Tuesday 29 April 2014

Diamond and Dybvig’s flawed criticisms of full reserve.

I’m always interested in arguments against full reserve. So far all I’ve found is a selection of badly flawed arguments, and this  paper by Douglas Diamond and Philip Dybvig is typical. It’s entitled “Banking Theory, Deposit Insurance, and Bank Regulation”. D&D’s criticisms of full reserve appear in their section III, and their argument (which clearly indicates they haven’t studied the subject) starts as follows. (D&D’s actual words are in green below).
“One proposal is to impose a 100% reserve requirement, that is, a requirement that intermediaries offering demand deposits can hold only liquid government claims or securities, for example, Treasury bills or Federal Reserve Bank deposits (which might pay interest). This proposal specifically restricts banks from entering the transformation business (they cannot hold illiquid assets to transform into liquid assets), and therefore the proposal precludes banks from performing their distinguishing function. If successful, this policy would remove the purely monetary causes of bank runs by limiting banks to performing liability services. The net effect of such a policy is to divide the banking industry into two parts. The regulated part of the industry would still be called banks but would be effectively limited to providing liability side services. The other part of the industry would be an unregulated industry of creative firms exploiting demand for the transformation services previously provided by banks but that banks could no longer supply under 100% reserves.”

Answer to the above passage.
The above passage is a joke. It certainly does not set out 100% reserve banking as proposed by 100% banking’s main advocates (e.g. Irving Fisher or Milton Friedman) in the years prior to D&D’s paper (1986). The above passage is simply D&D’s own bizarre idea as to what 100% reserve banking consists of.
To illustrate, Irving Fisher in his book “100% Money and the Public Debt” (1936) says “..each commercial bank would be split into two departments, one a warehouse for money, the checking department, and the other the money lending department…”. I.e. far from lending being done by what D&D call “unregulated creative firms”, lending entities are very much regulated under full reserve.
And Milton Friedman, another advocate of full reserve, describes full reserve in his book “A Program for Monetary Stability” much as Fisher does. Specifically Friedman says “The effect of this proposal would be to require our present commercial banks to divide themselves into two separate institutions. One would be a pure depositary institution, a literal warehouse for money…….The other institution that would be formed would be an investment trust or brokerage firm. It would acquire capital by selling shares or debentures and would use the capital to make loans or acquire investments.”
Neither Fisher nor Friedman say anything about one half of the banking industry being “unregulated”, as claimed by D&D.
D&D continue.
“Even if banks would still be viable without the rents to providing the transformation service, the proposal would just pass along the instability problem to their successors in the intermediary   business. The instability problem arises from the financing of   illiquid assets with short-term fixed claims (which need not be monetary or demand deposits).”
The answer to that is that obviously if “illiquid assets” are funded from “short-term fixed claims” then the relevant entity is fragile: or in D&D’s words the “instability problem” is “passed along”. Indeed, the latter defective form of funding would make the whole switch to full reserve near pointless. That’s why the advocates of full reserve (Friedman, Fisher, Lawrence Kotlikoff, etc) SPECIFICALLY advocate that funding is done by SHAREHOLDERS and NOT BY “SHORT-TERM FIXED CLAIMS”. Doh!

Mutual Funds.
Then in the rest of that paragraph of D&D’s, they make the point that the deposit taking half of the former banking industry is similar to money market mutual funds, and they complain about the fact that no transformation or “creation of liquidity” takes place as a result.
Well the answer to that is that stopping private banks creating liquidity or if you like creating money is a SPECIFIC OBJECTIVE of full reserve banking: it’s not a flaw which has remained hidden till those two geniuses Diamond and Dibvig revealed it. As Fisher put it, “We could leave the banks free, or at any rate far freer than they are now, to lend money as they please, provided we no longer allowed them to manufacture the money which they lend.”
Next, D&D ask:
"If banks adopted this structure, who would hold the illiquid assets (loans) currently held by banks?"
Well if D&D had bothered reading the Chicago plan and/or Fisher and/or Friedman, they’d know the answer, which is of course that those “illiquid assets” are held by the lending entities or lending departments of banks that arise when full reserve is implemented.

Commercial Paper.
Next (para starting “Commercial banks…”) D&D point out that corporations use commercial paper to raise cash in a hurry, and that this process would be more difficult under full reserve.
Well the answer to that is that short term loans to corporations are only one of many types of loan in modern economies. E.g. there are very small scale high interest loans made by back street loan sharks, and long term and relatively low interest rate loans granted to mortgagors, to name just two. And contrary to D&D’s claims, there is nothing very special about large short term loans to corporations: that is, a number of GENERAL POINTS can be made about lending given a switch to full reserve and which are applicable to all types of lending, not just lending backed by commercial paper. Those points are as follows.
First, full reserve obviously restricts lending, but given the excessive and irresponsible lending that caused the crunch, it’s not immediately obvious why that’s a problem. As to the demand reducing effect of that restriction, that can be made up for by creating and spending base money into the economy, which in turn results in firms and households having a bigger stock of money. Thus any interest rate rise caused by implementing full reserve would tend to be counterbalanced by a reduced need for households and firms to take on debt.
The net result is that those corporations which D&D are so worried about (and indeed all other debtors or potential debtors) would tend to keep a larger stock of money to tide them over periods when their stock of money tended to be low, rather than resort to money lenders. And give current record levels of private debt, that’s probably a desirable outcome.

