Monday, 4 June 2012

The Vickers Commission had no grasp of the full versus fractional reserve argument.

The UK’s “Independent Commission on Banking” produced an interim report and a final report. The interim report dismissed full reserve in a few sentences, while the final report had nothing to say on the subject. Thus the interim report’s “ideas” (to put it politely) on this subject are presumably contained in the interim report.

The purpose of this post is not to argue for full or fractional reserve, but just to deal with the commission’s flawed ideas on the subject.

The first relevant section is 4.120, which reads, “Like narrow banking, a complete move from fractional to full reserve banking would drastically curtail the lending capacity of the UK banking system, reducing the amount of credit available to households and businesses and destroying intermediation synergies. To its proponents, this shrinkage of credit is a benefit, as it removes the current ability of banks to ‘create money’, a prerogative they consider should be reserved for the state.”

Well full reserve clearly would “curtail” bank lending, ALL ELSE EQUAL.

But the advocates of full reserve do not propose (surprise, surprise) leaving all else equal. They propose making good the deflationary effect of banning fractional reserve by increasing the monetary base.

By the same token, if banks make part of their profit from foisting payment protection insurance on people who don’t need it (or from bashing old ladies on the head and stealing their handbags), then the latter two undesirable activities should be banned. And very possibly that would constrain banks’ ability to lend. However it would be patently absurd to argue that foisting payment protection insurance on people or bashing old ladies on the head should therefore be permitted.

If banks currently do something undesirable, the activity should be banned. As to any deflationary effect, that can be easily dealt with by giving the economy a dose of stimulus – by increasing the monetary base or whatever.

More monetary base means less credit is needed.

Over the last couple of years the authorities in several countries have in fact increased the monetary base, though not of course because they have switched to full reserve. And they’ve channelled the extra funds to a large extent into the pockets of the wealthy, and the incompetents and fraudsters who run banks: a stroke of genius.

But assuming the extra money is effectively held by ordinary households and businesses, there’d be a reduced need for the “credit” which the commission makes much off. To illustrate, for every extra thousand you have in your bank account, that’s one thousand less that you need to borrow, should you want to borrow so as to buy a house or car.
(Incidentally, I used the phrase “effectively held by ordinary households” above for the following reasons. Strictly speaking, monetary base can only be held by banks. However, if for example a household sells Gilts, the household gets a cheque from the Bank of England, which the household deposits at its commercial bank. The net effect is that the household holds extra “commercial bank” money, while the commercial bank holds extra monetary base. However, the commercial bank is only acting as an agent or intermediary here: effectively, the household holds monetary base).

What are “intermediation synergies”?

Next, section 4.120 claims full reserve would curtail “intermediation synergies”.

As to exactly what these "synergies" are, there is no explanation, thus the word “synergies” looks like an important sounding word slipped into the text with a view to impressing all and sundry. It does not impress me.

As regards “intermediation”, there is one form of intermediation would be left untouched by the switch from fractional to full reserve: that is the fact that banks bundle up the money from a large number of small deposits and turn them into larger loans to a smaller number of borrowers (or at least a different NUMBER of borrowers).

As to intermediation in the form of maturity transformation (“borrow short and lend long”), it was precisely this that brought down Northern Rock, and has brought down hundreds of banks throughout history. Thus we needn’t shed tears about restricting or banning maturity transformation.

Or as Martin Wolf put it, “To these points must be added the vulnerability inherent in borrowing “short and safe”, in order to lend “long and risky”. If we were not so familiar with banking, we would surely treat it as fraudulent.”

Safe accounts and investment accounts.

The next relevant section of the commission’s report is No. 4.121 which reads, “Some have argued that full reserve banking should be mandated as an option for all deposits, so that depositors could choose whether or not their money was lent on. It is important to find safe deposit options and having these options might help to reduce the need for a government guarantee applicable to all deposits. However, safer deposit options than bank deposits do already exist (such as National Savings & Investments or safety deposit boxes), although these do not offer the same transactional capabilities as a current account. There is no prohibition on the establishment of a full reserve bank (or a narrow bank) which could provide such capabilities, though it would likely have to charge for them. In light of deposit insurance, mandating that all depositors have such an option appears unnecessary.”

As regards the first sentence, this implies that lending is not possible under full reserve. That is not true. Under a full blown full reserve system commercial banks can perfectly well lend: it’s just that they have to obtain ALL THE FUNDS for lending from depositors rather than create some or all the funds out of thin air.

Safe and investment accounts.

The rest of that section claims that the purpose of full reserve is to give depositors the “option” of safe accounts, and that because such ultra-safe accounts already exist, full reserve “appears unnecessary”, as they put it.

But what’s the point in putting your money into these existing safe accounts when the taxpayer underwrites riskier and more profitable forms of deposit account?

Half the problem with the existing bank set up is that banks, plus their customers can have their cake and eat it: that is, profit from risk taking when the risks pay off, but have the taxpayer foot the bill when the risk does NOT PAY OFF. And this is one of the main problems the commission was supposed to sort out: it is one of the main questions on which the commission was supposed to have some expertise!

Those who advocate 100% safe deposit accounts where the money is not loaned on at all or is loaned on in an ultra-safe manner do not just want to make this an “option”, as the commission calls it. They want to FORCE depositors to choose between safe accounts and riskier or “investment” accounts where depositors are acting in a COMMERCIAL manner, and are thus not entitled to taxpayer support if it all goes wrong. At least this is what was proposed in the joint submission to the commission authored by Prof. Richard Werner, Positive Money and the New Economics Foundation. And the above “force” (absent blatant fraud) ensures that taxpayers do not have to bail out the above “have our cake and eat it” crowd.

Under the current system, if Joe Bloggs lends directly to corporation X, Y and/or Z (e.g. by buying their bonds) and it all goes belly up, Joe Bloggs loses his money. In contrast, if Joe Bloggs deposits money in a commercial bank, and the bank lends Joe Bloggs’s money to the above corporations, and it all goes belly up, the taxpayer rescues Joe Bloggs.

That is an absurdity which the above mentioned Werner submission deals with. In contrast the Vickers commission fails to deal with the absurdity because it specifically allows banks to lend depositors’ money to corporations behind their much vaunted “ring fence”.


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