Bank credit is an elemental thing consisting of purchasing power which a bank manufactures. This credit manifests itself in two forms, namely, bank notes and bank deposits.
Thomas Bruce Robb, The Guaranty of Bank Deposits, 1921
Financial crises are about bank debt. Debt is a financial contract under which the borrower promises to repay a fixed amount (known as par value, principal, or face value) at an agreed future date, the maturity date. Be-tween the date when the money is borrowed and the date when it is to be repaid, the borrower may also pay interest to the lender. If the borrower does not repay the principal or interest, then there are consequences. For non banks, the consequence may be bankruptcy, a legal procedure for allocating ownership of corporate assets. For banks it is different: bank regulators intervene, and ultimately there may still be bankruptcy. Bank debt is shortterm, giving the lender/depositor the right to get the cash back quickly. With banknotes or checking accounts, the bank customer has the right to demand cash at any time the bank is open. With repo and commercial paper, the maturity can be overnight, a few days, a week, or a month. Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007 (some also involved currency crises in which the value of the domestic currency declined precipitously). Indeed, there cannot be systemic crises without bank debt.’ But bank debt is needed for conducting transactions and is necessary for an economy to function. There is a demand for transactions by households and lit pus, and banks supply the debt, lhis is an elemental feature of market economies. Debt is the tecnology for conducting trade. it is short-term and designed to be “safe”. Bank debt is essential to transacting because it provides liquidity.
For example, if you had to sell a Van Gogh painting (lucky you to own one!) quickly, von would lose money. You don’t really know what the paint- milk., is worth unless you are an art expert. And few people would believe that it was . Van Gogh. Anyone who actually knew the painting’s worth could claim it was fake and try to buy it at a very low price. So you would take the painting to an auction house, and they would research its provenance, put out a cata-logue, and after a year or so hold an auction. You would realize more of the value of the painting. You could not realize the value of the painting at short notice unless you were willing to take a great loss. On the other hand, a Trea-sury bill can be sold easily without loss of value. There is no need to deter-mine the provenance of a U.S. Treasury bill its value is known by all. Bank debt attempts to privately create this property of a Treasury bill, and this property is called liquidity. Liquidity is a slippery and elusive idea. John Maynard Keynes wrote that an asset is liquid if its value is “more certainly realizable at short notice with-out loss” (Keynes 1930, 67). To trade easily, with liquidity, participants should not need to be concerned about whether the price of the “money” is right. The usual cause for concern, however, is the possibility that one side to the transaction knows more about the value of the money than the other side. in fact, just the possibility of one side knowing more than the other lowers the possible value of the transaction, even if no one really knows anything. Let’s take a concrete example. Richard Levin, president of Yale University, lives in New Haven, Connecticut. Suppose he goes to New York City to see a show, and before the show he wants to buy lunch at Belushi’s Samurai Deli. Suppose President Levin offers a ten-dollar free banknote from the Bank of New Haven to Mr. Belushi to buy a sandwich. The following questions come up: First, what is the ten-dollar bill worth in terms of gold or silver what is the discount from par? Second, does either party secretly know more than the other party about the value of the banknote? If there is a supposed discount from par, known from the secondary note market, there can still be a question of whether one party secretly knows that this discount is too high or too low. A party that knows a secret is said to have private information, and the situation between the two parties is then said to be one of asymmetric information. The problem is that if one party suspects that the other party knows a secret about the value of the money, he may suspect that he -will be taken ad-vantage of and may not trade. Then President Levin won’t get his sandwich and will go to the show hungry. To get him his sandwich, we are interested in knowing how the problem of secrets can be minimized. Minimizing the prob-lem of secrets is the same as creating liquidity. If there is no information to learn secretly, there can be no secrets, as with a Treasury bill. To minimize the problem of secrets, money must be backed with collateral that is riskless, or near-riskless. As we have seen, the problem is that the private sector cannot create riskless—secret-free—collateral. This was exactly the problem we saw earlier with the Free Banking Era, the Na-tional Banking Era, and with federal deposit insurance. In other words, if the collateral is riskless, and everyone knows the collateral is riskless, then there is no problem. And if it is costly to produce secret information, it may not pay to bother learning a secret if the collateral is near-riskless. Let’s go back to President Levin and Mr. Belushi. Suppose President Levin secretly knew that the Bank of New Haven backed their notes with risky col-lateral, and imagine that he knew the secret information that the note is only worth seven dollars. President Levin can benefit from this secret knowledge if he can use it to buy a sandwich worth more than seven dollars. Mr. Belushi then loses. Of course, it could be that Mr. Belushi knows the secret that the note is only worth seven dollars. He could then claim that the note is only worth five dollars. President Levin can accept that statement and lose two dollars (if it’s really worth seven dollars), or he can forego the sandwich and go to the show on an empty stomach.
If President Levin and Mr. Belushi thought that there were no secrets, and they each knew that the other thought the same way, then the note would be worth ten dollars, and a ten-dollar sandwich would be exchanged for the ten-dollar bill. That’s the world of believing that there are no secrets. There’s an-other world; let’s call it the transparent world. In this world, they both know the secret that the note is worth seven dollars. Then only a seven-dollar sand-wich could be exchanged. They are better off if they think that neither knows a secret than they would be if the secret information were revealed. If they are both ignorant, a ten-dollar sandwich can be exchanged. If they are both informed, then only the seven-dollar sandwich can he exchanged. If one of the two knows the secret and the other was aware of this, then the uninformed party might not trade at all, or accept that he will be taken advantage of. And if the sandwich is all the transactions in the entire economy, then there is a big dif-ference between a ten-dollar club sandwich and a seven-dollar baloney sandwich. The transaction technology is not just about prices—ten dollars versus seven dollars—because the actual amount and the quality traded are differ-ent. In one case a ten-dollar club sandwich is traded, in the other a seven-dollar baloney sandwich.
These are different goods, one more desirable than the other. Perhaps an analogy will help to make the point that this is a tech-nology. To get from New Haven to New York City, President Levin would have to take some means of transportation. In the early part of the 19th cen-tury he would have traveled by stagecoach. The trip would have taken the better part of a day, so President Levin wouldn’t have gone very often. Thus trade between New Haven and New York City was infrequent compared to a decade or so later when there was a train line between New Haven and New York City (later this the famous “New Haven,” a legendary railroad that oper-ated from 1872 to 1969). With the railroad line in place, the transaction costs were reduced. In the same sense, if the money is secret-free, the transaction costs are reduced. Markets are liquid when all parties to a transaction know that there are probably not any secrets to be known: no one knows anything about the col-lateral value and everyone knows that no one knows anything. In that situa-tion it is very easy to transact. The situation where there is nothing to know or nothing worth knowing—no secrets—is desirable and allows for efficient transactions. The idea that knowing nothing is desirable may seem counterintuitive. The whole idea of “efficient markets” is that asset prices contain information. But the stock market is much different from interbank and money markets. Bank debt is a senior claim on the collateral: debt holders are paid first and stock or equity is paid last. Since stockholders are paid last, all information about the collateral is relevant for them, so they have a big incentive to learn secrets—legally or otherwise. So in the end, there are no secrets (in theory), which is why the price reflects the information. With bank debt it is the opposite. The goal is to have no information revealed, and no possibility of any party wanting to learn, because of the overall cost of learning the secret.