Friday, 6 June 2008
Show me the money
When I was young, I thought that banks were full of cash. I imagined that my local high street bank had a vault, buried deep underground, holding uncountable millions of bank notes. Then I grew up and learnt about fractional reserve bank.
Far from holding huge quantities of banknotes, I learnt that banks hold a small fraction of their assets as cash. Through a trick of double entry bookkeeping, banks create electronic money, using what little cash they have to manage the daily customer demand for notes.
Of course, fractional reserve banking has been around for centuries. Nevertheless, today things are different. It is hard to imagine a time when banks held such a small proportion of their assets as cash.
For several decades, the bank of England has measured commercial bank liquidity. Three of those measures are presented in the chart above; the broad ratio, the reserve ratio and the narrow rate. The precise definitions of these measures are unimportant. Basically, they all measure the proportion of cash or near-cash financial instruments banks hold relative to their total assets.
Since the mid-1960s, banks have dramatically reduced their holdings of liquid assets. Most of the decline happened in the early 1970s, when financial markets were liberalized.
However, the long-term chart hides a more recent decline. Here is the same chart showing the same ratios over the last ten years. Again, the story is dramatic. At the risk of exaggeration, banks hold virtually no cash or liquid assets.
This problem has not gone unnoticed down at the Bank of England, though there is little evidence that the FSA realize it. Here is what the BoE recently said about commercial bank liquidity:
"Some measures of sterling liquid reserves have fallen since 1967. Banks have diversified their liquid asset holdings beyond those shown — for example, to include other currencies — and increased their use of repo markets, but the overall historical pattern is one of a marked decline in cushions of high-quality liquid assets."
Is this a problem? Again, here is how the BoE frame the issue:
"While firms themselves have strong incentives to be resilient to liquidity shocks, they may make less provision for liquidity risk than is desirable for the system as a whole."
Decoding the sentence I think is saying that there might be a problem here.
Recently, the BoE, along with other central banks and regulators have been looking into the issue. In the wake of Northern Rock and Bear Stearns, liquidity ratios are likely to come back into fashion. It is time for banks to again start holding cash down in the cellar.