New Jersey State Bank Primer
By Caleb Brody
With Additional Credit and Thanks to, Wan Cha.
What is the Proposed New Jersey State Bank
Over a year ago, Governor Phil Murphy signed an executive order forming a new board to oversee a taxpayer funded State Bank for the state of New Jersey.[1] This action drew both accolades and criticism from NJ citizenry looking to understand the ramifications to their personal lives. Some argue that this is a radical move as no state has formed its own bank since North Dakota in 1919.[2] Others see it as an opportunity for the state to provide new services for its taxpayers. Gov. Murphy asserts that the State Bank will “help[] small businesses succeed, . . . provide[] student loans at affordable rates and open[] lines of credit to municipalities needing long-term infrastructure and affordable housing.”[3] Detractors, such as State Senator Anthony Bucco, call the plan a “looming catastrophe.”[4] Critics also point to red flags in the process of creating the State Bank, such as the lack of a commission to study the feasibility of the Bank before the executive order was signed and the financial scandal surrounding one of the bank’s implementation board members.[5] This primer evaluates the idea on its merits; it does not criticize the process by which it was formed. Many of the details of the State Bank’s potential activities still have not been completely decided and are left up to the purview of its 14-member board, leaving the true scope of the State Bank’s activities still a subject of debate. This primer will also explore the history and complex web of economic effects caused by state and central banks.
Why Banks Matter
Central banking has performed a myriad of different roles throughout U.S. history. The role of producing and controlling the supply of items traditionally thought of as money, such as paper and coin currencies often referred to as “M0” by economists, remains the purview of the treasury department. However most modern economists accept an expanded definition of money often called “M3”. M3 counts a wide array of bank deposits as also being money. By accepting deposits and issuing loans, banks can allow the same bills to be effectively owned by multiple people;“printing money” without the use of a press. Central banks, which almost always carry both the explicit and implicit backing of the full faith and credit of the government, have enormous power to dictate monetary policy and control the money supply or provide favorable cost of capital to favored businesses without regulatory oversight. While some economists view this form of money creation as favorable to traditional methods of raising capital, others warn of the central bank strategy’s vulnerability to corruption by obfuscating the process of government subsidy.
A Brief History of US Central Banking Leading Up to the Formation of Early State Banks
The United States has a unique and tumultuous history with central banking. In 1782, only one year after the ratification of the Articles of Confederation and 5 years prior to the signing of the United States Constitution, the federal government effectively subsidized the Bank of North America by purchasing a controlling share in its initial public offering.[6] Several states moved to allow citizens to pay taxes using bank certificates leveraging an even greater subsidy. This bank was eventually replaced by the First Bank of the United States which received even greater powers and subsidy from Congress. At this point, the majority of U.S. currency was still issued by state governments and much of the central bank’s deposits came from private sources or foreign governments. Several founders feared the growing power of the First Bank and it was disbanded in 1811.[7] Without the ability of the Central Bank to easily issue new currency the government had to rely on more traditional measures to raise capital. The War of 1812 was funded primarily through the issuance of bonds, then known as Treasury Notes, which later needed to be repaid plus interest. In 1816 James Madison signed the charter for a Second Bank of the United States with similar properties to the first. Twenty years later, the Second Bank was finally disbanded after a long political battle between the pro-bank National Republicans and the anti-bank Democratic-Republican Party.[8] It would be another 25 years before another central banking experiment was attempted and almost a century until the modern Federal Reserve was established.
The power vacuum left behind by the Second Bank of The United States did not last long. Alabama, Kentucky, Illinois, Vermont, Georgia, Tennessee, South Carolina, Missouri, Indiana and Virginia formed their own State Banks. Unlike the Second Bank, several of these banks were wholly owned by the state. At the time, these banks could only issue loans which were backed by some amount (known as the reserve ratio) of valuable assets, often gold. Although none of these banks still exist today, their conception in an era without central banking established a framework for State Banks to come later.
The Powers of a State Bank
State Banks carry two important privileges that differentiate them from private banks. First, they hold the backing of the state which provides additional security to their notes. During the Great Depression, when many bank deposits either could only be redeemed at a fraction of their face value, or not at all, most Central Bank notes could be redeemed for their full value from a pool of state money. The second major advantage is their freedom from market interest rates. This power will be discussed more later; however, it allows the State Bank to create bushiness which would otherwise not exist. In many ways these State Banks functioned in the same way that Federal Banks do but with a reduced scope. As an example, by the end of the 1950s, most of the North Dakota farmland purchased from farmers during the Great Depression had been sold. Meanwhile, the State Bank of North Dakota was making home mortgage loans in small communities when community banks were not doing so.[9] This is highly reminiscent of the U.S. Federal Reserve’s purchase of over $1 trillion of US mortgage bonds (over 30% of the market) in 2020[10] when private banks and financial institutions refused to maintain their price and liquidity.
How Banks Work
To understand central banks, it is critical to contrast them with private banks. A private bank is a private business and therefore exists only if it can make money. A business can make money in one of three ways. The first way is “operating.” An operating bushiness sells a good or provides a service. Goods and services are similar in that they both generally require both tools (or parts) and labor. The difference between the cost of the parts and labor and the price at which the good or service is sold is the operating profit of the business.
