Monday, 21 July 2014

Biagio Bossone criticises full reserve banking.

The world is awash with incompetents criticising full reserve banking (FR). I dealt with a large number of these here.
However, this paper by Biagio Bossone entitled “Should Banks be Narrowed” is in a different league: he has obviously studied the subject in detail, and the first few pages are faultless.
However, as soon as he starts to criticise FR he goes off the rails, and for the following reasons.

Bossone’s first argument.
His first argument in favour of the existing banking system (i.e. against full reserve) starts as follows (his p.13). Incidentally, I’ve put all his words in green.
“An important strand of research, following Diamond and Dybvig (1983), stress the role of banks as insurers against liquidity shocks.”
Dear oh dear: it was the banking system itself which around 2005 was the MAJOR CAUSE OF a “liquidity shock”. The banking system itself didn’t “insure against” that “liquidity shock”. It failed in spectacular and disastrous fashion in that regard. It was TAXPAYERS who provided TRILLIONS OF DOLLARS of “insurance money” to deal with the “liquidity shock”.
Incidentally, it’s not entirely clear when his paper was written, but it looks like it was around 2000 to 2002. Perhaps Baggio wouldn’t have said the above were he writing today.
Anyway, Baggio continues:
“In a setting where all individuals are initially identical but learn only subsequently to have different intertemporal consumption preferences, banks are shown to generate liquidity to help individuals who discover to be “patient” consumers to satisfy their needs. (Is that English?) They do so by transforming illiquid assets into liquid deposits. This is possible because the averaging out of the withdrawal demands from a large number of depositors allows banks to stabilize their deposit base and transfer deposit ownership without liquidating the assets. From this angle, the social benefit of banking derives from an improvement in risk-sharing, i.e., the increased flexibility of those who have an urgent need to withdraw their funds before the assets mature (Diamond and Dybvig 1986).”
Now what on Earth makes Baggio think that under FR households and firms can’t borrow, as the above passage implies? The only difference between the existing system and FR is that under the latter, lending is carried out by “banks” or “entities” that are funded just by shareholders, as opposed to the existing system under which lenders are funded mainly by depositors. Indeed, as Baggio himself put it a page or two earlier:
“Commercial banks having to switch to narrow-banking regulation could be expected to transfer their credit exposures to existing or newly-established finance companies, which typically operate with higher capital ratios and fund themselves with relatively larger volumes of long-term debt.”
Baggio then repeats the above error (i.e. assuming that no one can borrow under FR) when he says:
 “In fact, the benefit of banking cannot be fully appreciated if the asset and the liability side of the bank balance sheet are not considered connectedly. The benefit derives from the banks using their stable deposit base to finance production technologies that increase output over time.” 
To repeat, under FR, (if we have to use large numbers of pseudo technical words, a tactic much favoured by academics trying to hide their ignorance) “production technologies” can be “financed over time” perfectly well under FR.
Baggio then claims “This crucial link between liquidity and production is explicitly recognized in Diamond and Rajan (1998, 1999), where banks are regarded as superior devices to tie human capital with real (illiquid) assets, and where the sequential service constraint ordering the way in which banks service withdrawal demands (up to when they become illiquid) work as an incentive for bankers to behave prudently.”
Gosh: bankers behave “prudently” under the existing system do they? Baggio clearly lives in cloud cuckoo land.
The point remains, however, that production requires patient money and involves risks, while agents with money may not be as patient and risk-inclined to lend it to firms: banks do provide a mechanism to reconcile both sets of preferences by generating liquidity. Narrow banks are designed precisely not to do so.
Baggio doesn’t give a definition of “patient money” but presumably he means money which relevant owners or holders are prepared to lock up for significant periods. And clearly the existing banking system does what Baggio claims it does in the passage quoted just above: that is, it enables long term investments to be funded from short term deposits (or from “unpatient” holders of money to use his terminology). However, that argument is easily demolished, and as follows.
There is no escaping the fact that borrowing short and lending long, which is what traditional banks do, is risky: the brute and undeniable fact is that banks have failed regular as clockwork throughout history. And there are a limited number of ways of dealing with that problem. Let’s run thru them.
First, taxpayers can stand behind banks (the “solution” adopted in the UK). But’s just a subsidy of banks, and subsidies misallocate resources, i.e. reduce GDP. Plus regulators the world over are agreed that bank subsidies should be removed: an objective they’ve spectacularly failed to achieve.
Second, government (i.e. taxpayers) can simply abstain from helping failing banks (the policy adopted in New Zealand, and tried in Cyprus in 2013). But that means that depositors take a hair cut when a bank fails, which effectively means that depositors become very near to being shareholders. And that pretty much amounts to full reserve banking!! Or to be more exact, where depositors take a hair cut when a bank fails, that bank is effectively one of those “existing or newly-established finance companies” to which Baggio referred above.
And if one assumes that in addition to those risky deposit takers, there is some form of ultra-safe deposit taker or savings bank (like National Savings and Investments in the UK), then that all amounts to FR to all intents and purposes.
Third, banks can be allowed to fail, but depositors are reimbursed via a self funding FDIC type insurance system. Now that is very near to FR, at least in the sense that bank subsidies are removed. In fact the only difference between a FDIC insured banking system and FR (far as I can see) is that under the latter, commercial banks do not issue money, whereas under an FDIC system they do. I dealt with the relative merits of those two systems here and concluded that FR is better than an FDIC insured banking system.

Given the obvious defects in Baggio’s first few criticisms of FR, I can’t be bothered reading any more of his paper.

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