Friday, 24 August 2012

Those famous “risks” run by banks are a farce: they achieve nothing.

The basic risk run by a bank is thus. First, it accepts $X of deposits, second it promises to return the $X to the depositor (maybe plus interest and maybe less bank charges) and third, it lends on or invests the money in ways that are less than 100% safe. Well that’s a bet which is guaranteed to fail at some point: when the loans or investments go bad.

Of course the crooks and fraudsters who run banks will tell you the risk of bank failure is minimal if the AMOUNT loaned on or invested is SMALL compared to total deposits and loss absorbing buffers (like capital). And Tories or other politicians who are funded by said crooks and fraudsters will agree (they’re paid to).

However, the above ratio is NOT SMALL: the latest “ratio” or degree of leverage as proposed by the Basle regulators is a staggering 33:1. That is, if bank assets decline by a mere 3%, shareholders are wiped out! That might be safe compared to the lax standards of banking in recent years. But basically you’d have to be RAVING BONKERS to call that safe. (For verification of the 33:1 point, see pages 8-9 of the Vickers final report.)

What does the risk achieve?

Does it increase the TOTAL AMOUNT loaned or invested? Let’s examine that question.

Anyone contemplating investing has two options. The first is to invest or lend DIRECT: e.g. in the stock exchange or for example invest in their own business or lend to a relative for the latter’s business. The second option is to invest via a bank: i.e. deposit money in a bank and let the bank do the investing or lending.

And the attraction of the second option is that you’re guaranteed your money back, or so says the bank. But that guarantee can only be made fool-proof with taxpayer backing.

Thus the “invest via a bank” route WILL RESULT in more investment, but partially as result of the taxpayer guarantee, or taxpayer funded subsidy: a ridiculous justification for the latter increase in amounts invested.


Additional lending will also come about as a result of bank expertise. First, banks have the lawyers, etc needed to draw up mortgage agreements, etc. That is, the mortgage business functions more efficiently when bank lawyers draw up mortgage agreements than where INDIVIDUALS lend to each other on an informal basis.

Incidentally, banks are also supposedly experts (hilarious this one) at gauging the creditworthiness of potential mortgagors. Which of course explains why they dished out mortgages to those with “no income, no job or assets” (NINJA mortgages). But we’ll let that one pass.

Anyway, back to “expertise in drawing up mortgage agreements”. The important point to appreciate about this expertise is that is has NOTHING TO DO WITH the “promise to return $X” point. That is, it would be perfectly feasible to have organisations (e.g. existing banks) which deploy their mortgage arranging expertise AND in which people can deposit their money, but where depositors carry the loss if a significant proportion of the mortgages turn out to be “non-performing”.

Indeed, organisations of this sort already exist. They’re called “unit trusts” in the UK and “mutual funds” in the US. That is people can invest in these entities. And the actual investment decisions are taken by people who are supposedly experts at investing (although their actual performance in that regard is miserable). And any losses are carried by the investors.

The 64k question.

So the $64k question is this. Should banks promise to return $X for every $X deposited – a promise that can only be made with 100% certainty if the taxpayer stands in the background. Or should depositors, in the event of the underlying assets falling in value, have to carry the relevant loss, just as they do when investing in the stock exchange?

Well it’s a no brainer isn’t it? If a bank makes ANY LOAN OR INVESTMENT based on the “guaranteed your $X back basis” there is a finite risk, however small, of taxpayers having to come to the rescue. That is, the latter arrangement INEVITABLY INVOLVES a taxpayer subsidy, however small. And banks are supposedly COMMERCIAL organisations. Thus any activity they pursue which involves a subsidy should be OUTLAWED. It’s that simple.

Put another way, if depositors want to act in a commercial manner – i.e. get interest on their investments / deposits – they should have to carry the losses normally involved in commercial activity.

And what’s the problem with that? Facebook shares have recently taken a battering. That’s capitalism. Has the sky fallen in?

Genuinely 100% safe deposits.

Of course if depositors REALLY WANT 100% safety they should be allowed it. But investing or “lending on” is not 100% safe. Thus any money such depositors put into banks should not be loaned on or invested. In consequence, such depositors will get no interest.

Full reserve banking.

Now what do you know? A system under which, 1, depositors who want interest have to carry any losses stemming from the underlying investments and in which, 2, depositors who want 100% safety get no interest is called “full reserve banking”.

Under fractional reserve banking, banks “lend money into existence” as the saying goes. That is, private banks create money. Under full reserve they can’t do this.

And in a system where depositors who want interest have to carry the loss on underlying assets, what such depositors have in banks is no longer money: it’s more in the nature of unit trust units. And the latter are never counted as part of the money supply in any country I know of. Thus no money creation takes place here. This is full reserve, not fractional reserve.

As to those who want 100% safety (and who get no interest), their money is not loaned on, so no money creation takes place there either.


The ideal rules or regulations governing FRACTIONAL reserve are the rules or regulations governing FULL reserve.



  1. 'And banks are supposedly COMMERCIAL organisations. Thus any activity they pursue which involves a subsidy should be OUTLAWED.'

    I'm not sure why you assert this. If the effect of the subsidy was to boost economic activity there may be a net welfare gain for all. Essentially you are rewarding the bank for the positive externality of its actions, so as to provide an incentive.

    Now it may, in practice, be the case that the moral hazard problem then wipes out this welfare gain. But that is really an empirical question and might be tackled other than by limiting banks' ability to lend.

    Did you get round to checking out this post -

    1. What is this “net welfare gain”? I’ve never known anyone point to any such gains, and certainly I can’t think of any – at least nothing approaching the welfare gains derived from the British Health Service or free state education for kids.

      In contrast, I can think of a horrendous welfare loss that derives directly from the fractional reserve model: the credit crunch, tens of millions of extra unemployed in the US and Europe, and a loss of GDP over the last five years amounting to 5% of GDP or thereabouts.

      I will look at your paper in due course, but I’m always short of time and energy!

    2. 'What is this “net welfare gain”? I’ve never known anyone point to any such gains,...'

      In a nutshell, the creation of circulating credit allows the coming together of resources to create new value in ways that would not otherwise be possible. The negatives have, at least, to be weighed against that positive.

    3. If by “circulating credit” you simply mean “money”, I’ve nothing against money. The question at issue is whether money should be created by just the central bank and government or whether private banks should get in on the act as well.

    4. Exactly, and the answer is yes, if the benefits of decentralisation of decision-making and (at least part of the) risk can be made to outweigh the remaining centralised risk.

    5. Re decentralisation, as far as making decisions on individual investments goes, there is little difference between full and fractional reserve. In both cases, the decision is made by the borrower and bank manager (where investments are funded by loans from banks).

      Full reserve actually involves slightly more decentralisation when it comes to the latter sort of decision. Reason is that under full reserve there is less bank loan funded economic activity, and to make up for that, the government / central bank spends monetary base into the economy which means every household and business has more money in its kitty, and thus does not need to borrow so much. I.e. under full reserve, individual households and businesses have more power over investment decisions than under fractional reserve.


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