Game of Transformations: the Liquidity Version

The pretence that the illiquid real assets of an economy — the factories, capital equipment, houses and offices — can suddenly be converted into money or liquidity is the essence of the alchemy of the present system.”

– Mervyn King, former governor of the Bank of England (2016)


Does money have a basic molecular substance or structure? Though some might argue that it is created ex nihilo, such an assertion does not help us to understand under what conditions, what constellations, or what processes, money takes its form and comes into being. What we can say at this point is that it appears banks have succeeded in achieving this magnum opus, this transformation out of which money comes into being and starts to flow.

But this transformational work is not done for nothing. It involves risks for which banks demand a reward. Where there are rewards, there will be competitors, and only those who play by the rules will be permitted to continue playing. This is the Game of Transformations.

The Players: Banks

Objective (i.e. the reward): Profits

Let’s begin with the basics of lending money, one of the primary sources of bank profits…

This simple explanation by Tyrion Lannister is a good start. But just to be sure we don’t get off on the wrong foot, we should remember that the particular manner in which banks lend is generally quite different than how lending between individuals takes place (something I have discussed here). The latter case usually involves a lender offering cash to a borrower in return for the borrower’s IOU (verbal or written); in essence, a swap of cash for an IOU, or from the borrower’s perspective, a swap of an IOU for cash. In contrast, there is no cash exchanged in bank lending — it’s just a swap of IOUs.

Banks swap their own short-term liabilities (i.e. deposits) to acquire longer-term assets (i.e. loans), but those assets are someone else’s liabilities; hence, a swap of IOUs. Implied in this swap is a transformation: what we might call a maturity transformation, where the word maturity is just a fancy way of saying, “agreed upon period of time” at the end of which a loan must be repaid. By making this swap, a bank takes a borrower’s promise of a future ability to pay and transforms that promise into present purchasing power, in a kind of financial alchemy.

For performing this alchemical transformation, banks charge a price, known as the rate of interest. Simply understood, the interest rate is an exchange rate between the present and the future. It is the price of money today in terms of money tomorrow, or the price of money tomorrow in terms of money today, both of which are expressed by the concept of the time value of money. So long as it is positive, the interest rate embodies the general preference for present money over future money.

Now, bankers are well aware that not everyone is a Lannister. The existence of the possibility that borrowers may break their promise and not pay back their debts means that bankers make it a part of their business to understand the creditworthiness of their borrowers. They must be able to tell the Lannisters of the world from the Bronns of the world. Being at the centre of a nation’s payment system makes banks especially suited for this task, able to observe with a vigilant eye, who is and who is not paying their debts. (Of course, observation is never a completely objective function; it is always conditioned, and in this case, it is conditioned by the profit-motive).

Based on these observations, bankers rank borrowers according to the credibility of their respective promises to pay, and then charge a premium that reflects those rankings. Lower premiums will be charged to borrowers with high credibility rankings, while higher premiums will be charged to borrowers with low credibility rankings.

Accurately distinguishing between high credibility borrowers and low credibility borrowers is important if banks are to limit their losses and maximize their profits. They must walk a delicate line between charging interest rates that are too high and those that are too low. Charge too high an interest rate and the demand for money today will pivot towards a competitor or be choked off altogether. Charge too low of an interest rate and the expected reward will fail to compensate banks for the risks they are taking on.

Underestimate these risks and banks may be able to undercut their competitors. But if actuarial assessments of risk are worth their salt, keep that kind of behaviour up long enough and the law of large numbers will forcefully assert itself, with the rate of defaults outweighing any of the added benefits of undercutting the competition. Then again, aside from underestimating credit risk, we live in a world of radical uncertainty, cohabited by black swans and other wildlings.

A couple of wildlings navigating a world of radical uncertainty.

Playing the Game — Liquidity Transformation

Along with credit risk, banks also assume risks associated with another kind of alchemical transformation they perform. That risk is known as liquidity risk, related as it is to liquidity transformation. To understand liquidity transformation, a few examples will help.

Ex. 1 — An illiquid tangible asset into liquid money

Let’s assume Bronn owns a home, but in between jobs as a sellsword, he’s short on cash. He doesn’t want to sell his home, and besides, he needs cash right now and likely wouldn’t be able to sell his home in time to meet his cash needs, unless he sold it for 5 bucks or something. Bronn’s problem is that he has liquid needs, but an illiquid asset.

