How to put fractional reserve banking into check mate.

In three easy moves! Here’s how…

First, the phrase “fractional reserve” is a bit of a misnomer, so I’ll use the phrase “existing bank system” instead.

Commercial banks under the existing system have assets on one side of their balance sheet which can fall in value (when silly loans are made). Plus they have liabilities that are very largely FIXED IN VALUE. That’s amounts owed to depositors and bondholders. And that’s just asking for trouble. I.e. when the assets fall in value, the bank/s concerned are technically or actually insolvent. And there’s no disputing the fact that thru history banks have failed regular as clockwork.

Solution No.1: bank subsidies.

One solution to that problem is to have the state stand behind commercial banks, which states / governments actually do, and big time. Witness the TRILLIONS of dollars of public money recently used to rescue banks. But that amounts to a subsidy of banks and subsidies misallocate resources. I.e. unless there is some very good social reason for a subsidy, the subsidy will reduce GDP.

Solution No.2: strict bank regulation.

Strict regulation could take the form of stopping banks engaging in anything the least bit risky. But that flies in the face of the fact that if risky ventures had been banned over the last two centuries, the industrial revolution would never have taken place. I.e. many of the most worthwhile advances are INITIALLY very risky.

Solution No.3: upping bank capital requirements.

Banks could be forced to hold much more capital. Indeed Anad Atmati and the chief economics commentator at the Financial Times, Martin Wolf advocate capital ratios of about 25%. And 50% wasn’t uncommon in the 1800s, all of which is in stark contrast the currently prevailing 3% - 6%. But then the 3% - 6% is the consequence of the corrupt banker / politician nexus. Though the word “nexus” isn't quite right: the word “cesspit” as used by Martin Wolf in the title of his above article is more appropriate.

But there is what might be called a “logical self-contradiction” in the “high capital ratio” idea, as follows.

If a 25% or so capital ratio makes banks totally and completely safe, and if government is sure that that ACTUALLY DOES make banks safe or failure proof, then government will be able to remove all bank subsidies (i.e. TBTF, deposit guarantees and lender of last resort etc). But if banks are totally safe, then there is no difference between shareholders on the one hand and on the other hand, depositors and bond holders. That is, none of those three latter run any risk. (They will incidentally thus all demand the same return on sums deposited at or invested in the bank.)

But that amounts to FULL RESERVE BANKING!!!! That is, under full reserve (at least as advocated by Positive Money, Milton Friedman, Laurence Kotlikoff, etc), there is only one type of funder for, or creditor of lending entities / banks. And that is shareholders (or people who are effectively shareholders, even if they aren’t actually called shareholders).

Solution No.4: Just abandon bank subsidies.

In that case depositors and bondholders become risk takers, i.e. shareholders. But that’s full reserve banking! One could of course get round that by abolishing TBTF and lender of last resort while supporting depositors via some sort of self-funding FDIC insurance system. But in that case the appropriate insurance premium would equal the difference in risk run by depositors and shareholders. Plus that premium would inevitably be passed on to depositors. So that little wheeze gets depositors nowhere, plus it doesn’t cut the cost of funding banks.

Conclusion.

So the conclusion is that there are only two possibilities, and as follows. First banks can be less than totally safe, in which case they need subsidising. But that misallocates resources and reduces GDP, so that option does not make sense. Second there is full reserve banking.

Check mate.

QED.