I was disappointed to see
that First Trust Bank, a commercial bank based in Northern Ireland, will stop issuing its own brand
of banknotes. Under different
names, First Trust has been in the business of providing paper money for
almost two hundred years, starting
with the Provincial Bank of Ireland back in 1825.
99.9% of the world's population uses government-issued banknotes. A small
sliver of us—those who live in Northern Island, Scotland, Hong Kong, and
Macau—get to use privately-issued banknotes. Prior to First Trust's
announcement, I count twelve private issuers scattered across the globe:
Northern Ireland: Bank of Ireland, Danske Bank (formerly Northern
Bank), First Trust Bank, and Ulster Bank
Scotland: Bank of Scotland, Clydesdale Bank and The Royal Bank of
Scotland
Hong Kong: HSBC, Standard Chartered, Bank of China (Hong Kong)
Macau: Banco Nacional Ultramarino, Bank of China (Macau)
Now there are just eleven.
To our modern sensibilities, privately-issued banknotes seem just strange.
But before central banks emerged on the scene, privately-issued banknotes
were the norm. Larry
White and George
Selgin have chronicled how the Scots were particularly adept at this task.
Scotland's banking system, which was much more free than the British one, had
relatively few bank failures in the 1700 and 1800s compared to the British
one, which tried to put limits on banks' ability to issue notes.
In the 1800s this Scottish "free banking" system was imported into
my country, Canada, by Scottish immigrants. People might assume that private
banknotes were risky instruments, and that's why we needed governments to do
the task. But as the chart below shows, between 1868 and 1910 Canadians
experienced almost no losses on banknotes.
Canada had no central bank (until 1935) or
deposit insurance (until 1967).
But look how safe it was to own banknotes issued by private Canadian banks in
the 1800s & early 1900s. No losses! Private banks can do a good job
handling the note issue.
Source: https://t.co/tUpAahouyg pic.twitter.com/jdHlpZUlHO
— JP Koning (@jp_koning) February
13, 2019
Only a minute trace of our private banknote heritage remains. In addition to
the four jurisdictions that have been allowed to maintain the tradition, a
few central banks are still
publicly-traded—a vestige of their old status as private issuers. In the
case of banks in Northern Ireland and Scotland, their ability to issue notes
has been grandfathered. Only the seven existing licenses are allowed and no
new entrants are permitted. Once First Trust gives up its banknote franchise,
it can never get it back.
First Trust says that its exit from the banknote game is a commercial
decision. Let's take a quick look at the profitability (or not) of issuing
banknotes. First Trust ATMs and branches can either dispense
government-issued Bank of England banknotes or its own brand. If First Trust
dispenses its own brand, then it must incur an extra set of costs including
printing & design, note destruction, and policing against counterfeits.
If it stocks its ATMs with Bank of England notes, it avoids these costs.
But there is a benefit to issuing its own brand of notes. For each note it
issues, First Trust "earns the spread". Unlike its other forms of
debt, First Trust needn't pay any interest to its banknote holders. But like
its other forms of debt, it can earn income on the set of associated assets
it holds to "back" those liabilities. If this income outweighs production
costs, then it makes sense for First Trust to issue its own notes.
How much does First Trust make on its note issue? For each paper pound that
Northern Irish and Scottish banks issue, they are obliged to lodge 1) 60
pence at the Bank of England in the form of banknotes and 2) 40 pence in the
form of deposits. Given that Scottish and Irish banks have issued around £7.6
billion in private notes, this means they have collectively invested in some
£4.6 billion worth of Bank of England banknotes. Since regular notes like £50
are bulky, the Bank of England issues massive 'Titans' and 'Giants' to cut
down on storage costs.
£100 million "Titan" note.
Scottish & Northern Irish private banks have issued £7.6 billion in
banknotes. They must back 60% of this—or £4.6b—with Bank of England notes.
Better to use Titans than £50 notes... it takes just 46 Titans to store £4.6b
compared to 92 million £50s. pic.twitter.com/UuZ4PUBMoh
— JP Koning (@jp_koning) February
17, 2019
For issuers like First Trust, the £4.6 billion worth of Titans and Giants is
dead money—they don't earn any interest on it. But the other £3 billion or so
in backing assets held in the form of deposits earns interest. The gap
between an issuer's 0% funding costs and interest income paid by the Bank of
England is what generates a profit of their banknote franchise.
On Twitter, John Turner points
out that it was once very profitable for Northern Irish and Scottish
banks to issue notes, but new regulations in 2009 changed this:
"Prior to legislation passed in 2009, issuing notes
was extremely lucrative for banks because they only had to hold backing
assets (essentially reserves at the Bank of England) at the weekend, leaving
those funds free to generate income during the trading week. Some
estimates suggest that this generated £70m per year for Northern Irish banks
alone. Since the passage of the Banking Act (2009), banks are required
to hold backing assets against their note issue at all times. " (source)
Another reason seigniorage
has shrunk is a decade of low interest rates. Northern Irish and Scottish
banks currently earn just 0.75% on the deposits held at the Bank of England,
but in the 2000s they would have been earning as much as 5.75%.
All four Northern Irish issuers (and the Scottish ones too) will have
suffered from the 2009 legislative change and generally low rates, but First
Trust particularly so—its banknote issue is far smaller than that of Bank of
Ireland and Ulster. Looking at its 2017 Annual Report, First Trust issued
just £300 million of the £2.4 billion worth of Northern Irish banknotes in
circulation. Which means it earned just £900,000 in seigniorage last year
(£300 million x 40% x 0.75%). It's hard to imagine that this is enough to compensate
it for its printing and other costs.
By comparison, the Bank of Ireland has issued around £1.2 billion in
banknotes with Ulster Bank accounting for another £800 million. Both of these
competitors can spread their fixed costs around far more efficiently than
First Trust can.
First Trust's announcement puts me in a bit of a conundrum. I think the
financial privacy provided by cash is important. And so is the robustness
that it engenders. Banknotes are a decentralized payment instrument that
can't break down in the face of disasters. Cash systems are also open: no one
can
be censored from using them.
At the same time, I see no reason why commercial banks shouldn't be allowed
to issue banknotes. But what happens when the private provision of cash
breaks down? In countries like Northern Ireland with privately issued cash,
we are seeing low interest rate go hand-in-hand with banks eliminating cash.
And this in turn means less financial privacy, openness, and robustness.
In short, when interest rates fall to zero, private banks will try to
preserve their spreads by pushing the interest rate that they pay on their
short-term liabilities (like savings and chequing accounts) into negative
territory, say by implementing higher account maintenance fees. But they
can't do this with cash. A banknote's rate is fixed at 0%. Rather than
absorbing losses from banknotes, private issuers will simply cancel their
note issue, much like First Trust has done, forcing everyone into
account-based products.
If the UK's low rates persist for another few years (and fall even further)
then the remaining private issuers in Northern Ireland and
Scotland—Clydesdale Bank, Bank of Scotland, Ulster, Danske, etc—would also be
forced to stop printing notes. Both countries would become cash-free zones.
And since cash is the best way to transact anonymously, Scotts and Northern
Irish would have little to no financial privacy. All transactions would
proceed through easily-censored account-based payments systems that break
when the power goes down.
Luckily for the Scots and Northern Irish, they have a backup. The Bank of
England can fill any void left by commercial banks with its own notes. Unlike
commercial issuers like First Trust, the Bank of England isn't driven by
profits. Even as its banknote profits shrinks to nothing, the central bank can
keep on supplying currency—and thus financial privacy, openness, and
robustness—to the people. Perhaps there is a role after all for public
issuers of paper money to play.