A bank can solve that problem by applying its alchemical powers to transform the value congealed in Bronn’s home into liquid money. Treating the value of the home’s equity as collateral, the bank issues Bronn credit, which he can draw on to make payments or convert to cash as his needs require. In modern parlance, this kind of transformation is usually referred to as a home-equity line of credit or HELOC, allowing the homeowner to ‘tap’ into the equity value in their home. Just as water is a liquefied form of H2O, money represents a liquefied form of past value accumulated in real assets.

In this instance, the bank is less concerned about default risk because it always has recourse to the collateral (i.e. Bronn’s house) if Bronn decides not to pay back the loan. However, by doing this transformation, the bank has exposed itself to liquidity risk. It has increased its liquid liabilities, while at the same time increasing its loan assets that may not be easy to liquidate if the bank needs to. (If Bronn has defaulted on his debt, it would be especially hard for the bank to liquidate this asset, and if the price of Bronn’s home were falling…hmmm, did somebody say ‘subprime mortgage crisis’?)

Ex. 2 — Intangible credit into liquid money

Now suppose that Bronn is not fortunate enough to own a home nor any other real tangible asset, there is still another way that he could access a bank’s alchemical powers: he could offer up his own illiquid credit in exchange for a bank’s liquid credit. You see, banks have solved the fundamental alchemical problem, as posed by Minsky: “everyone can create money; the problem is to get it accepted.” Remember, banking is just a swap of IOUs; the difference, however, is that a bank’s IOUs are treated as money, whereas yours and mine are not.

In exchange for a loaf of bread, Bronn could offer up his own IOU at the local bakery. But, even if the baker knows and trusts Bronn and accepts his promise to pay, she may not be able to transfer that IOU to a third party. Bronn’s credit is personal, vouched for by the baker’s opinion of his reputation, and sealed with a handshake. It lacks the general transferability that bank credit has, and thus lacks the market liquidity that bank credit has.

Yet if Bronn’s reputation with his bank, as attested to by his credit score, is of the creditworthy variety, then Bronn has funding liquidity. If the baker prefers the liquidity of bank credit over Bronn’s personal IOU, the bank can use its own established reputation to vouch for Bronn’s reputation, extending him a loan contract, inscribed in the law. Bronn’s payment with the bank’s transferable credit, rather than his own IOU, satisfies the baker’s preference for liquidity.

Accounting for Bronn’s worthiness: “Credit is the economic judgment on the morality of a man” (Marx, 1844).

By maintaining a reputation for honouring his promises to pay, Bronn provides evidence of a future willingness to pay. Combined with evidence of future ability to pay, Bronn has built himself an intangible asset that he can use to back his promise of procuring some future value, and which he can pledge in order to access the bank’s alchemical power of transforming illiquid personal IOUs into its own liquid credit. That pledge will no doubt require Bronn to return to his duties as a sellsword in order to pay his debt, a job that could very well cost him a literal “pound of flesh.”

In a society in which the predominant form of money circulates as a kind of bank debt, perhaps it is not so much in Bronn’s pocket that he carries his social power and bond with society, but in his bank’s opinion of his worthiness for credit. By the bank’s assessment of his worthiness, Bronn obtains his daily bread. I guess the bankers really are doing God’s work after all.

The Rules

Liquidity transformation is risky business. By offering their own liquid IOUs in exchange for the illiquid IOUs of their borrowers, banks are increasing their short-term obligations to pay without necessarily securing the reserves — cash and central bank deposits — necessary to fulfill those obligations.

As you can see, the more a bank expands its balance sheet through the extension of increasing amounts of credit to borrowers, the bank’s means of payment (i.e. cash and reserves) become a smaller proportion of the total liabilities that it may be called upon to honour at any given moment. Thus, the risk of failing to pay increases, and if a bank fails to pay, it’s out of the game. If you can’t pay, you can’t play.

