The Bank-Centered View of the Money Market - Part 1: Why Banks Are Different

Abstract

This paper introduces modern readers to the basic understanding of the banking system that was held by academics and practitioners in the early years of the 20th century – that is, to traditional banking theory. This theory is completely inconsistent with the theoretic framework that views banks as financial intermediaries that receive deposits and invest those deposits in assets. Thus, this paper first sets forth in detail the basic elements of traditional banking theory and then relates those elements to the modern network effects literature. From this a bank-centered view of the money market is derived: all demand and short-term bank liabilities, including contingent liabilities, are potential money and near-money assets, and any non-bank liabilities that have monetary properties will derive them from their relationship with the banking system. This framework is then used to evaluate modern money markets, and this paper finds that indeed the so-called market-based money market in fact functions as a means of reallocating the bank liabilities held (indirectly) by the public from deposits to wholesale and contingent bank liabilities. This paper proposes that bank liability-based measures of the money supply be developed, and that regulators recognize that contingent bank liabilities often function as a substitute for deposits and should be regulated similarly.