Cecchetti and Schoenholtz on bank reserves.

“Making Finance Safe” is the title of a recent and flawed article by Stephen Cecchetti and Kermit Schoenholtz. They start by pondering the question as to how much capital banks should have.

Their first questionable claim is that “No one really knows for sure” how much capital banks should have. Well I beg to differ and for the following reasons.

There is no good reason for taxpayers having to subsidise or stand behind money lenders, any more than there is a reason for taxpayers to subsidise steel production, restaurants or garages. Ergo all such subsidies / guarantees should be removed. Indeed it is widely accepted that the TBTF subsidy should be removed. And as to lender of last resort, Walter Bagehot (contrary to popular belief) did not approve of that subsidy: he accepted it because he thought it would be politically impossible to remove (see last chapter of his book “Lombard Street).

But if all such subsidies / guarantees ARE REMOVED, then all those who fund a bank / money lender are ipso facto shareholders: that is, all such “funders” (even if they are CALLED “depositors” or “bond-holders”) are in effect shareholders in that they stand to make a loss or be wiped out if the money lender / bank gets into serious trouble. And that equals a capital ratio of 100%.

Incidentally the latter point about removal of all subsidies effectively resulting in a 100% ratio is set out in this book of mine (featured in the column to your left). See bottom of p.19.

Fractional reserve.

Next, C&S refer to an article of theirs entitled “Narrow Banks Won’t Stop Bank Runs”. In the latter article they try to defend the existing or “fractional reserve” banking system, and their first argument in defence of fractional reserve is that fractional reserve banks are allegedly “experts in providing liquidity both to depositors and to borrowers.”

Well the answer to that is that it does not require any great “expertise” to supply depositors with “liquidity”: you just set up a bank / deposit taker, credit the accounts of those depositing money, give them cheque books, debit cards etc (except in the case of no hopers - drug addicts or similar) and that’s about it.

 In short, providing depositors with liquidity is at least in principle a very simple job which both a fractional and full reserve banking system can easily do. Come to that, it’s a job which state employed bureaucrats can easily do: and indeed they actually do that job in the case of various state run savings banks around the world (e.g. National Savings and Investments in the UK).

Borrowers.

As distinct from depositors, there are those wanting to borrow from banks / lending entities. As just mentioned, according to C&S, fractional reserve banks have “expertise” in this area as well. As they put it, fractional reserve banks provide “lines of credit (such as home equity loans that can be used when the borrower needs the funds).”

Now hang on. As C&S themselves point out earlier, 100% reserve or full reserve also involves making loans to those who want them. Thus fractional reserve banks are no more “experts” in this field and full reserve banks. So C&S’s argument there just isn't an argument for the existing or fractional reserve system.

Runs.

Next, the authors claim that runs would be just as likely under full reserve as under the existing system. As they put it, “Since the mutual funds would be holding illiquid loans – remember, they are taking over functions of banks – collective attempts at liquidation to meet withdrawal requests would lead to ruinous fire sales.”

Now that claim is a howler: it indicates that the authors don’t understand or have temporarily forgotten the basic characteristics of full reserve banking. But before I explain why, there’s just one incidental point to clear up in relation to the “mutual funds” they mention, as follows.

Under full reserve, the banking industry is split in two, as indeed C&S themselves point out. One half just accepts deposits and lodges those deposits in an entirely safe manner, e.g. at the central bank. The second half arranges loans, but it is funded just by shareholders, or stakeholders who are in effect shareholders. And that second half CAN TAKE THE FORM OF mutual funds.

As the authors put it in reference to the sundry variations on the full reserve theme:

“All of these proposals, both the old and the new, have a common core: banks should be split into two parts, neither of which would supposedly be subject to runs. The first part is a narrow bank that provides deposits that are as safe as a central bank asset; the second operates like a mutual fund or investment company in which any risk of fluctuation in the value of the assets flows directly through to the ultimate investor.”

Incidentally that quote is from C&S’s “Narrow Banks..” article rather than the “Making Finance Safe” article.

So . . . there are two mutually exclusive claims there. The authors claim first that any fall in value of underlying assets “flows directly through to the ultimate investor” (i.e. if he assets fall by 10%, then the “ultimate investor’s” shareholding falls by about 10%). And that’s what ACTUALLY WOULD HAPPEN under full reserve.

But they also say that given a lack of confidence by investors, the mutual fund would have to engage in “ruinous fire sales” to “meet withdrawal requests” (in the same way as traditional or fractional reserve banks have to meet withdrawal requests).

So which is it? Well the answer is that the first description of full reserve is correct and the second is nonsense.

That is, shares in those mutual funds would work in exactly the same way as shares or stakes in EXISTING mutual funds that invest in stock exchange quoted corporations. Indeed they work in exactly the same way as shares in the latter corporations work. That is, if you buy some of those shares, the fund or corporation is under NO OBLIGATION WHATEVER to pay you anything or “meet withdrawal requests”. The shares simply float in value in line with the value of the underlying assets and the consensus of opinion as to what those assets are worth.

If confidence in General Motors declines, GM does not engage in a fire sale of its car plants in order to ensure that shareholders get any particular number of dollars for their shares. And the same applies to those buying a stake in lending entities / mutual funds that organise loans under full reserve.

Conclusion.

I haven’t dealt with all the points made by C&S, and may do so at a later date. But certainly they seem to be less than totally clued up, to put it politely.

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P.S. (Later same day). I just realised the title of the above post is not too brilliant, referring as it does to bank reserves. That should have been bank CAPITAL.