If it weren’t for the systemically important role that banks play in not only financing new business enterprise and economic development, but also in the smooth functioning of the payments system, governments wouldn’t be so concerned about the inherently risky business in which banks are involved. But because banks do play such key roles, governments like to assume the role of referee, keeping the players in line while trying to maintain the continuity of the game’s play as much as possible.

a) Keeping the Players in Line (monetary discipline)

One simple rule that some governments enforce is a reserve requirement. For example, in the U.S., banks with more than $122.3 million in deposit liabilities are required to maintain a 10% reserve ratio over a 14-day maintenance period. In other words, banks must hold an amount of cash and central bank reserves equivalent to 10% of their deposits. The maintenance period allows banks to fall below the 10% level on any given day as long as they maintain an average of 10% over two-weeks.

The flexibility allowed by the maintenance period gives banks extra time to deal with any abnormal fluctuations in payment behaviour that leads to large outflows of cash and reserves on any given day (something I have discussed here). In such a case, a bank’s first lines of defense are the money markets. Banks experiencing reserve deficiencies turn to borrowing, usually overnight, in these markets in order to satisfy the reserve requirements.

If we were to start from the assumption that the banking system as a whole was holding plenty of excess reserves, then acquiring more reserves for any particular bank should be relatively unproblematic. That is, if the current ratio of reserves to deposit liabilities for the entire banking sector were sitting at about 15%, then any particular bank that fell below the 10% reserve requirement should be able to acquire the necessary reserves in the money markets.

However, given a fixed absolute level of reserves in the banking system, if banks continue to lend, generating a general expansion of credit, then the level of reserves relative to deposits will begin to shrink. As the ratio approaches the 10% level, the amount of excess reserves in the system will become increasingly scarce, making it harder and harder for an individual bank to attract the necessary reserves.

This scarcity would begin to exert upward pressure on money market interest rates, bid up by banks seeking required reserves. As these rates rise, so too do banks’ borrowing costs, eating into their profits. In order to maintain their profit margins, banks would have to increase the interest rates they charge to their borrowers. As mentioned earlier, a rise in interest rates charged by banks can choke off the demand for money today. But, this whole scenario assumed that the total level of reserves in the banking system was fixed. In practice, they generally are not.

b) Maintaining the Continuity of the Game (monetary elasticity)

i) Open Market Operations

Modern central banks have found that the objectives of their respective monetary policies are generally best achieved by targeting the level of interest rates rather than the absolute level of reserves. Thus, given a specific target for the key overnight lending rate in the interbank money market, central banks will supply whatever reserves are necessary in order to hit that target. If there is upward pressure on that interest rate due to a general expansion of credit, then the central bank will inject reserves into the banking system.

In a situation where there is upward pressure on the fed funds rate, the Federal Reserve will intervene to inject reserves through a process known as open market operations (OMO). To make the injection, the Fed draws on its bottomless pit of reserves to purchase government treasury securities (i.e. government debt) from primary dealers (i.e. banks that act as trading counterparties to the Fed and as market makers for U.S. Treasury securities).

In this way, the Fed stabilizes the interest rate by allowing banks to shift some of their less liquid assets on to its own balance sheet in exchange for liquid reserves — just as private banks do liquidity transformation for their clients, the Fed performs liquidity transformations for banks. Banks monetize personal debts while the central bank monetizes the government’s debt. (Are we getting closer to understanding the basic molecular substance and structure of money? Or at least one of its elemental properties?)

The reserve injection relieves the upward pressure on the rate of interest. The Fed can also relieve downward pressure, or even increase rates, by selling securities in a reverse OMO transaction.

Open Market Operations (and you thought government debt was only good for paving roads, building bridges, dams and fighter jets).

The important thing to remember, however, is that if the Fed does decide to raise interest rates in an attempt to slowdown the expansion of credit, the raising of rates is not a direct limit to the amount of lending done by banks. It is indirect, and works primarily through the channel of demand rather than supply. By raising rates, the Fed puts pressure on banks to raise their rates as well, which may serve to choke off demand for loans rather than acting as a direct limit to the supply from banks. Whatever the interest rate is, banks will supply whatever loans they can to meet the demand, keeping in mind, of course, the creditworthiness of who is demanding.

