the liabilities of banks and other financial institutions as “would be lenders” in a counterfactual economy without financial intermediaries:

“…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.”

Tobin’s general description of banking holds up well today. Commercial banks manage credit risk, liquidity risk, and interest rate risk, among other types of risk. They have systems for the measurement of risk and for the allocation of capital to those risks and to the individual banking businesses that incur them. There is an overarching oversight process that includes risk committees and asset-liability committees (ALCOs) undertaking regular systematic reviews of risk exposures. Strategy decisions are made about target asset-liability mixes and pricing parameters. There are internal funds transfer pricing systems to ensure that current market interest rates are reflected immediately in the interest margins that result for each separate banking business according to current asset and liability pricing. These various management components survey and steer the financial intermediation effect in its totality. Moreover, all types of financial intermediaries manage their balance sheets with such techniques of portfolio management, risk management, asset-liability management, and capital allocation.

Just as the bank lending officer ignores the reserve position in making lending decisions (a point made often by heterodox observers), risk and asset-liability managers ignore “loan create deposits”. The deposit origination process is simply not relevant to the portfolio management approach. It is an operational feature of minimal importance – according to Tobin’s strategic portfolio management description – and in fact. For example, the critical credit risk characteristic of an individual loan has nothing to do with the fact that loans create deposits. Banks are concerned with risk to net interest margins, not the fact that demand deposits are created endogenously.

The relationship between the strategic portfolio management approach and the operational endogenous money phenomenon can be explored by examining what happens to the medium of exchange after a commercial bank has issued it. What is its life cycle, so to speak? How is it used, and what becomes of it? Tobin explores this sort of thing by resorting to the analogy of the “widow’s cruse”.

Tobin’s “Widow’s Cruse” Analogy

Tobin refers to a “widow’s cruse” in describing commercial bank deposit creation. A somewhat archaic and awkward analogy, it suggests an unlimited supply of something. His point is that banks do not enjoy such a widow’s cruse capacity for deposit creation and balance sheet expansion. The widow’s cruse fails in the case of commercial banks.

Commercial banks are constrained in their deposit expansion both within their own banking intermediary category and against competing intermediary institutions such as insurance companies, pension funds, mutual funds, and investment firms. A number of factors impinge on the volume of bank deposits that can be produced and survive in final stock form. These factors operate at the original point of deposit creation, and subsequent to that point.

First, in order to create deposits, banks first must have suitable opportunities available to expand their assets. New asset originations must satisfy criteria for assuming the credit risk that is inherent in lending and asset acquisitions. Acceptable asset opportunities must be combined with a required return on equity capital. Loans are priced according to the cost of funding (including the cost of equity capital) and associated administrative expenses. The required margin translates to a capital constraint (quantity and price) rather than a reserve constraint. (Where required reserves are applicable, it is the cost rather than the availability of reserves that is a factor.) Moreover, the quantity of capital is sometimes a scarce resource. Banks can only take on new risk if they have excess capital. And this depends on their level of retained earnings and their access to new capital if required. And even in the presence of excess capital, banks may choose to use it in share buybacks rather than new asset acquisitions if the cost of equity capital is too high relative to available asset opportunities. A bank that decides on a share buyback is momentarily unconstrained by the quantity of capital but constrained in the supply of asset opportunities that meet required return on equity hurdle rates.

Second, the contractual nature of loan agreements require that they be repaid. This is a source of natural “reflux” of the medium of exchange, since demand deposits are extinguished when loans are repaid. The banking system balance sheet and medium of exchange expand on a net basis over time to the extent that asset acquisition and the corresponding “efflux” of the medium of exchange exceeds this contractual reflux.

Third, the ultimate fate of the demand deposits initially generated by asset expansion is generally uncertain even within the banking system. Banks compete within their own intermediary group for all of their desired liability forms, including demand deposits. Banks expect the deposits created by their own new lending activity to end up at other banks as the result of the borrower’s use of funds elsewhere. Individual banks are subject to continuing competitive pressures from other banks in retaining existing deposits. Demand deposits thus pose a risk in terms of both liquidity and interest rate exposure, because they can migrate easily to other banks and/or require higher interest rates to retain in the event of monetary policy tightening.

