Thursday, 7 July 2011

Full reserve banking, and the arguments against fractional reserve banking and maturity transformation.

Abraham Lincoln: “The government should create, issue and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers.”

Thomas Jefferson: "I believe that banking institutions are more dangerous to our liberties than standing armies...The issuing power should be taken from the banks and restored to the Government, to whom it properly belongs."

Milton Friedman: “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”

Introduction and definitions.

Fractional reserve banking is a characteristic of the banking system we have today. Fractional reserve itself consists of two basic characteristics. One is that commercial banks do not need to lodge all the money deposited with them at their central bank: they only lodge a “fraction” of such money at their central bank. The second is that they can lend out more than has been deposited with them, that is, they can create money out of thin air.

Full reserve banking is what might be called the opposite of the above, though there are a number of compromises between fractional and full reserve. Under “pure” or “unadulterated” full reserve, commercial banks must lodge all money deposited with them at their central bank, plus they cannot create money out of thin air. This necessarily means that banks cannot lend. In this scenario, sometimes called “narrow banking”, lending is carried out by institutions which are funded wholly by shareholders rather than depositors. This system certainly has its merits.

However the option advocated below is to insist that where depositors want instant access to their money, such money must be invested in a 100% safe manner and be genuinely “instant access”, i.e. the money must be deposited at the central bank. To that extent, banks would be genuinely “full reserve”. However, it is argued below that depositors should be able to allow their money be loaned on by a bank. But in this case the money is no longer instant access and there is no taxpayer funded rescue for such depositors if the bank goes bust.

Maturity transformation takes place where a bank “borrows short and lends long”: for example, it uses money from instant access accounts to fund relatively long term loans, such as mortgages. This practice is also undesirable for reasons set out below.

Fractional reserve.

One of the main opponents of fractional reserve is Huerto de Soto. In chapters 1, 2 and 3 of his book “Money, Bank Credit and Economic Cycles” he claims that fractional reserve breaks fundamental legal principles, a claim also made by other Austrian economists.

That argument is weak in that if an activity is on balance beneficial, the fact that it breaks laws or legal principles is not important: in this situation, it is the laws or legal principles which need amending, not the activity that should be banned.


Another problem with fractional reserve, which de Soto and others have long drawn attention to, is that it leads to instability. The processes via which this instability arises are well known, one of them being asset price bubbles. That is, asset prices rise for some reason. That makes those assets a better form of collateral for further borrowing (i.e. money creation by commercial banks). This money is used to boost asset prices still further, and so on. And we all know the end result: a crash or credit crunch.

Another source of instability is thus. Business and/or consumer confidence can rise for no apparent reason. That swells order books. Firms order more capital equipment, and much of this capital equipment consists of “big spend” items. This large additional expenditure exacerbates the instability. And then it dawns that some of the projects and investments were built on sand, and the crash ensues.

Readers who have studied economics may well object to the latter paragraph on the grounds that another factor making for instability has been slipped into the argument, namely the “accelerator”. This is the above mentioned process whereby a slight increase in demand leads to a relatively big increase in capital equipment spending. But in the absence of commercial banks’ able to create money out of thin air, employers wanting to fund capital expenditure would find the process more difficult. Thus the two problems, the accelerator and fractional reserve reinforce each other.

Then comes the recession.

Come a recession, the whole process goes into reverse. That is, everyone “deleverages”, just as they have in the current recession. That is, commercial banks and their customers put the money creation process into reverse just when they shouldn’t!

The scale of this destruction of commercial bank money during the deleverage phase is documented in this Credit Suisse publication – see in particular the first three or four pages.

Instability and reserve requirements.

The above rapid expansion in private bank created money in a boom would not occur if banks ALWAYS made full use of their reserves AND if central banks strictly enforced reserve requirements. But banks do not always make full use of their reserves: witness the huge excess reserves that they currently have. If banks suddenly made full use of these reserves, there would be a dramatic increase in private bank created money.

As to central banks strictly enforcing reserve requirements, they just don’t, as Steve Keen has shown.

