Robust Convertibility

By Gonzalo Schwarz

Not as exciting as Robot Convertibles, but much more important.

What determines the extent to which a bank can be trusted to honor its fixed-rate redemption commitments? The answer that's at least implicit on most writings is that what matters is the nature of the assets backing a bank's IOUs, and especially the extent to which those assets consist of cash reserves. As a bank's reserves approach 100 percent of its outstanding demand liabilities, its ability to meet redemption requests improves, other things remaining equal; and if it actually maintains 100-percent reserves even a systemic run cannot force it to suspend. The case for currency boards, as more robust alternatives to central banks for preserving fixed exchange rates, rests entirely on this simple truth, which is also one of the arguments (but by no means the most important argument) offered by those who favor 100-percent reserve commercial banking over a fractional-reserve alternative. But while the argument in question is valid so far as it goes, it overlooks a far more important determinant of the robustness of a bank's commitment to convertibility. For if history is any guide a bank's ability to fulfill its contractual obligations matters far less than its willingness to do so. And that willingness depends less upon the state of a bank's cash holdings than on its legal and economic status. Specifically it depends on whether the bank is so privileged as to be able to default on its promises without running the risk of being forced into liquidation, or that of being taken over by its creditors, or even that of losing much business. A competitive and privately-owned bank, lacking any special privileges, can't default with impunity. It's outstanding liabilities are just that--liabilities--which means that it has to honor them or face legal consequences, including either its liquidation or a transfer of ownership. In earlier times a bank's owners might also have been liable to an extent exceeding the nominal value of there shares, and perhaps to the full extent of their personal wealth, with imprisonment the normal penalty for non-payment. Moreover even if the owners of a competitive bank might somehow have escaped legal penalties for nonpayment of the bank's debts, they could hardly have avoided the market penalty consisting of the utter ruin of the bank's reputation, and the corresponding, wholesale loss of business to more reputable banks. There would still be no question of the bank's continuing to be a going concern...Continue reading...image:

Sign up here to be notified of new articles from Gonzalo Schwarz and AIER.