Issue #33: The Origins and Evolution of the Modern Monetary System

Part 5: "Liability Management" – Negotiable Certificates of Deposit (CDs)

Recall that there are a few fundamental innovations that have radically transformed our monetary and banking system in the post-WWII era:

1. Liability Management (a.k.a. “wholesale finance”) – the expansion of banking strategy that transformed banks from passive acceptors of deposits to aggressive operators in the money market. This includes federal funds borrowing/lending, repo, commercial paper, money market funds, eurocurrency/eurodollar banking, and much more.

2. Securitization (a.k.a. “market-based finance”) – the disintermediation of traditional commercial bank lending in favor of bonds and the pooling of illiquid, untradable loans to form liquid, tradable securities. This includes the proliferation of mortgage-backed securities, high-yield bonds, increased IG corporate bond issuance vs. loans, and other asset-backed securitizations. This also coincided with the advent of the pension system, which indirectly funneled America’s future retirement savings into the financial market.

3. OTC Derivatives and Value-at-Risk (VaR) – combined with Basel risk-weightings, these innovations introduced increasingly esoteric and mathematical definitions of “money-ness,” resulting in the redefinition of money as “bank balance sheet capacity.” This also cemented the shift of bank business models towards fee-generating, off-balance sheet banking activity as opposed to maturity transformation based on net interest margin or balance sheet expanding arbitrage.

In the first issue of this installment, I covered “asset management” (the traditional model of banking, in the form of deposit-taking and lending), which we can build upon to begin to understand exactly how and why our modern financial system is so different from the textbook description of deposits, reserve requirements, and money multiplication. In the second issue of this installment, I covered the first part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the domestic federal funds market. In the third issue of this installment, I covered the second part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the international Eurocurrency/Eurodollar banking system. In the fourth issue of this installment, I continued covering the development of the international Eurocurrency/Eurodollar banking system, focusing on the entrance of US banks into the Eurocurrency/Eurodollar borrowing and lending market.

If you have not had a chance to read Issue #8, Issue #11, Issue #16, and Issue #28 of Monetary Mechanics yet, I suggest you do before continuing below, as it contains important information, but here is a brief review for you if you need it:

Commercial banks create new money (deposits) when they extend new loans. Banks are simultaneously limited by statutory reserve requirements (prior to March 2020) and, more importantly, by self-imposed liquidity constraints. Banks need reserves to settle transactions and payments with other banks, such as when deposits are transferred, or when an individual or business pays another in bank deposits. In a world without a private market for Federal Funds, daylight overdrafts on Fedwire, or the ability to regularly borrow from the Federal Reserve’s discount window, banks depended on attaining and retaining deposits to replenish their reserves.

These limitations defined the relatively more repressed financial regime of the early post-WWII era (as contrasted against that of the 1960s-2010s). Prior experiments with the liberalization of money and banking in the early 20th century, coupled with the subsequent Great Depression and the period of financial repression during WWII, left people skeptical about the benefits of a liberalized money and banking system.

The development of the private market for Federal Funds permitted large money-center banks to borrow reserves from small countryside banks, enabling large money-center banks to deliberately operate with a structural short position, where they lent more than they had reserves on hand, knowing that they could borrow the difference in the federal funds market, for the purpose of expanding their marginal lending activities. More importantly, the development of the private market for Federal Funds spearheaded the redevelopment of an informal interbank network that, together with other methods of liability management that I will soon cover in this and other issues of Monetary Mechanics, began to transform the model of banking from a deposit-facing one to an interbank-focused one.

As US dollar deposits found their way offshore and onto the balance sheets of banks in London, Paris, Frankfurt, and Zurich, the Eurocurrency/Eurodollar banking system emerged as a supranational, informal interbank network that linked the world’s various financial systems into one tightly woven web. Consequently, this evolution led to the emergence of a structure of international interest rates that were (and still are) distinct from, as well as largely independent of, national interest rates – a development that is without parallel in modern economic history.

In this issue of Monetary Mechanics, I will cover certain changes to the money and banking paradigm that can collectively be called “liability management” and the re-emergence of “wholesale finance.” While there is a myriad of other financial and regulatory developments that I could fill an entire book (if not several books) about, I will attempt to cover some of the most important developments that are still relevant to and required for the functioning of our monetary and banking system today.

