Permanent Liquidity And Ending Bank Subsidies

November 1, 2019

A financial crisis occurs when liquidity in the financial markets suddenly disappears. To cope with such an event central banks are ready to inject liquidity into the financial system. Liquidity is another word for central bank currency. The recent turmoil in the repo market demonstrated that some market participants were in need of central bank currency. That may happen because central bank currency is the ultimate means of settlement.

Reserve requirements are nearing zero so this is a bit odd. It appears that market participants like banks hoard central bank currency. Apparently central bank currency is attractive to hold. That can cause financial crisis. To prevent that, a holding fee on central bank currency might be advised, which is a feature of Natural Money. Natural Money has the following characteristics:

  • Central bank currency carries a holding fee of approximately 10% per year, so if you hold central bank currency then € 1,00 turns into € 0,90 after a year, which can make it attractive to lend out money at negative interest rates.
  • The holding fee is the new lower bound for interest rates, not the interest rate in the market. Interest rates on bank accounts might be around -2% per year in terms of central bank currency, so people don't pay the holding fee but the interest rate in the market.
  • Cash is a short-term loan to the government and carries an interest rate equal to short-term government loans in the market, which might be -3%. Henceforth, cash and central bank currency have different rates to prevent cash from being hoarded when interest rates are negative.
  • It is expected that interest rates go negative and remain in negative territory, so once most interest rates are negative, positive interest rates can be phased out to forestall a quest for yield leading to irresponsible risk taking.
  • Inflation is likely to end and deflation might set in, so the inflation rate might be -1%, which means that the price level goes down with 1% per year.

The most useful feature of Natural Money for ending liquidity crises is the holding fee on central bank currency. With Natural Money banks can borrow currency at the central bank at an interest rate of zero. This is unattractive as it is the maximum interest rate a bank can make on loans. In this way the central bank doesn't end up subsidising a commercial bank, even more so because the currency carries a holding fee.

Central bank currency is the ultimate means of payment. With Natural Money a bank can borrow central bank currency at zero interest to pay its creditors. Central bank currency is legal tender so creditors must accept a payment in central bank currency. Those creditors could end up holding currency that has a steep negative yield. And so they may become interested in any security a liquidity strapped bank has on offer.

As a consequence only a bank in distress would take up central bank credit. If a bank remains on this credit for a longer period of time, it can be considered bankrupt. It should then attract additional capital, be sold or dissolved.

There is another profound consequence of the holding fee. Holding central bank currency would be unattractive. Except for reserve requirements, there will be no reason to hold currency. The excess currency in the financial system might be offered to the central bank in exchange for securities it has on its balance sheet. Quantitative easing could be undone and the central bank may make a considerable profit in the process.

If reserve requirements are to disappear in the future as capital requirements are replacing them, central bank currency may disappear out of the financial system entirely and become an accounting unit only. Introducing Natural Money might accelerate this development as there would be little reason for banks to keep reserves as they would be costly to hold. Liquidity crises could be gone forever and the banking sector would not be subsidised.

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