Thus the Fed plays an accommodative role, pumping reserves into the banking system when credit expands and sucking them out again when credit contracts, giving the monetary system the characteristic of elasticity. Like physical matter that expands when heated and contracts when cooled, credit is in a state of flux, constantly expanding and contracting as per the particular economic climate. Indeed, as Professor Perry Mehrling explains in his Economics of Money and Banking lectures, this contraction and expansion of credit happens on a daily basis, over the course of the business cycle, and along with the rise and the fall of nations.

My rendition of a diagram I first came across in Perry Mehrling’s money and banking lectures.

ii) Lender of Last Resort

For the most part, banks meet their liquidity needs by borrowing in the money markets, selling some of their asset holdings to other market participants, or through the accommodative actions of the Fed in maintaining its interest rate target. However, if ever an individual bank finds itself temporarily short on liquidity, in order to avoid a general panic in the financial system, the Fed stands ready to fulfill a role played by many modern central banks — the lender of last resort.

This role is perhaps best summed up by the Bagehot principle, paraphrased here by former Deputy Governor of the Bank of England, Paul Tucker, “…to avert panic, central banks should lend early and freely (i.e. without limit), to solvent firms, against good collateral, and at ‘high rates’.”

The logic behind the principle is that central banks should be willing to lend only to banks suffering from a temporary liquidity crisis so as to prevent a general panic within the financial system, but to avoid lending to insolvent banks so as to impose some discipline on banks’ lending practices (I’ve written about the distinction between illiquidity and insolvency here).

Balancing Elasticity and Discipine

Elasticity and discipline are two opposing poles, the careful balancing of which are key to the functioning and stability of the monetary system. Central banks allow for an elastic money supply that expands and contracts according to the needs of trade, but want to maintain the power to impose discipline when banks begin having a little too much fun and forget their duties to ensure the creditworthiness of their own borrowers.

This balancing act strikes at the very heart of the question of what money is, in both substance and structure, and additionally, what money does. Among money’s potential functions, one is that of being a stable store of value and another is that of being a medium of exchange. Yet, there exists a tension, which is both social and political as much as it is economic, between these two functions that is revealed in the attempt to balance monetary elasticity and discipline.

On the one side are the hard-money advocates that see the ability of private banks and governments to create money, seemingly out of nothing, as a threat to money’s stability as a store of value. If it can simply be created ex nihilo, then its value is meaningless. Such advocates emphasize the need to keep money scarce; therefore, the importance of discipline. They long for a return to the gold standard in which money’s supply is tied to a limited quantity of some real tangible commodity, or look forward to a Bitcoin future, in which money’s supply is regulated by some predetermined algorithm, out of the hands of both banks and governments.

But if money becomes too scarce it ceases to function as a medium of exchange — people would rather hoard it than exchange it. On the other side then, are the soft- or easy-money advocates, stressing the need for a flexible, or elastic, money supply that responds to the liquidity needs of businesses and private households. When money is kept too scarce, people naturally look for substitutes, with a whole hierarchy of credit evolving underneath whatever hard-money is operating at the time.

Creditors whose assets are denominated in the monetary unit of account take the hard-money stance to protect their stores of value, while debtors yearn for the liquidity of easy-money to meet their obligations. Governments attempt to manage these conflicting positions, giving banks the ability to expand credit while requiring them to maintain a certain level of discipline.

If there is not enough discipline in the system, then money as a stable store of value is at risk, no less than the economic and political stability of the nation. Thus, the privilege of creating money given to banks by governments also comes with the responsibility of imposing discipline. A general expansion of credit backed by promises to pay that turn out to be dubious is not only hazardous for individual banks, but also for the entire financial and monetary system in which they score their profits.

As mentioned before, banks must be able to distinguish the Lannisters of the world from the Bronns of the world, as well as the wildlings, the subprimes, and even the Targaryen girls…

But even dubious assets are not always enough to merit a fall from grace, especially for banks considered to be systemically important. As Charles Goodhart writes, “ Just as it is the metier of God to have mercy on sinners, however heinous the sin, so it is the metier of central banks to provide liquidity to systemic financial institutions, however dubious are the assets on their balance sheets.” Systemic financial institutions are lynchpins to the wheels of commerce, which are lubricated by the credit-money they issue. Let them fail and what game shall be played then?


Thus I deny morality as I deny alchemy, that is, I deny their presuppositions

– Friedrich Nietzsche (1881)