These limitations defined the relatively more repressed financial regime of the early post-WWII era (as contrasted against that of the 1960s-2010s). Prior experiments with the liberalization of money and banking in the early 20th century, coupled with the subsequent Great Depression and the period of financial repression during WWII, left people skeptical about the benefits of a liberalized money and banking system.
In this issue of Monetary Mechanics, I will cover the first major innovation in liability management, which is the development of the private Federal Funds (FF) borrowing market in the early 1950s. Since there are too many important topics to cover here all at once, in future issues of Monetary Mechanics, I will also attempt to cover:
Recall from earlier that banks are limited by both general reserve requirements and interbank settlement and liquidity requirements. The development of the private FF market allowed city banks, which typically had more plentiful lending opportunities, to borrow reserves from country banks, which typically had less plentiful lending opportunities, but an abundance of deposits. This allowed the city banks to expand their marginal lending activities and, as a result, facilitated additional money creation.1
Large money-center banks, as chronic borrowers of FF, built up a synthetic FF short, as they designed their asset structures with the belief that they would always be able to roll over FF funding as needed.9 Such a synthetic FF short is reminiscent of the synthetic dollar short position held by European banks during the 2007-2008 financial crisis and by most foreign financial institutions today.
Eventually, due to the robustness of the private FF market, a stigma about discount window borrowing began to develop. Because there was a large liquid market for FF borrowing, people equated banks being forced to borrow from the discount window with banks being shut out of the private market (most likely for good reason).
The EFF rate ultimately broke out above the discount window rate when Morgan Guaranty used their reputation to borrow above that rate in 1964. Until then, no bank dared to borrow above that rate, because they were afraid of signaling to others that their assets were rejected at the discount window.10 In fact, banks were so afraid of implicating themselves that they were actually losing money in the process due to the overly low FF rate at that point. There was no particularly obvious reason why it took so long for this to happen, but all it took was one bank to break that psychological barrier, which resulted in an entire paradigm shift in thought and action.11
At the same time as this transformation was happening in the US domestic money markets, other similar developments were also happening in international money markets, which became increasingly interconnected and globalized. These parallel innovations included Eurocurrency/Eurodollar banking and borrowing practices and negotiable certificates of deposit (CDs), which I will soon cover in the next issue of this installment on the origins and evolution of the modern monetary system.
Liability Management (a.k.a. \u201Cwholesale finance\u201D) \u2013 the expansion of banking strategy that transformed banks from passive acceptors of deposits to aggressive operators in the money market. This includes federal funds borrowing/lending, repo, commercial paper, money market funds, eurocurrency/eurodollar banking, and much more.
Securitization (a.k.a. \u201Cmarket-based finance\u201D) \u2013 the disintermediation of traditional commercial bank lending in favor of bonds and the pooling of illiquid, untradable loans to form liquid, tradable securities. This includes the proliferation of mortgage-backed securities, high-yield bonds, increased IG corporate bond issuance vs. loans, and other asset-backed securitizations. This also coincided with the advent of the pension system, which indirectly funneled America\u2019s future retirement savings into the financial market.
OTC Derivatives and Value-at-Risk (VaR) \u2013 combined with Basel risk-weightings, these innovations introduced increasingly esoteric and mathematical definitions of \u201Cmoney-ness,\u201D resulting in the redefinition of money as \u201Cbank balance sheet capacity.\u201D This also cemented the shift of bank business models towards fee-generating, off-balance sheet banking activity as opposed to maturity transformation based on net interest margin or balance sheet expanding arbitrage.
In the previous issue of this installment on the origins and evolution of the modern monetary system, I covered \u201Casset management\u201D (the traditional model of banking, in the form of deposit-taking and lending), which we can build upon to begin to understand exactly how and why our modern financial system is so different from the textbook description of deposits, reserve requirements, and money multiplication.
Commercial banks create new money (deposits) when they extend new loans. Banks are simultaneously limited by statutory reserve requirements (prior to March 2020) and, more importantly, by self-imposed liquidity constraints. Banks need reserves to settle transactions and payments with other banks, such as when deposits are transferred, or when an individual or business pays another in bank deposits. In a world without a private market for Federal Funds, daylight overdrafts on Fedwire, or the ability to regularly borrow from the Federal Reserve\u2019s discount window, banks depended on attaining and retaining deposits to replenish their reserves.
In this issue of Monetary Mechanics, I will cover certain changes to the money and banking paradigm that can collectively be called \u201Cliability management\u201D and the re-emergence of \u201Cwholesale finance.\u201D While there is a myriad of other financial and regulatory developments that I could fill an entire book (if not several books) about, I will attempt to cover some of the most important developments that are still relevant to and required for the functioning of our monetary and banking system today.
Before I begin, I want to emphasize that I believe this is the single most important yet misunderstood transformation in the global monetary and banking system in the post-WWII era. This is perhaps due to the fact that many academics, analysts, and financial market participants choose to focus heavily on the development of the \u201Cshadow banking\u201D sector during the 1980s and the 1990s (including securitization, ABCP conduits, OTC derivatives, the repeal of the Glass-Steagall Act, etc.).
There is no doubt that these developments profoundly transformed the nature and function of commercial banking, as well as the rest of the financial system. However, I believe that the groundwork for this monumental transition was laid long before, and, as a result, we can only tackle the problems that the financial system faces today by understanding the changing of bank behavior that facilitated banks\u2019 shift from passive acceptors of deposits to active operators in the money markets.
The development of the private FF market is less important for the precise amount of extra balance sheet expansion and money creation that it permits, but more important for the fact that it enabled elasticity in the medium of exchange and flexibility in managing a bank\u2019s asset and liability structure.3 Prior to the development of the private FF market, banks often kept more reserves than required (a behavior that was especially enhanced in the 1930s), resulting in an uneven distribution of reserves in the banking system (uneven relative to lending opportunities).
The private FF market was the first wholesale (i.e. interbank) market to emerge since 1929, and banks rapidly reacquainted themselves with the idea of trading interbank liabilities, buying and selling funds, and managing liquidity on both sides of their balance sheet. Thus, the development of the private FF market (and the wholesale interbank market in general) was essentially a \u201Cre-development\u201D that moved the conduct of banking and bank-like activities away from the traditional depository base and towards trading with other financial market participants.4
There is no central physical marketplace for Federal funds [or repurchase agreements], the market consists of a loosely structured telephone network connecting the major participants\u2026 The Federal funds and term Federal funds transactions are normally \u201Cunsecured\u201D\u2026 For this reason, unsecured Federal funds transactions are done only by institutions that enjoy a very high degree of mutual confidence.5 2b1af7f3a8