Moreover, the banking system as a whole requires demand deposits as a source of funds to convert to other liability forms. In order to avoid excessive risk, banks will attempt to convert demand deposits opportunistically to alternative funding forms such as time deposits, debt, and equity capital – so as to strengthen the risk profile of the overall funding structure for the balance sheet. (The cases of issuing new equity capital and generating equity internally through retained earnings both require demand deposit conversion.) The banking system is thus proactive in reshaping the risk profile of the original demand deposit flow created by lending and other types of asset acquisition. The default assumption that banks just sit on the fruits of their demand deposit creation is incorrect.

Fourth, the banking system competes with other financial intermediaries for desired liability forms. If an insurance company issues a new policy, it is competing with a bank that issues a demand deposit liability. This is fundamentally true in the sense that – in a counterfactual financial system without insurance companies – agents would be forced to construct their own insurance cash flows using bank liabilities. Tobin also illustrates the case where demand deposits are used to acquire insurance policies (for example). Insurers as a consequence then seek to acquire financial securities as assets and banks sell some of their liquid securities in response to that demand, resulting in the destruction (reflux) of demand deposits originally issued by the banking system. All intermediary institutions manage their balance sheets in such a competitive context, and they have considerable influence and control over their balance sheet compositions through product design, active pricing, and risk management.

Thus, Tobin essentially distinguishes between a strategic view of banking and an operational view. An operational or monetary view of banking focuses on micro transaction details – things like bank reserves and “hot potato” and “reflux” monetary behaviors. But such “hot potato” and “reflux” effects operate ubiquitously and continuously in financial markets. It’s called the flow of funds – involving the partial success and failure of the widow’s cruse in ongoing flux. As described above, the cruse can fail through limited expansion at origination, contraction at termination, internal conversion, or net sale of assets from the banking system.

Once deposits are created, the liability side of an individual bank balance sheet is in play. Funding is at risk, unless locked in from a liquidity management perspective. In the ongoing process of financial intermediation and balance sheet management, the maintenance of funding dominates the process of loan creation or extinction. Banks need to retain and attract a share of demand deposits (and other liability forms) once they have been created. They need them as an item in the ongoing liability mix and as a source for conversion into other liability forms or equity. No bank can afford to hemorrhage its share of the medium of exchange liability form as a stock item on the balance sheet.

All intermediaries are subject to such liquidity and other risks. In that sense, it is arbitrary to type a mutual fund or insurance company as a financial intermediary and a bank as not. If anything, the liquidity risk inherent in demand deposit liabilities emphasizes the importance of individual banks retaining and attracting them – notwithstanding their ability to create them. Their ability to create them is constrained by the economics of credit risk and capital management. Their ability to retain them is constrained by the effectiveness of their liquidity management. A time deposit provides liquidity and interest rate protection since it can’t be moved to a competing bank until it is converted to the medium of exchange at maturity. Debt and equity provide similar liquidity protection. Once new money is created, it becomes the object of competition within the banking system.

The Chicago Plan and its variations argued for the confiscation of demand deposit capacity from commercial banking and the ring fencing of demand deposits with a 100 per cent reserve requirement. These types of proposals tend to overlook the fact that banks have a self-interested motive to convert much of the demand deposit base that originates from lending to other liability forms for purposes of risk management. And in all of this, the operational characteristic of deposit creation is essentially irrelevant, given subsequent competition for desired liability forms.

The Interface of Government and Commercial Banking

Tobin distinguishes between the “fountain pen money” of commercial banks and the “printing press money” of government. The paper’s focus is the former. He makes the distinction between the natural reflux channels for commercial bank money, as described above, and the core “hot potato” characteristic of government money. But what he is really talking about in the latter case is the consolidated government financial position. This is the position that is popularly appreciated now in heterodox circles as the “net financial asset” position (NFA) held by the non-government sector. This position is created over time by government budget deficit efflux and surplus reflux. To the degree that the budget is exogenous, the private sector portfolio that results is a “hot potato”. But this may be debatable to the extent that there is an argument for the “deep endogeneity” of the government fiscal position.

In this context, Tobin does not illuminate the decomposition of NFA into its component parts – bank reserve balances, banknotes and coins, and government bonds. In particular, he does not discuss the scenario of open-ended structural reflux from commercial bank deposits to banknotes and coins. And that is understandable, since his paper is about an ongoing functional and viable commercial banking system.

Two related papers

Financial Intermediaries and the Effectiveness of Monetary Controls (with William Brainard, 1963)

The Commercial Banking Firm: A Simple Model (1982)

These papers along with the one discussed here constitute a consistent treatment of the banking system as a type of financial intermediary in competition with others, and with individual banks operating as active portfolio managers.


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