High powered advocates of full reserve.

As for the idea that full reserve banking is an idea advocated by a few cranks, this is far from the case.

1. Milton Friedman (p.247) advocated full reserve, and specifically for the above reason: to bring better stability. See also Friedman’s book, “A Program for Monetary Stability”.

2. Another high powered opponent of fractional reserve is Mike Shedlock.

3. And third, there is William Hummel.

Interest rates are not optimised under fractional reserve.

Another problem with fractional reserve is that it degrades the market’s mechanism for optimising the amount of borrowing. Reasons are thus.

The amount of borrowing is optimised where the benefits of borrowing equal the costs of the consumption forgone in order to make the borrowing possible. Or to be more exact, the marginal benefits of borrowing need to equal the marginal costs or “disbenefits” of forgone consumption.

Under fractional reserve, the BENEFITS of borrowing are quantified well enough. For example a business can easily enough work out the benefits it derives from borrowing so as to purchase machinery. But there is a problem with consumption forgone, which is that when a bank creates money out of thin air and lends it, no consumption is forgone!

Well, on the face of it no consumption is forgone. But of course there is no such thing as a free lunch: that is, someone somewhere has to forgo consumption in order to enable someone else borrow and consume resources.

To be more accurate, the fact of one entity borrowing and spending increases demand, and assuming the economy is at capacity, demand somewhere else has to be reined in. In practice in 21st century advanced economies, and given increased borrowing and expenditure, government will rein in demand by one of the many means at its disposal: increasing interest rates, public spending cuts, tax increases, and so on.

To illustrate, if government damps down economic activity by public spending cuts (e.g. on health and education) then the foregone consumption needed to make additional borrowing possible is born by the employees and consumers of health care and educational services: a nonsense.

The above argument can be put another way, as follows. Assume full reserve is in operation. Assume that fractional reserve is then allowed. Banks will then be able, at least in theory, to create thin air money and lend it at ridiculously low interest rates, e.g. 0.1%. If the going rate is well above 0.1%, that does not matter for the relevant banks because obtaining the money to lend costs those banks nothing.

To summarise, fractional reserve results in an economy with artificially low interest rates which in turn results in too much economic activity being loan funded rather than equity funded.

And finally, assuming we ban fractional reserve, and lending declines, there is the question as to where the extra money comes from the enable more equity funding to take place. Well that’s easy: having the government / central bank machine create and spend extra money into the economy is not difficult.

The latter policy is advocated by Modern Monetary Theory, and by the Werner paper. And as Milton Friedman said in the third chapter of his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with . . . an additional dollar in cash balances.” (From Ch 3 of his book “A Program for Monetary Stability”)

The conclusion about fractional reserve.

The conclusion is that fractional reserve is not beneficial. Interestingly, were it banned, we would revert to what economists call a “loanable funds” scenario. In this scenario, the total amount of money is more or less fixed, or at least it expands at an annual rate strictly controlled by the central bank. This means that given a rise in demand for borrowed money, interest rates would rise.

A rise in demand for anything normally results in a rise in price. Plus, where the rise in demand for borrowed money would in the absence of the interest rate rise result in demand in excess of that planned by the government / central bank, the interest rate rise would constitute an “automatic stabiliser”.

Maturity transformation.

Maturity transformation equals “borrow short and lend long” and on the face of it, everyone wins from maturity transformation (MT). Depositors get a higher rate of interest than they otherwise would. Those borrowing from banks pay a lower rate of interest than they otherwise would. And banks make a profit from organising the whole thing, that is “intermediating”.

The main problem is that MT it is risky: if short term interest rates rise or short term money simply becomes unavailable (much the same thing), then the institutions which engage in MT) are caught short. This explains the downfall of Northern Rock, and the downfall of hundreds of banks since Roman times two thousand years ago.

