The Vickers Commission’s incompetent objections to full reserve banking.

The UK’s Independent  Commission on Banking, the so called “Vickers Commission”, objected to full reserve banking. Their reasons are in section 3.20, 3.21 and 3.22.

Their first mistake is to make a distinction between what they call “narrow banking” (section 3.20) and what they call “limited purpose banking” (3.22). They claim that narrow banking involves not lending on depositors’ money: e.g. simply lodging such money at the central bank or investing in government debt.

In contrast, they claim that limited purpose banking involves having lending institutions funded just by loss absorbers or shareholders.

Well now, if institutions that accept deposits cannot lend on those deposits, then necessarily institutions that lend will be funded not by depositors but by shareholders or similar types of loss absorber! Thus “limited purpose” and “narrow” banking are simply opposite sides of the same coin. Indeed, that fact was explicitly recognised by Milton Friedman and Lawrence Kotlikoff in that the banking systems the advocate involve splitting the banking industry into two halves: entities or accounts which simply accept deposits and warehouse money, and second, entities which lend, but which are funded by shareholders.

Thus in the paragraphs below I’ll refer to the above “coin” or combination as “full reserve banking”, while still referring to the spurious distinction between narrow and limited purpose used by Vickers.

Narrow banking.

Vickers’s objections to narrow banking are in 3.20 and 3.21. The following (in green) is section 3.20 and the first half of 3.21.

3.20. Proponents of a different kind of structural reform known as ‘narrow banking’ argue  that the function of taking deposits and providing payments services to individuals  and SMEs is so critical to the economy that it should not be combined with risky  assets. Under a strict form of narrow banking the only assets allowed to be held against such deposits would be safe, liquid assets. Since lending to the private sector necessarily involves risk, such banks would not be able to use the funding from deposits to make loans to individuals and SMEs. Should ring-fenced banks be allowed to make such loans? 

3.21 If ring-fenced banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high. If all current retail deposits were placed in narrow banks, around £1tn of deposits which currently support credit provision in the economy would no longer be able to do so. Alternative sources of credit could arise – for example if narrow banks could  invest only in short-term UK sovereign debt (‘gilts’) the current investors in gilts would  need other assets to invest in, since the stock of gilts would be more than taken up by the demand from narrow banks.  

If you have any grasp of how the banking system works you should be able to spot the flaw there. The basic flaw is that Vickers regards money in a similar way to the way children regard piggy bank money. That is, Vickers is assuming there is  some sort of fixed pot of money to be allocated to borrowers, or not, and that if money deposited in the ring-fenced section of the banking industry cannot be loaned on, then relevant borrowers will find it hard to obtain loans. The reality of course is that private banks and central banks can and do expand and contract the money supply as they see fit. And given the introduction of full reserve, they’d simply adjust the total amount of money to suit, and as a result, thus there’d be none of the “high economic costs” to which Vickers refers. But that glosses over a lot of detail, so let’s look at the details.

The first mistake in the above passage from Vickers is the assumption that depositors would want ALL THEIR MONEY lodged in a 100% safe fashion. (That’s where Vickers says “If all current retail deposits..” Notice the word “all”).

That is, some depositors hold some of their money for the well-known “asset” motive, rather than for the “transaction” motive, as explained in the introductory economics text books.

And “asset money” tends to go into deposit or “term accounts” where it earns more than the zero rate of interest normally available from current or checking accounts. And a proportion of term account money, if full reserve banking were introduced, would be put into investment accounts (under Positive Money’s full reserve system) or into lending unit trusts under Lawrence Kotlikoff’s system. So to that extent (and contrary to Vickers’s suggestions) there’d be no effect on the amount being loaned to borrowers.

And even if the latter PM or Kotlikoff accounts/entities were not specifically set up, they’d arise automatically. That is, if the narrow banking rule were imposed, there’d be a whapping great gap in the market which would be filled by entities offering loans and funded by shareholders.

Let’s now turn to those wanting money lodged in a 100% safe fashion.

Reduced lending.

Now suppose banks are barred from lending out money in transaction / current / checking accounts. In that case, as section 3.21 rightly points out, deposits would have to be backed by what Vickers calls “safe liquid” assets. Section 3.21 suggests Gilts (i.e. government debt). But monetary base would do equally well. Let’s say it’s the latter.

That would mean the central bank would have to make available an increased amount of monetary base to meet the new demand. (I’ll deal with the possible inflationary effect of that below).

But at the same time, as Vickers rightly suggests, there would initially be significant number of viable lending opportunities which would go unfunded. In Vickers’s phraseology there’d be “economic costs”, which is a bit vague. To be exact, the above reduced lending would have a deflationary effect .

But that’s easily dealt with, and at no real cost simply by implementing stimulus (monetary and/or fiscal). Problem solved! And some of that stimulus would cause additional lending.

Given the constraints on bank lending that are inherent to full reserve, it could well be there’d be less lending even after the latter stimulus. Would that matter?

Well if you’re one of those politicians who worship the ground that banksters walk on (that’s about 95% of politicians), and who think that the more lending and debt we have the better, then less lending “matters”.

However the important question here is: what’s the OPTIMUM amount of lending? Well I suggest the optimum is the amount that takes place in a genuinely free market: that’s a market where banks are not subsidised, as they are at the moment.

And under full reserve, banks are not subsidised. Hence the optimum amount of lending and debt is the amount that would take place under full reserve. QED. Game set and match to full reserve banking.

Section 322.

This section deals with what Vickers calls “limited purpose banking”. And section 322 claims:

“First, it would constrain banks’ ability to produce liquidity through the creation of liabilities (deposits) with shorter maturities than their assets. The existence of such deposits allows households and firms to settle payments easily.”

Well now everyone has tumbled to the point that we need a form of money because that “allows households and firms to settle payments easily”.  But there is absolutely no reason why the private sector has to do that job. That is, there is nothing to prevent us having a system under which the only issuer of money is the state. Indeed, many of those who have studied the origins of money claim that in most societies or civilisations, money was first produced by the state to facilitate collection of taxes. King Henry I’s introduction of tally sticks to England around 1100AD was a classic example.

And full reserve is a system under which only the state issues money. And under full reserve, the state would issue whatever amount the private sector wanted: or to be more exact, whatever amount induced the private sector to spend at a rate that brought full employment.

Section 322 continues:

“Second, banks would no longer be incentivised to monitor their borrowers, and it would be more difficult to modify loan agreements. These activities help to maximise the economic value of bank loans.”

Now where on Earth does Vickers get the idea that “banks would no longer be incentivised to monitor their borrowers”? Quite the reverse. That is, under the existing system banks can make risky loans in the knowledge that if that pays off, they keep the profit, but if it doesn’t, the taxpayer picks up the bill!!!

Not much of an “incentive to monitor” there is there?

In contrast, under full reserve, those who invest in entities that lend, stand to lose out if the entity makes silly loans. That’s what I call “incentive” to monitor. In particular, and taking the sort of full reserve system advocated by Positive Money and Lawrence Kotlikoff and others, investors specifically have a choice as to what is done with their money.  So if they really want to take a big risk, they can. But the probability is that about 95% of those who currently have money in deposit or term accounts would want to see their money used in a very conservative fashion. That is, they’d specify that their money was used not to fund NINJA mortgages, but to fund for example mortgages where house owners had a minimum 20% or so equity stake.

As for Vickers’s claim that under full reserve “it would be more difficult to modify loan agreements..”, I’m baffled. Under the law as it stands any two parties are free to come to any agreement they like, as long as it’s not illegal: and in particular they can include a bit of “modifiability” in the agreement, or not, just as they please.