Why Reserve Requirements Fail, but Downpayments (and Capital Requirements) Can Limit Money Creation

What’s the difference between reserve requirements and downpayments or capital requirements?

Previously in this newsletter I have stated that the way to restrict or tighten credit is to require down payments for loans. Ultimately, the only restriction is the price at which collateral is appraised, but a downpayment creates a buffer of safety around changing prices, giving you some wiggle room. What a down payment does is make it so that a borrower can only use a limited percent of the value of their collateral to create new money.

So if you have a home worth $350k, and the downpayment is 15%, then you must put up 10% +5% or $35k + $17.5 = $52.5k in order to get the loan. The collateral is valued at $350k, but you can only use it to lend or borrow $297.5k. If you are looking to get a home equity line of credit, similarly, your credit limit would stop at that $297.5k, where you still have 15% left over equity in the home.

Well this sounds an awfully like “reserve requirements” under a fractional reserve system, there are important differences which I want to discuss. Both are intended to similarly limit the amount of money that can be created, but they work very different in practice, and have very different effects.

For a large bank or institution, the equivalent of a down payment is what is known as a “capital requirement”. Similar to a downpayment, these regulations stipulate that these institutions are required to retain a certain amount of extra net worth.

Capital requirements are a very messy and complex part of financial regulation. You can get a small glimpse of this in the middle of this interview of Nathan Tankus by Paul Krugman: https://www.crisesnotes.com/liquidity-volatility-and-market-craziness-paul-krugman-interviews-nathan-tankus-again/

The relevant part of that article is discussions of Basel 1, 2, and III.

Reserves vs Downpayments

So for now, we will talk about these requirements for excess equity, using the simple term “down payment”, but for nuance we can acknowledge that capital requirements involve a lot more details and specifics than we can cover here.

But at a basic level, what is the difference between a reserve and a downpayment? To answer that question precisely, we must first cover what exactly a deposit is.

What Are Deposits? Why Are They Special?

One thing that may not be initially obvious, is that a deposit is just a debt owed to you.

But unlike other debts you as a depositor can call that debt at anytime and immediately receive full payment. So where a mortgage will have a specific schedule of payments on a recurring monthly interval, repaying a deposit debt is completely unscheduled and spontaneous.

There are two important consequences of this. The first is that for this reason, deposits are very useful for making payments. Because the full value of the debt can be “called in”, at any time, there is much less perceived uncertainty as to the price of that debt.

And because this kind of debt has a very stable price, it makes it very easy to use to pay people. The recipient can go and collect the deposit if you transfer that debt to them.

This principle is both what is behind the original invention of paper currency with goldsmiths, as well as being important to describe how payment systems operate today, in that debts are transferred between different parties.

The second consequence of this short term callable debt, is that the bank or issuer has to be ready to pay that debt at any time. In other words, they have to be highly liquid. And it is in this need to be always liquid, that reserve requirements come into play, as well as being somewhat redundant or self-contradicting.

Reserves are For Covering Deposit Debts on Demand

Because a failure to allow withdrawal of a deposit, is the most obvious and immediate symptom of bank failure, it is natural to want to regulate reserves. The problems with this approach, however, begin almost immediately.

First of all, a deposit is just one kind of debt, when banks can issue all different kinds of debt. So there are no restrictions created on other kinds of debt, and nothing to ensure that banks are overall solvent.

Secondly, a reserve requirement is very easy to check if you are a regulator or inspector, but it cannot apply 24/7, otherwise a bank could not actually use those reserves to pay out depositors.

So what we have is an end of day reserve requirement, which is basically why we have “overnight” interest rates. A bank borrows money to have the proper level of reserves when they are inspected(maybe zero, if that is the reserve requirement, as opposed to overdraft), but then immediately they can do whatever they want.

Downpayments Require Excess Equity, Reserves Require Excess Liquidity

And this is the fundamental difference. A downpayment requires excess equity and considers the entire balance sheet of assets and liabilities, whereas a reserve requirement only considers deposits liabilities and reserves, which might just be a small percent of the total balance sheet.

What Does This Have to Do With Interest Rates?

Even though reserve requirements are now zero, the logic of interest based monetary policy, is still based on the idea of banks competing for scarce reserves which they borrow and lend at a specific rate of interest. Some banks earn money lending reserves, and others pay money to borrow reserves.

This whole paradigm is a very narrow view of banking and payments, whereas downpayments encourage a broader view of asset prices, collateral appraisal, and balance sheets.

The sooner we move away from this narrow model of limited reserves, to a broader model of disciplined asset prices and maintaining net equity, the better off we will be with reforming monetary policy.

What are Zero Rates, If Not Free Money?

A zero rate of interest is not free money, rather, it represents perfectly efficient money or credit creation with no overhead costs. It is turning collateral into liquid money with no surcharge attached.

So while there will always practically be overhead costs involved in lending and borrowing, it makes sense to make these costs as consistent and small as possible.

What would actually be “free money” is credit or money creation with no substantive collateral, or where the price of the collateral was in a bubble with an insufficient buffer of downpayment. Downpayments can be adjusted according to the perceived excess growth in asset prices.