The problem can on the face of it be solved by having government or central bank stand behind banks engaging in MT. But there is no excuse for taxpayers subsidising this or any commercial activity. Plus the cost of this implicit subsidy is horrendous: it was put by Mervyn King, governor of the Bank of England at £30bn a year for the UK, or roughly 2% of UK GDP, (see p.7 here).

So there is an obvious case for curtailing MT and thus cutting the subsidy and the risks inherent in MT. But this raises an equally obvious objection, namely how far can this curtailment go before it starts to seriously impede bank activity, and in turn, economic activity in general.

Indeed, Mervyn King lends support to this “impede economic activity” argument when he says “Nevertheless, there are benefits to this maturity transformation – funds can be pooled allowing a greater proportion to be directed to long-term illiquid investments, and less held back to meet individual needs for liquidity.” (See p.8 of King's paper). Indeed Brad de Long made a similar complementary remark about MT.

The flaw in King’s “funds can be pooled” argument is that it assumes that bank balances represent REAL and unused resources. The truth is that a bank balance is simply a book keeping entry: it is not composed of real physical resources, as pointed out by Prof.R.A.Werner and co-authors (p.26).

The Tobin tax.

A possible solution to the problems created by MT, a solution advocated by Mervyn King (p.11), is some form tax on banks roughly similar to the well known Tobin tax. This, so the argument runs, would compensate society for the occasional and serious damage done by those once every ten or twenty years recessions or credit crunches.

But that does not actually prevent the damage! It’s like car insurance. Car insurance is better than no car insurance, but it doesn’t of itself prevent the death and destruction wrought by cars. So stopping the damage, if that is possible, is the best solution in the case of cars or banks.

The merits of MT don’t exist.

Having disposed of one popular argument for MT, i.e. that it “makes use of” idle bank balances, is there anything else to be said for it? Well I can’t see anything.

Of course if we halved the extent of MT, that might reduce the risks arising from it to a low or negligible level. But if an activity imposes low levels of risk while conferring no benefits at all, it might as well be banned.

Also MT has similarities to fractional reserve, in that both make available funds that can be loaned out. Thus some of the arguments put against fractional reserve above can also be put against MT. In particular, these additional funds, other things being equal, will require the suppression of various forms of economic activity, and (as pointed out above) in a thoroughly illogical manner.

To summarise, the arguments for MT are feeble, plus it involves risks. Ergo it might as well be banned.

Do we need such a large banking sector?

Another reason for doubting the benefits of a large borrowing or bank sector so far as promoting economic activity goes is that bank assets in the UK relative to GDP have multiplied TENFOLD between 1970 and 2006. (See “Banking on the State”, p.3, (2009) by Piergiorgio Alessandri and Andrew G Haldane.)

In other words, prior to 1970, the UK had a pathetically small bank sector compared to nowadays. But strange to relate, economic growth prior to 1970 was much the same as after 1970.

Or as Lord Turner, head of the UK’s Financial Services Authority put it, much bank activity is “socially useless”.

Political problems.

Stopping government guarantees for deposit accounts which earn any significant interest would be a dramatic change. Howls of protest would ensue. But this is just a measure of how far commercial banks and depositors have wormed their way into the public purse with a view to featherbedding themselves.


1, Fractional reserve should be curtailed.

2, Where depositors want absolute safety, they are no doubt entitled to taxpayer backing for their deposits. But these depositors cannot have their cake and eat it: that is, they cannot earn nice rates of interest deriving from the fact that their money is used for commercial purposes. Moreover, commercial use of this money amounts to a taxpayer subsidy for commerce, and it is widely agreed that it is not the job of taxpayers to subsidise commerce. Banks holding money in 100% safe deposit accounts should back this with monetary base (plus possibly some government securities).

3, As to deposit accounts where the relevant money is lent on, there should be no taxpayer backing. The possibility that institutions offering such accounts might become systemic risks can be minimised by limiting the size of such institutions. The systemic risk is also reduced by the mere fact of requiring depositors to lock up their money for a significant period: this constitutes a reduction in the extent of maturity transformation effected by banks.

Note: this article was substantially re-drafted on 6th Aug 2011.

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