Money lenders cannot be controlled?
In their penultimate sentence, D&D make the following claim which they don’t even try to substantiate: “Furthermore, the proposal is likely to be ineffective in increasing stability since it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity.”
Well the first flaw in that argument is that under full reserve, as explained above, “liquidity” or money is created by the central bank, not private banks. Thus it’s debatable as to whether there is any sort of “vacuum” to which D&D refer.
However, printing money and lending it out, which is what private banks do, is a potentially profitable business. So doubtless numerous shadow banks would try to get into the money or liquidity creation business.
However, one answer to that was given by Adair Turner (former head of the UK’s Financial Services Authority) put it and in reference to shadow banks which prior to the crunch were scarcely regulated at all: "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."
But clearly imposing those “bank-like safe-guards” will never be done with 100% efficiency: that is, numerous smaller shadow banks will try to evade the rules. But actually there isn't a huge problem there, and for the following reasons.
The tax authorities normally manage to trip up naughty self-employed people with a turnover of £50k or £100k a year who are not declaring their earnings to the tax authorities.  And £100k a year is a RIDICULOUSLY SMALL turnover for a shadow bank. Thus the authorities ought to be able to uncover the existence of any shadow bank with a turnover of say more than £1m a year, and if they can do that, that cracks the problem.

Can small entities create money?
Moreover, it is debatable as to how much money creation small shadow banks, particularly small ones can do. My Penguin dictionary of economics starts its definition of money with the sentence “Anything which is generally acceptable as a means of settling debt.” Now the liabilities of well-known and large High Street banks are “generally acceptable” for the purposes of buying a car or purchasing your groceries. E.g. cheques drawn on Barclays or Lloyds are widely accepted, and credit cards with “Barclays” or “Lloyds” or “Visa” printed on them are generally accepted. But you’d probably be wasting your time with a cheque drawn on some unheard of shadow bank.
Maturity transformation.
Moreover, size pays when it comes to maturity transformation. To illustrate, if a bank is funded by ten thousand depositors, the bank can calculate very accurately the proportion of those depositors likely to withdraw their money in a particular week or month.
In contrast, if a bank is funded by just TEN depositors or other type of short term creditor, it would be well advised not to do any transformation at all.
So to summarise, failing to keep tabs on the smaller shadow banks would be a minor problem for full reserve.

Diamond and Dibvig’s attempt to criticise full reserve is hopeless.


  1. To my way of thinking, the D and D statement

    "The instability problem arises from the financing of illiquid assets with short-term fixed claims (which need not be monetary or demand deposits)."

    mis-characterizes the cause of instability. I believe the correct source of bank lending instability is the expectation by depositors that they can always have access to their money.

    Access to money is always important to depositors because all depositors think of their deposits as being property. Stated another way, each depositor thinks of his deposit as being a placement of property into the hands of the bank for safe physical storage, identical to placement of a car into a parking garage. All depositors fully expect to retrieve their car (money) upon demand.

    Now, when the bank lends the cars (money) without permission, there are certainly more cars (money) on the street than there would be without bank lending. More cars (money) on the street does increase activity which many think as a good result.

    A potential problem lurks when all the permanent owners of cars and temporary owners (borrowers) of cars want their cars at the same time. There is not that many cars.

    So, to my way of thinking, a shortage of cars is not the same as a mismatch of when cars are available on a time sharing basis.

    1. Can't see the difference between your description of the problem and D&D's. Perhaps my brain isn't working today.

    2. D and D use the words "with short-term fixed claims". Short term claims implies that the banks have control of the property for a short but predictable period of time.

      On the other hand, depositors understand that they have instant, or near instant, access to their property.

      The difference in perceptions has the result of banks becoming dependent upon the average of human daily decisions as contrasted to the effects of legally binding agreements. The intersection of the two concepts is sufficiently blurred as to allow bank runs, sabotaging predictability..

    3. Yes, I agree there’s a difference between a deposit that can be withdraw anytime, and a short term loan to a bank which is not repayable for a specific period. But the difference is a bit blurred in that even if a bank is funded mainly by the latter, it can still run into serious problems. Northern Rock relied on the latter type of funding. That worked OK for years, then the source of that funding dried up. Lehmans was similar.


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