With Liberty, Justice, and Money for All

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Scholar advocates for regulating banks like infrastructure.

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When you go to your local bank, are you interacting with a private company or an organization that is, in effect, an extension of the federal government?

On the one hand, banks do operate as private companies. They match savers with borrowers, taking savers’ money and using it to offer loans to borrowers—all while turning a profit by charging more interest on their loans than the interest they pay on deposits. On the other hand, banks also essentially “create” money by making such loans available in the first place, and issuing money is a key function of the federal government.

Vanderbilt University Law School professor Morgan Ricks adopts the latter view, arguing in a recent paper that banks’ money creation is “an intrinsically public activity.” As a result, banks should be regulated like other critical public infrastructure in the energy, communication, and transportation sectors, claims Ricks.

In particular, Ricks favors having bank regulators use three regulatory devices common in infrastructure regulation: rate regulation, entry restriction, and universal service requirements. Using these tools to regulate banking would produce more economically efficient outcomes than does current bank regulation, which Ricks claims treats banking too much like a purely private activity entitled to a presumption against regulation.

Ricks argues that treating banks as public infrastructure would allow the government to regulate interest rates directly, thus overcoming problems that have emerged in recent years as the Federal Reserve tried to manage the economy following the 2008 financial crisis.

Before the crisis, the Federal Reserve regulated interest rates by requiring private banks to maintain a cash reserve to fulfill withdrawals by depositors, the required size of which was proportional to the bank’s total amount of deposits. When the total reserves of the banking system barely exceeded required reserves, Ricks writes, reserves were scarce and banks had limited ability to increase the amount of deposits they maintained.

To help satisfy its reserve requirement in such a scarce environment, a bank could borrow excess reserves from another bank, which were paid back at a later date along with interest. When reserves were scarce, the Federal Reserve could influence this interest rate by injecting money into or extracting money from banks’ reserves. The impact of these changes was then passed through to the interest rates banks set for their customers, which in turn stimulated or contracted the economy.

During the 2008 crisis, however, the Federal Reserve had to loan significant reserves to banks, and reserves still remain anything but scarce today—meaning banks borrow from each other less. Because of this dynamic, Ricks argues, the interest rate that banks pay on borrowed reserves is much less responsive to injections or extractions of cash by the Federal Reserve, which has effectively lost that tool for implementing monetary policy.

As a result, the Federal Reserve now pursues monetary policy by adjusting the interest rate that it pays banks on reserves that banks hold in excess of the required amount, as well as the interest rate it pays on agreements with nonbanks.

In theory, these rates should pass through to the rates that banks and nonbanks offer in other markets. In practice, however, these entities appear reluctant to follow a rate hike by the Federal Reserve with one of their own, limiting the effectiveness of this tool as well. Ricks also points out that the rate paid by the Federal Reserve to banks is higher than the rate paid by banks to their depositors, raising concern that taxpayers are subsidizing banks.

Ricks argues that infrastructure regulation would overcome the Federal Reserve’s predicament. After all, if the government had explicitly decided to outsource money creation to private entities, entrepreneurs would have bid for those bank charters. The winners would have paid the government, over a given period, the difference between what it would cost to finance their activities with private, nonbank agreements and what it actually costs to finance those same activities with deposit accounts—which they can only maintain by having a bank charter.

Because entrepreneurs would pay only this difference, Ricks concludes that they would be indifferent to the interest rate that the government requires to be paid on deposits. That issue would be between the government and depositors. In this way, the government would pursue monetary policy by setting interest rates directly, eliminating many of the problems that the Federal Reserve faces today.

The effectiveness of rate regulation also relies on entry restriction, a regulatory tool Ricks discusses in another paper. He notes that such restriction already exists in U.S. bank regulation: No person or entity can maintain deposits without a banking charter. Ricks argues that, given deposits’ role in creating money, such entry restriction serves to confine money creation to only the government and those private banks that agree to its terms.

As discussed, a central bank can set monetary policy through reserve requirements and interest payments on reserves. But when any kind of entity has the right to “create” money through lending, Ricks notes that the Federal Reserve’s rules for banks will impact only a fraction of the greater universe of money creators, significantly hampering its ability to implement monetary policy.

In addition to controlling rates and entry, traditional infrastructure regulation often includes universal service requirements. Ricks argues that similar requirements are needed in the financial sector because 28 percent of Americans are unbanked or underbanked, meaning that they rely entirely or in significant part on expensive nonbank services to cash checks or otherwise transact money.

Market forces alone might require extending banking services to only those customers who cover their cost to banks by paying fees. But Ricks argues that this view ignores the spillover benefits that universal access could produce for all of society, such as increasing the unbanked and underbanked customers’ participation in the national economy.

Ricks finds ample historical support for universal access in the cases of electric and gas utilities, telecommunications, and transportation. Expanding access in those sectors facilitated spillover effects that were in fact more efficient than excluding swaths of the population from accessing the infrastructure in question.

Viewing money creation as a public activity, Ricks argues, suggests new regulatory solutions foreclosed by viewing it as a private enterprise—solutions that could produce more efficient and politically desirable outcomes than relying on private market forces alone. For Ricks, traditional infrastructure regulation offers a “proof-of-concept” that demonstrates that rate regulation, entry restriction, and universal service requirements could also succeed in regulating banks.