RDP 8811: Monetary Transmission in a Deregulated Financial System 2. Conceptual Framework

Before looking at the implications of the trend towards a fully deregulated financial system, it is useful to define how the structure of such a system would look. The first point is that in such a futuristic financial system currency would be likely to play a decreasing role as a means of making transactions. It is therefore assumed below that all transactions will eventually be carried out using plastic cards (either debit or credit). The model conclusions do not depend on this assumption. The crucial condition is that there exists close substitutes for currency across a large share of transactions.

Secondly, it is assumed that all bank deposit rates (and lending rates) are set by market forces, ensuring that the central bank can no longer influence the differential rate of return on bank deposits and other assets in the economy. As discussed by Fama (1983), banks will merely provide a variety of portfolio management services and relative rates of return will reflect only the differing risk characteristics of the financial instruments marketed by banks and the relative costs of offering alternative banking functions. There will, in fact, be no distinguishable difference between banks and non-banks; unless the central bank wishes to maintain the distinction via prudential requirements.

With the (non-bank) private sector no longer holding outside money and, with so-called ‘inside money’ now earning market rates of interest, the central bank will clearly have less influence over an aggregate that reflects the private sector's transactions balances. This is an important point and it is worth further explanation. By allowing banks to set deposit and lending rates (an inevitable result of non-bank financial innovation), central banks have encouraged financial institutions to move towards liability management and away from a situation in which the authorities have a direct influence over their liabilities (the textbook definition of money) via the money/bond interest differential. This has already happened to a large extent in a number of countries and was largely completed in Australia by 1980. It is for this reason that the paper tries to avoid labeling intermediated financial assets as money.

One suggested response to this situation is that the central bank could extend its reserve requirement net to include all financial institutions that offer transactions facilities. As Tobin (1987) points out, this also requires that reserve requirements capture the ability of individuals to make transactions using credit cards. The central bank would, therefore, need “to set reserve requirements as a function of the bank's net transactions account balances plus aggregate credit lines”. (Tobin: 1987, p. 154)

Such a proposal, while possible, seems highly unlikely as it would almost certainly lead to financial innovations which avoided reserve requirements. It seems more likely, given current trends, that reserve ratios will not be widened to include the broader spectrum of financial institutions. Indeed, given the microeconomic misallocation of resources generated by reserve requirements, it seems more likely that they will become of less importance in the OECD countries in the future.

A third implication of the current trend towards financial deregulation is the tendency for banks to pass on interest rate risk to end-users by offering more floating rate facilities on both deposits and lending instruments. This is a world wide trend well documented by the Bank for International Settlements (1984). The implications of this trend are not fully understood, but one important effect is that changes in short-term rates may now impact on the IS curve more quickly and to a larger extent, if the private sector faces short-run liquidity constraints.

In such a fully deregulated environment, would there be a need for a central bank? The world did, of course, get by without central banks for centuries and many, including Greenfield and Yeager (1983), King (1983) and Harper (1984), have argued that a return to private commodity or fiduciary monetary system is a realistic alternative. It seems most likely, however, that there will remain a demand for perfectly liquid risk-free central bank reserves both to provide a stable numeraire and as a means of interbank settlement. A return to a private commodity or fiduciary-based monetary system seems unlikely largely because of the reasons that led to the decline of such systems. In particular, the need for a perfectly liquid risk-free lender of last resort is crucial to maintaining confidence in a modern financial system based on a vast network of credit. As discussed in Havrilesky (1987), banking systems have generally relied on the supply of an outside asset to settle interbank accounts and to draw on in times of crisis. Given that such an outside asset can be viewed as a public good, it makes sense that it be supplied by a public authority. If this is the case, (and it is assumed so in the rest of the paper) then monetary policy would continue to operate in much the same way as it does today.