The second way a business can make money is “financing.” Financing involves getting money from another source with the intention to repay it later. Most businesses use banks for their financing activities, either in the form of business loans or by using investment banking services to raise money from capital markets. A bank cannot make money by issuing loans to itself, so banks are special in their financing. Rather than raising money from loans, banks raise it from their customers in the form of deposits. The fact that the interest rate at which a bank raises money, called its weighted average cost of capital (WACC), is lower than the rate at which it loans the money out is critical to its survival.
The third way a business can make money is by “investing.” Investing is a vast and complicated field, but basically, it happens whenever a business gives someone money in the hope of getting more money later.
This is where the primary difference between a bank and other businesses becomes important. Most businesses raise money from banks (financing) with the understanding that they will need to pay back more money than they borrowed. These traditional businesses hope that their operating profits will outpace their financing losses. Once the business has matured to the point that it makes constant operating profits, it no longer needs to raise new capital and instead can begin paying down debt, lowering the magnitude of its financial profits/losses. Conversely, a bank in its purest form, has no operating profits. Although many banks do make some operating profit from fees or other miscellaneous activities, nobody goes to a bank to pay fees. A bank primarily makes its money by constantly taking in new money and using it to make new loans. A bank’s profits are primarily “investing profits”, not “operating profits” and its constant cravings for new capital makes it hypersensitive to its WACC. In other words, while a traditional business makes a profit by creating goods and selling them for more than they cost to create, a bank makes a profit only as a consequence of being able finance itself at a lower interest rate than other businesses can access.
How State Banks Handle Profits
The five largest private sector banking institutions in the U.S. (ranked by assets under management) are JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Company, Citigroup and U.S. Bancorp. Each of these companies is owned primarily by shareholders. When the bank makes a profit, it: (a) first pays any loans it may owe, (b) then pays interest on its deposits, (c) then the Board of Directors decides how much of the profits should be retained to run or grow the business, and (d) finally pays out any remaining profits to its owners (shareholders). A State Bank works the same way. The State Bank of North Dakota (BND)’s website states that “Bank profits are returned to the State. The ND Legislature appropriates the transfer of funds to the state’s General Fund. Every legislative session reviews the state’s budget needs and the amounts designated from BND’s capital for the General Fund will vary based upon the needs of the state and BND’s desire to maintain adequate liquidity and capital.” In other words, money not needed to run or grow the business is paid out to its owners, who just happen to be that state. In this way a state bank, once funded, can become a source of profit to the state. However, these “profits” only exist because the government has paid a large initial sum of capital to the bank in the first place. In this way the creation of a State Bank is economically indistinguishable from the state government making a large loan to itself and therefore “printing” new money.
Helping Small Businesses Succeed
One of Governor Murphy’s primary aims for a State Bank of New Jersey would be to aid in the creation and functioning of small businesses. A State Bank has the power to do this. Because the State Bank is funded by taxpayers and not solely by deposits, it has a far lower WACC than a traditional bank. This means that a State Bank can, in theory, make loans on far more favorable terms. However, because the bank has yet to be established, it is difficult to know exactly how the State Bank would go about locating small businesses to provide loans to. One recent model for how a small business loan program might work is the Paycheck Protection Program (PPP) designed to provide relief to small businesses during the first wave of the Coronavirus pandemic. Through PPP the federal government utilized the private banking sector to identify and make loans, while the public sector provided funding. Urban revitalization consultant Pat Morrissy has suggested that the State Bank of New Jersey could provide “low-cost capital” while public policy think tank New Jersey Citizen Action published a brief envisioning a State Bank of New Jersey without any retail branches, akin to larger federal central banks.
The problem is that PPP loaned over $1 billion to publicly traded businesses which in turn paid out their profits to Wall Street.[11] Many taxpayers do not consider these corporations to be “small” businesses. The intermediary banks, including Governor Murphy’s former employer Goldman Sachs, chosen to carry out these loans have not proven the ability to discriminate between small business and larger ones. On April 3, 2020 Matt Levine, a popular financial journalist, former investment banker, and attorney wrote “if you are giving emergency loans/grants to local restaurants now is not really the time to sell them shiny new interest-rate derivatives. If you do not already have a relationship with a small business, you might not be excited about vetting it for the government just for this program.” There are many governance issues that come with giving a State Bank the power to give better-than-market loans. The money just as easily could end up in the hands of corporations with greater corporate lobbying power.
Looming Uncertainty
The Federal Deposit Insurance Corporation (FDIC) was established in 1933 with the hope of protecting the banking deposits of U.S. citizens from “runs” or large financial disturbances which could bankrupt the banks. Today it ensures that, in the event a bank is unable to pay back an individual’s deposit money, money is set aside by the federal government to reimburse up to $250K for each of five account types the individual may hold. State Banks do not carry FDIC insurance; however, they are generally backed by the faith and credit of the state itself. This means that, in the event a large financial disturbance caused the State Bank to become insolvent, the state government and not the federal government could be forced to eat the cost.
Conclusion and Outlook
A New Jersey State Bank would form an entirely new power structure in the State of New Jersey. It would create a new entity with the effective power to print new money and subsidize whichever businesses it chooses. A State Bank would wield a subset of the power of the federal reserve. It could conceivably use that power to subsidize green energy or small businesses. It would also have the power to put money in the pockets of investment banks. Because the State Bank would retain a portion of its earnings and hide behind the complexity of the banking system, it would be free to make these decisions mostly without regulation or democratic input. These great powers would come at the cost of a financial risk given to the NJ taxpayer. At the end of the day it is the purview of policy makers and not economists to determine if the potential benefits outweigh the risks. For New Jersey voters, it’s a proposal that needs to be carefully scrutinized.