Making bank failures impossible
is easy. To be exact, making the SUDDEN failures impossible is easy: obviously
an inefficient bank should be allowed to fail sooner or later. But it’s the
SUDDEN failure that does the damage.
Sudden failure can be ruled out
as follows.
Make depositors choose between two
types of account. First there are 100% safe accounts where depositors’ money is
not loaned on or invested (that’s why it is 100% safe). It could just be lodged
at the central bank. Second there are
accounts where depositors’ money IS LOANED ON (or invested), but in that case
depositors foot the entire bill if the loans go bad. Money in the first type of
account would be instant access, but would earn no interest. Money in the
second would take longer to withdraw, but WOULD EARN interest (because the
money is doing something).
That way the bank as such cannot
suddenly fail, though there is nothing to stop it shrinking, or shrinking to
nothing over a period of time.
In fact the above system is
pretty much the system advocated by Laurence Kotlikoff .
Unit trusts / mutual funds.
One variation on the above theme
advocated by Kotlikoff to which I have no objection is that depositors who want
their money lending on or investing just put their money into a unit trust of
their choice (mutual fund in the US). And those unit trusts could perfectly
will include trusts that take over the lending function traditionally done by
banks.
Thus the latter trusts would in
effect become banks (depending on your definition of the word bank). Or those
trusts could be legally separate entities from existing banks while still being
run by traditional banks - indeed most
large banks already run a range of unit
trusts.
In effect, those with a stake in
those trusts would become shareholders, and Mervyn King alluded to the advantage
of a system of that sort when he said,
“…we saw in
1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did
the banking crisis. Equity markets provide a natural safety valve, and when
they suffer sharp falls, economic policy can respond. But when the banking
system failed in September 2008, not even massive injections of both liquidity and capital by the state could
prevent a devastating collapse of confidence and output around the world.”
Moreover, George Selgin, who is
not incidentally an advocate of full reserve banking, suggests a similar “fail
safe” system for the banking system he favours. On p.30 of his book “The Theory
of Free Banking”, he says, “For a balance sheet without debt liabilities,
insolvency is ruled out….”. (His book is available for free online).
Put safe account money into
government bonds?
Another variation on the above
theme is that “safe” money could be put into short term government debt instead
of simply being lodged at the central bank. That way, the money would earn some
minimal rate of interest.
Personally I’m not keen on that
as government debt can fall in value. As to Greek government debt, well we
better not go there.
The variety of unit trusts would be larger.
An advantage of the above system
is that depositor/investors would have a better range of choices as to what
their money is put into. For example it could be made compulsory for banks to
offer a trust where funds are invested just in mortgages where the house owner
has a minimum 30% or so equity stake. That sort of investment would be 99.9%
safe, though it clearly would not earn a spectacular rate of interest.
In fact under the above Kotlikoff
system, British mutual building societies would become “mortgage granting
trusts”. And as to the idea that turning building society depositors into
shareholders would be a big shock for them, that is questionable. Mervyn King
recently pointed out that those building society depositors are already in
effect the shareholders. (See question 4510 here.)
As to bank departments that
currently specialise in loans to firms and industry, those would become unit
trust entities. Thus depositors wanting their money invested for example in
small firms would be able to do so.
Adopting the “two account”
system does not involve implementing full reserve.
While advocates of full reserve
banking tend to advocate the above split between safe accounts and investment
accounts / unit trusts, adopting that split does not mean adopting full reserve
banking lock stock and barrel (far as I can see).
Would loans become more
expensive?
Well loans would become more expensive
IN THAT taxpayer subsidies for the banking system are removed. But that’s a
move towards a more efficient allocation of resources, isn’t it? That is, it is
generally accepted that subsidies misallocate resources. I.e. removing the
subsidy makes us all better off.
Another possible reason for
supposing that loans would become more expensive is that those funding lending
institutions would be, or would in effect be shareholders, and it is commonly
thought that shareholders demand a bigger return on capital than depositors.
Well that argument was disposed of by Messers Miller and Modigliani.
M&M’s basic argument is that
the risks run by a bank are a GIVEN. Thus the charge made for bearing that risk
is also a GIVEN. Thus that total charge is not influenced by the number of
shareholders amongst whom the risk is split.
There have of course been various
attempts to criticise M&M, but I’m not impressed by the criticisms. For
example Paul Tucker (who recently nearly became the new head of the Bank of
England) trots out a popular and very feeble criticism of M&M. He says:
“As for all firms, interest paid
by banks on debt is deductible from corporation tax, which reduces the cost of
debt relative to equity. Other things being equal, the average cost of funding
can therefore be reduced by issuing debt.”
Well the simple answer to that is
that tax is an entirely artificial imposition on businesses: it does not
reflect any sort of economic reality. For example if red cars were taxed more
heavily than blue cars, that would not be evidence that red cars were
inherently uneconomic compared to blue cars.
I’ve actually come across two
other papers which trott out that “tax” point recently, and if that’s the best
that critics of Miller and Modigliani can do, then it’s game set and match to
M&M, far as I can see.
Conclusion.
Let’s make sudden bank failures
impossible: it can easily be done.
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