Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
Financial Repression

• Recommended Reading Beim, David / Calomiris,
  Charles, Emerging Financial Markets, pp. 47 - 59

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Financial Repression

• 1. Overview
• We have seen before that governments tend to
  regulate financial corporations and in particular
  commercial banks in their ordinary operations.
• The fundamental justification why these
  regulations exist is the presence of asymmetric
  information in borrowing and lending and the
  arising need for monitoring and screening of
  borrowers and banks in financial markets.

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Financial Repression

• 1. Overview
• While some of these regulations such as a certain
  standard of disclosure or accounting standards
  are without doubt improving the quality and
  efficiency of these markets, other instruments
  such as deposit insurance or restrictions of bank
  interest rates on say deposits are more
  questionable.
• The reason for this is that governments always
  (to different extents) have interfered with
  financial markets to generate revenue and to
  direct the allocation of credit in their interest.

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Financial Repression

• 1. Overview
• The reason why financial markets are interesting
  for governments is that significant revenue can
  be created - largely without the notice of the
  public. We have already seen one similar example
  in the case of seignorage gains. By inflating the
  government exchanges interest bearing debt
  against non-interest bearing money creating a
  (largely unnoticed) inflation tax.
• Most people, hence, are not aware that
  governments historically have oppressed their
  financial systems for these purposes.

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Financial Repression

• 2. A simple model of bank lending
• To analyze the impact of financial market
  regulation on bank lending lets work with a
  simple version of the loanable funds model.
• Lets assume that all loans are bank loans, such
  that the supply of loanable funds is provided by
  savers exclusively through banks.
• As always both the supply and demand of loanable
  funds is a function of the (real interest) rate.

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Financial Repression

• 2. A simple model of bank lending
• In a world, where banking is costless, the
  interest rate at which depositors provide their
  funds (the deposit interest rate), should equal
  the interest rate that lenders receive on their
  loans (the lending interest rate).
• Since the operation of banks requires the input
  of productive factors, banks need to operate on
  profits, such that the lending rate in reality
  exceeds the deposit rate.

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Financial Repression

• 2. A simple model of bank lending

LS - Supply of Loans (through deposits) by
Depositors
rL Lending rate
Interest rate spread
re Fricitionless equilibrium rate
rD Deposit rate
LS Demand for Loans
L1
L2
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Financial Repression

• 2. A simple model of bank lending
• The graph above illustrates this situation. If
  banking was costly a frictionless equilibrium
  rate re would be provided to both depositors as
  well as lenders, at an equilibrium level of
  credit of L1.
• Banks in reality, however, charge a larger
  lending rate rL than the deposit rate rD they pay
  out, such that the actual amount of credit
  provided is only equal to L2.
• The difference between rD and rL is known as the
  interest rate spread.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• Banks have been subject to regulation in a
  variety of ways (as discussed above). In the
  following we focus on
• Interest rate ceilings on bank deposits
• High reserve requirements
• Any restrictions of bank competition (such as
  directing bank credit, public ownership,
  micromanagement of banks, entry restrictions
  (especially to foreigners), restriction of
  capital flows, etc.)

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 1. Interest rate ceilings on bank deposits
• Upper boundaries on interest rates banks can pay
  on their deposits are common (in the U.S. 1930
  1970, Regulation Q).
• The justification is usually the prevention of
  excessive competition between banks.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 1. Interest rate ceilings on bank deposits
• How do interest rate ceilings affect bank
  lending? Instead of charging the deposit rate a
  bank would normally pay (rD), banks now are
  forced to pay a lower deposit rate (rDc) on their
  deposits, reducing the amount of funds supplied
  by depositors.
• To offset this decrease in bank funds, banks will
  increase the lending rate accordingly from rL to
  rLc.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending

LS - Supply of Loans (through deposits) by
Depositors
rLc
rL
re
rD
Interest rate ceiling
rDc
LS Demand for Loans
L1
L2
L3
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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 1. Interest rate ceilings on bank deposits
• This has two effects
• First, it reduces the amount of loans banks are
  actually offering from L2 to L3.
• Second, it creates rents for banks, since the
  interest rate spread increases from (rD rL) to
  (rDc rLc).