In this issue of Monetary Mechanics, I will cover the third major innovation in liability management, which is the development of large negotiable certificates of deposit (CDs) in 1961. While various forms of time deposits had already existed prior to the invention and introduction of large negotiable CDs in 1961, negotiable CDs were particularly noteworthy precisely due to their negotiable nature. When they neared their maturity, they were basically a marketable interest-bearing liquid asset. Unlike negotiable CDs, ordinary time deposits could not be transferred and could not bear interest at a maturity of less than 30 days.¹ Since there are too many important topics to cover here all at once, in future issues of Monetary Mechanics, I will also attempt to cover:

• The creation of bank holding companies (BHCs) in 1956

• The issuance of commercial paper (as well as other wholesale liabilities)

• The development of the repurchase agreement (repo) market by government securities dealers shortly after WWII

Before I begin, I want to emphasize that I believe this is the single most important yet misunderstood transformation in the global monetary and banking system in the post-WWII era. This is perhaps due to the fact that many academics, analysts, and financial market participants choose to focus heavily on the development of the “shadow banking” sector during the 1980s and the 1990s (including securitization, ABCP conduits, OTC derivatives, the repeal of the Glass-Steagall Act, etc.).

There is no doubt that these developments profoundly transformed the nature and function of commercial banking, as well as the rest of the financial system. However, I believe that the groundwork for this monumental transition was laid long before, and, as a result, we can only tackle the problems that the financial system faces today by understanding the changing of bank behavior that facilitated banks’ shift from passive acceptors of deposits to active operators in the money markets.

Due to quantitative data limitations, I will utilize mostly qualitative data in the form of narrative exposition and evidence from reputable sources. However, I will also utilize objective numerical measures where available, accessible, and relevant.

The Development of Negotiable Certificates of Deposit (CDs)

Negotiable certificates of deposit (CDs) are scarcely mentioned, if at all, in today’s financial media, as their importance to the global monetary and banking system has significantly diminished over the years. However, it is indisputable that the development of negotiable CDs, along with the gradual surge of financial innovations that together comprise the concept of bank “liability management,” dramatically and irrevocably transformed the character of banking in the United States.

Prior to 1961, banks depended primarily on demand deposits as their main source of funding/financing. Since banks were explicitly restricted by Regulation Q from being able to pay above certain interest rates on deposits, banks tried to implicitly provide a variety of free services (e.g. payment services) in order to compensate for this.

Prior to 1961, CDs already existed in a negotiable form for years. However, they could not become an important source of funding/financing for banks until they could compete with other short-term money market instruments. To do so, they would have to be readily marketable and to pay a market rate of return. In February 1961, a crucial development occurred in the form of a secondary market for large negotiable CDs, which were provided by the Discount Corporation of New York, a dealer in US government securities, up until that point. This secondary market for large negotiable CDs, by establishing a means through which an investor could sell his holdings quickly and at a low cost prior to their maturity, made CDs a truly liquid money market instrument. Soon, other large banks began to provide CDs and other large dealers began to participate in this secondary market.

However, by the late 1950s, most of the largest money center banks realized that many of their largest corporate customers found alternative workaround ways of lowering their average holdings of non-interest-bearing deposits, as the trend of rising interest rates also meant a rising opportunity cost of non-interest-bearing deposits. Since these non-interest-bearing deposits were a significant source of funding/financing for these money center banks, it was imperative for their survival that these money center banks find a way fast to retain their corporate customers.

Source: Board of Governors of the Federal Reserve System

The First National City Bank of New York (now Citibank) started to offer CDs to domestic business corporations, foreign investors, and government entities in February 1961, as a response to this state of affairs.² The most obvious objectives of this were to increase corporate deposits, as well as to allow banks greater discretion over their own sources of funding/financing, so that in a period of rising interest rates and rising loan demands, banks could increase their CDs to accommodate rising short-term credit demands. Consequently, the ability of banks to “buy” funding/financing by paying market interest rates added significantly to their flexibility, as well as aided significantly to their shift to liability management.

The development of negotiable CDs not only enabled banks to retain their corporate customers but also enabled banks to eventually remove the regulatory cap on explicit interest payments by forced deregulation. Since negotiable CDs were a marketable liquid security, the use of negotiable CDs by banks ultimately propelled banks away from traditional retail banking activities and toward wholesale financial activities.

Throughout the decade of the 1960s, banks and banking regulators played a game of hide-and-seek – banking regulators modified reserve requirements and interest rate ceilings on various financial instruments (to anticipate and counteract banks’ behaviors) while banks rotated between Eurodollar borrowings from offshore affiliates, negotiable certificates of deposit (CDs), commercial paper (CP), and various forms of repurchase agreements (repo) (to anticipate and counteract banking regulators’ behaviors).