Building a realistic banking system within a stock-flow coherent model Marc Lavoie University of Ottawa (based on work with Wynne Godley)

Work in progress Part of a manuscript written with W.G.: Monetary economics: an integrated approach to credit, money, income, production and wealth One block among several other blocks:  production firms block  households block  government sector block  central bank sector block

Two PK banking models The basic model Based on Godley CJE 1999 article Operational The more realistic model Adds several realistic features to the standard CJE model Operational, but still fragile

PK vs Neoclassical banks PK banks Bank loans are key Banks accept all deposits Banks provide all credit-worthy loans Banks set deposit rates which are endogenous loan rates are marked-up over deposit rates Neoclassical banks Asset allocators Make asset and liability choices Banks have supply functions of deposits and loans Deposit and loan rates clear deposit and loan markets

The buffer principle All sectors need a buffer that provides an adjustment factor Firms: inventories and bank loans Households: holdings of money deposits Government: bills issued Central bank: residual purchaser of bills or advances made to private banks Banks: bills held or advances obtained from central bank

The banks balance sheet constraint B bd = M1 s + M2 s - L s - H bd Banks provide money deposits and loans on demand, and they must hold bank reserves H bd ; All elements of the banks’ balance sheet are predetermined, except for Treasury bills B bd. Hidden equation of system: H bs = H bd Reserves are supplied on demand

The determination of interest rates The Treasury bill rate is set exogenously by the central bank (or by Taylor rule) The bond rate is also set exogenously, or it can be made endogenous The deposit rate is set by banks, based on a reaction function that depends on the liquidity preference of banks The lending rate is set by banks, with a markup on the deposit rate.

The banking liquidity ratio Banks compute a Banking liquidity ratio (BLR) BLR = T.Bills/Deposits This is the converse of Eichner’s 1986 degree of liquidity pressure (loans/deposits) The BLR must be within a certain range (bottom, top) in the medium run The BLR range is a reflection of bank liquidity preference

Liquidity mechanism When banks have an insufficient amount of bills relative to their liquidity preference, they increase interest rates on deposits, and induce households to trade their Treasury bills for bank deposits; this allows banks to recover a proper bills to deposits ratio. When banks have a liquidity preference for bills, they raise the (bottom, top) thresholds

Determination of deposit rates Deposit rates rise as long as BLR < bottom Deposit rates diminish as long as BLR > top Under the following two conditions: There is a ceiling to deposit rates: they cannot be any higher than bill rates There is a floor to loan rates: they cannot be any lower than bill rates When these conditions are not met, the BLR convention is inadequate system-wide

What happens when the bank liquidity ratio is inadequate system- wide ? In the overdraft system: banks pay little attention to their relative holdings of T.Bills; the conventionnal target BLR will be modified or ignored. In the asset-based system (anglo-saxon world), where bank liquidity ratios are important, there must be an escape market: this market is the commercial paper market; firms issue CP when loan rates are too high, and they retire CP when loan rates are low.

More realistic PK bank Banks issue equity Banks have retained earnings and net worth Banks make loans to consumers The loan markup over deposit rates is endogenous Banks face a BIS-imposed capital adequacy ratio (CAR) Banks may take advances from central bank Banks have labour costs

The determination of the own funds of banks OF b = OF b-1 + FU b + )eb s.pe b - NPL OF = own funds FU = retained earnings )eb s = new issues of bank shares NPL = non-performing loans (bankrupcies)

Realistic banks target profits Banks need to make a definite amount of profits, first to cover the dividends payments which their household shareholders view as desirable, and secondly to augment their own funds in line with the BIS rules on capital adequacy ratios. These two requirements, given the interest rates administered by the central bank, determine the spread between the rate of interest on loans and the rate of interest on deposits.

Targets of banks F b T = FU b T + FD b T FD b T = r db.OF b-1 or r db.eb s-1.pe b e -1 CAR = OF b / L s CAR M = minimum capital adequacy ratio CAR T = target capital adequacy ratio OF b T = CAR T.L s-1 If CAR M < CAR -1 < CAR T FU b T =  [(OF b T - (OF b-1 + )eb s.pe b e -1 )] If CAR -1 > CAR T,  = 0 If CAR -1 < CAR M,  =1

Determination of loan rates F b = r l.L s-1 + r b-1.B bd-1 - r m.M2 s-1 - r a-1.A bd-1 - WB b realized profits of banks; r l = r m + > the rate of interest on loans The endogenous markup > is obtained by equalizing the realized profits to the target amount of bank profits ; all else equal, low realized CARs require higher markups. The deposit rate is determined as in the basic model, on the basis of banks’ liquidity preference

Loans and deposits The relationship between loans and deposits, through the balance sheet constraint of banks, is given by the compulsory reserve ratio (res), the actual bank liquidity ratio (blr) and the actual capital adequacy ratio (car): L/M = (1 - res - blr)/(1 - car) Only by fluke would that ratio be 1.

Problems with the realistic banks It is much more difficult to find a reference steady state; Falling loans may actually lead to rising loan markups on deposit rates, due to the shrinking profit base that absorbs fixed costs; Loans to consumers create instabilities as well, because these loans are only partially absorbed by household deposits; Financial assets held by firms may be a partial solution, but this creates problems with regards to the determination of prices Commercial paper issued by firms help to stabilize interest rates.

Three experiments with the complete model (CP) Raise (again) compulsory reserve requirements Introduce random demand shocks Raise the target stock of fixed capital