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 1. Interest rate ceilings on bank deposits
• How can a government benefit from this? Often
  governments force banks to provide subsidized
  loans to government-favored borrowers to extract
  some of these rents.
• These rents are paid by private borrowers and
  lenders and tend to victimize small scale savers
  in particular in high-inflation economies, where
  real interest rates tend to become negative
  quickly if deposit interest rate ceilings exits.
• Note that this type of policy can only work if no
  market alternative such as a working bonds market
  exists.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 2. High Bank Reserve Requirements
• Within certain limits there is a clear-cut
  justification for why reserve requirements held
  by banks reduce the inherent liquidity problems
  in banking (as seen before).
• In most countries these reserve requirements are
  held with a central bank type institution which
  commonly does not pay any interest on these
  reserve requirements.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 2. High Bank Reserve Requirements
• Reserve requirements force banks to deposit hold
  monetary funds with the central bank which in
  turn allow the government to issue less interest
  rate bearing debt (this again, is a result of
  seignorage).
• How does this impact bank lending? Since banks
  have to hold unproductive reserves, for each
  level of loans the issue, they have to charge a
  higher lending rate rL2. In other words at any
  given lending rate they will supply less loans
  and the supply of loans will shift to the left.

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Financial Repression

• 2. A simple model of bank lending

LS1
LS2
rL2
rL1
re
rD1
rD2
LS Demand for Loans
L1
L2
L3
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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 2. High Bank Reserve Requirements
• The impact of this tax on banking is similar to
  the case above. The lending rate increases,
  consequentially the deposit rate decreases,
  making private lenders and borrowers worse off.
• Finally the amount of loans provided by banks
  decreases as well.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 2. High Bank Reserve Requirements
• The impact of this tax on banking is similar to
  the case above. The lending rate increases,
  consequentially the deposit rate decreases,
  making private lenders and borrowers worse off.
• Finally the amount of loans provided by banks
  decreases as well. Without going into details,
  note that this effect is typically elevated by
  the fact that seignorage creates inflation which
  should further requires bank to charge higher
  nominal lending rates and provide lower nominal
  deposit rates.

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Financial Repression

• 3. The Impact of Financial Regulation on Bank
  Lending
• 3. Restrictions on competition
• The ways in which governments regulate bank
  competition are numerous and range from attempts
  to direct bank credit in government favored
  investments over the nationalization of banks to
  closing financial markets to foreign
  participation (which is often less susceptible to
  government intervention).
• All of these interventions have ultimately the
  same impact They decrease the supply of bank
  loans to the private sector, causing the interest
  rate spread to decrease. The resulting rents are
  typically split up between banks, the government
  and government favored borrowers.

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Financial Repression

• 4. Financial Regulation Final Remarks
• While certain types of financial regulation
  clearly have their benefits (e.g. provision of
  information to borrowers through accounting
  standards), financial regulation does not come
  without a cost.
• 1. Deposit insurance removes private incentives
  of monitoring, therefore, causing a need for
  (costly) public supervision and monitoring of
  financial intermediaries
• 2. Restrictions of bank operations act as taxes
  on private savers and borrowers causing rents for
  governments and government-favored borrowers.

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Financial Repression

• 4. Financial Regulation Final Remarks
• This type of rent-seeking is particularly
  convenient for governments since it remains
  largely undetected by the public.
• If one has reason to believe that governments
  typically do a worse job at allocating capital
  efficiently (such a reason may be the fact that a
  government as opposed to a private saver does not
  run on profit, i.e. positive returns from
  investment), government regulation of financial
  markets can make markets less efficient often
  at the cost of small scale savers and investors.
• In the developed and emerging markets, the past
  30 20 years have, hence, seen an increased
  tendency to deregulate financial markets not
  rarely associated with bad experiences made with
  government control.