Quadruple-entry accounting
Quadruple-entry accounting
Two balance-sheet examples
Feedback and continued conversation in response to this post from a few days ago has prompted me to go one step further on my approach to schematic accounting. Here I spell out two examples as a way of illustrating the full set of possible balance-sheet transactions, which is replicated at the end of this post.
Example 1: Asset disintermediation ended the 2008 crisis
I have previously laid out a balance-sheet analysis of the 2008 crisis. The crisis ended, to summarize, when the Federal Reserve finally wound down the emergency liquidity programs and bought MBS on its own balance sheet. Those programs (CPFF, TAF, etc.) had allowed the US central bank to extend credit to banks and dealers to support those entities' holding of mortgage-backed securities. This is visible in this graph of the asset side of the Fed's balance sheet, where the several colors of liquidity programs give way to the green region of MBS:
The various lending facilities were wound down, and the proceeds were invested into mortgage-backed securities. At a very high level of abstraction, it is reasonable to say that the Fed took over the job of lending to the US housing market, or in Borja Clavero's terminology that the MBS asset was assigned from banks and dealers to the Fed. Likewise, it is reasonable to say that this was funded by a set-off of the liquidity facilities, a destruction of those claims. The high-level transaction is an example of a generic transaction that I would call asset disintermediation:
This analysis works only at a high level of abstraction: what I show here as single transaction is a summary of a trillion dollars' worth of actual transactions that took place over more than a year. Evidently, much detail is lost. More pointedly, the mortgage-backed securities that the Fed bought were newly issued, so it was not technically assignment—in fact, old MBS were destroyed and new ones created. But at a high level, it is true that mortgage-backed securities were the problem and the Fed took them onto its own balance sheet. And it is true that the new MBS were generated by a wave of mortgage refinancing, which destroyed the old MBS. The T accounts above are a useful and accurate, if very general, summary of what happened.
Example 2: CBDC risks liability disintermediation
Another example comes from current discussions about central bank digital currencies. CBDCs, recall, are a way to combine the benefits of currency, which is a liability of the central bank, with the benefits of deposits, which allow easy electronic payments. A concern—raised by some—about the introduction of CBDCs is that depositors will flee from commercial banks, preferring instead to hold funds directly at the central bank. This could, it has been argued, deprive commercial banks of a key source of funding. Such a process is illustrated to the right in this figure:
Only the central bank and the commercial bank sector are shown; depositors are omitted. In this summary transaction, the deposit liabilities of banks are replaced by the CBDC liabilities of the Fed. Loosely speaking, this can be thought of as novation: what was once a liability of banks is now a liability of the central bank. Banks' reserve deposits, meanwhile, are destroyed, which can thought of as a set-off. The whole transaction is an example of liability disintermediation, which is sketched out in generic form to the left.
A complete set of quadruple-entry transactions
On the left-hand side in each of these examples is a generic transaction. Each has a starting position, a transaction, and an ending transaction. These can be compressed a bit further, by looking only at the middle, where the balance-sheet positions change. Each generic transaction therefore has a more compact representation:
The full set of these compact representations, finally, fits into a single picture. The four columns show the four ways of making payment with A (assignment, set-off, issuance, novation); the four rows show the same four ways applied to B. I have given each combination a name that seems to me to capture what it is about—though readers may find other names.
What was the preceding phase, where the Fed created new reserves that were not subtracted from anyone's balance sheet?
I was thinking it's like Asset Intermediation, but that appears twice and if A is reserves in one, B had to be reserves in the other?
As for novation, why must the Fed deduct reserves? Can the Fed issue new CBDC accounts and pay inflation as interest on them to set monetary policy by encouraging savings on an individual level? (Analogous to paying banks interest on reserves so they don't undercut the Fed Funds rate?)