the plan for the future
28 September 2019
A financial crisis occurs when liquidity in the financial markets suddenly disappears. To cope with such an event central banks are ready to inject liquidity into the financial system. Liquidity is another word for central bank currency. The recent turmoil in the repo market demonstrated that some market participants were in need of central bank currency. That may happen because central bank currency is the ultimate means of settlement.
Reserve requirements are nearing zero so this is a bit odd. It appears that market participants like banks hoard central bank currency. Apparently central bank currency is attractive to hold. That can cause financial crisis. To prevent that, a holding fee on central bank currency might be advised, which is a feature of Natural Money. Natural Money has the following characteristics:
The most useful feature of Natural Money for ending liquidity crises is the holding fee on central bank currency. With Natural Money banks can borrow currency at the central bank at an interest rate of zero. This is unattractive as it is the maximum interest rate a bank can make on loans. In this way the central bank doesn't end up subsidising a commercial bank, even more so because the currency carries a holding fee.
Central bank currency is the ultimate means of payment. With Natural Money a bank can borrow central bank currency at zero interest to pay its creditors. Central bank currency is legal tender so creditors must accept a payment in central bank currency. Those creditors could end up holding currency that has a steep negative yield. And so they may become interested in any security a liquidity strapped bank has on offer.
As a consequence only a bank in distress would take up central bank credit. If a bank remains on this credit for a longer period of time, it can be considered bankrupt. It should then attract additional capital, be sold or dissolved.
There is another profound consequence of the holding fee. Holding central bank currency would be unattractive. Except for reserve requirements, there will be no reason to hold currency. The excess currency in the financial system might be offered to the central bank in exchange for securities it has on its balance sheet. Quantitative easing could be undone and the central bank may make a considerable profit in the process.
If reserve requirements are to disappear in the future as capital requirements are replacing them, central bank currency may disappear out of the financial system entirely and become an accounting unit only. Introducing Natural Money might accelerate this development as there would be little reason for banks to keep reserves as they would be costly to hold. Liquidity crises could be gone forever and the banking sector would not be subsidised.