How should lending entities under full reserve banking be funded?

Advocates of full reserve banking (e.g. Milton Friedman, Laurence Kotlikoff, Positive Money (PM), Richard Werner etc) are agreed that the banking industry should be split in two. Plus they agree that one half should simply warehouse money that depositors want to be totally safe. I.e. that money should just be lodged at the central bank, or be backed by base money. Another option (advocated by Friedman) is to invest some of that money in short term government debt. Plus they agree that the other half of the industry should lend to mortgagors, businesses and so on.

However, there is a lack of agreement on how the latter or lending half should be funded.

Friedman says that a lending entity would “acquire capital by selling shares or debentures”. That’s in Ch3 of his book “A Program for Monetary Stability”. Incidentally, “debenture” is another name for “bond”.

In contrast, Laurence Kotlikoff claims that just shareholders should do the funding, far as I can see. To be more accurate, Kotlikoff advocates that the lending half takes the form of mutual funds. However those who buy into mutual funds (existing mutual funds or the mutual funds advocated by Kotlikoff) are in effect shareholders. (“Mutual fund” is US-speak for “unit trust” in the UK).

Irving Fisher (at least in his book “100% Money and the Public Debt”) doesn’t say anything on funding, far as I can see.

PM advocates that funding is done partially by bank creditors who are more in the nature of depositors: that is those depositor / bank creditors are guaranteed $X back for every $X they put in, unless the lending entity fails badly, in which case those depositors lose out.

I’ll argue below that in fact the funding should be done ENTIRELY by bog standard ordinary shareholders. Here goes.

Why split the banking industry in two?

Let’s start with one of the basic the reasons for splitting the bank industry into the above two halves: deposit accepting and lending.

If the latter two activities are COMBINED, one big problem is that banks then have liabilities that are fixed in value (inflation apart) and assets that can fall in value (when incompetent loans are made). And that’s asking for trouble: certainly given the sort of capital ratios that were common before the recent crisis, i.e. about 3%, and assuming a bank’s assets fall in value by more than 3%, which isn't a big fall, then the bank is technically insolvent. That may lead to a run and thus to actual insolvency or it may not. Either way, it’s no way to run a railroad.

Moreover, the ever present and very real possibility of private bank insolvency is what induces governments to offer subsidies and other forms of backing for private banks, and subsidies do not make economic sense. Plus it induces governments to implement complicated bank legislation, much of which is of questionable effectiveness: witness the recent crisis.

So a solution is to separate the deposit taking from the lending process, which is what full reserve banking (FR) does. 

Should bonds be allowed?

To repeat, Friedman advocated that lending entities could be funded by both shares and bonds. And PM advocates having money lenders / lending entities funded at least partially by depositors of a sort.

But the problem with that Friedman / PM idea is that it re-introduces, at least to some extent, the very problem that splitting the bank industry in two is designed to solve, namely bank fragility:  bank runs being an example of that fragility (see John Cochrane for more on bank runs). That is, both bond-holders and depositors are promised SPICIFIC SUMS of money, so the relevant lending entity has liabilities that are fixed in value. And that makes insolvency possible. Put another way, it’s impossible for a bank / lending entity funded just by shares to go insolvent. As George Selgin put it in his book “The Theory of Free Banking”, “For a balance sheet without debt liabilities, insolvency is ruled out…”. (Incidentally, that was an aside made by Selgin: his book did not actually advocate FR).

Decent capital ratios.

Now it might seem that some sort of compromise is possible here: that is, instead of insisting that ALL lending entity funders are bog standard ordinary shareholders, wouldn’t a substantial increase in capital ratios do (e.g. the 25% or so ratio advocated by Martin Wolf)? That sort of ratio would mean that money lenders / lending entities were funded about 25% by shares and 75% by bonds or deposits. And certainly such an entity would be very near failure proof.

But the big question there is: what exactly is gained from allowing money lenders / lending entities to be funded by those bonds or deposits? The answer, is “nothing” and for the following reasons.

Suppose a lending entity is funded entirely by ordinary shareholders, and the decision is taken to fund it partially by PM’s depositors or Friedman’s bonds. The advantage of that might seem to be that funding the entity can be done at lower cost because depositors and bond-holders require a lower return on capital than shareholders.

But that idea is squashed by the Miller Modigliani theory (MM). MM has been criticised of course, but the criticisms are feeble, far as I can see. See under the heading “Flawed Criticisms of Modigliani Miller” in section 1.4 here.

Risk taking depositors.

There is actually another reason why having lending entities funded by depositors won’t reduce the cost of funding the entity, as follows. Under FR, to repeat, depositors take a risk, unlike the existing system in the UK where depositors are protected by taxpayers. Thus quite apart from MM, it is fantasy to suppose that if ending entities WERE FUNDED to some extent by depositors, that those depositors would accept the relatively low return they get at the moment in the UK.

Removing lender of last resort.

Another neat aspect of having just bog standard ordinary shareholders fund lending entities is thus.

It is a moot point as to whether lender of last resort (LLR) constitutes a subsidy of private banks. If the relevant loans REALLY ARE at the penalty rates mentioned by Walter Bagehot and if the relevant collateral really is first class, then LLR is not a subsidy. However, in crises there is always political pressure to relax standards and offer sweetheart loans gratis the taxpayer in exchange for collateral which is less than first class, and certainly that happened in the recent crisis.

Now LLR is only necessary where a lending entity has liabilities that are fixed in value because such an entity can go insolvent. In contrast, an entity funded by bog standard ordinary shareholders just can’t go insolvent.

Thus in as far as LLR is a subsidy, the need for that subsidy is much reduced or totally disposed of where lending entities are funded just by shareholders.

(Incidentally, and contrary to common perception, Bagehot did not actually APPROVE OF lender of last resort. In the last chapter of his book he said it was not worth trying to dispose of because there’d be too many vested interests and too much political pressure devoted to saving LLR. Or to put it bluntly, there were lots of millionaire banksters in his day, as there are nowadays, prepared to bribe politicians into continuing to channel taxpayers’ money into banksters pockets via LLR.)

Insolvency achieves nothing.

Yet another advantage of a “bog standard ordinary shares” is thus. If bonds or deposits fund a money lender / lending entity, then the entity can, to repeat, go insolvent. Now let’s consider what bond-holders or depositors get in that scenario.

Suppose (to keep things simple) a lending entity is funded entirely or almost entirely by bonds or deposits. And suppose the entity’s assets decline in value to 80% of book value and the entity is wound up. Well bond-holders and/or depositors would get about 80p in the £.

But suppose as an alternative, the entity is funded entirely by shares. In that case and given the same fall in value of assets, all that happens is that the shares drop to about 80% of their initial value. But there’s no need for insolvency proceedings: the entity soldiers on - or perhaps gets taken over.

So what do bonds or deposits achieve? Absolutely nothing! That is, in both of the above two scenarios, bank creditors get about 80p in the £. But in one case the bank / lending entity closes down, while in the other (the “bog standard share” scenario) the entity soldiers on. The latter is clearly the better option.

The chance of insolvency.

It could be argued in favour of having lending entities funded at least partially by bonds or deposits that given capital ratios of say 25% or 50% the chance of insolvency is vanishingly small.

Well the first answer to that is that is far from rare in the case of small US banks which go insolvent (and they do so at the rate of about one per week) to find that assets have declined to less than 50% of book value. And in one famous case assets declined to just 10% of book value. So in those scenarios, a 50% capital ratio doesn’t save the day.

It might be tempting to argue against the latter point that the latter sort of dramatic fall in the value of assets may apply to SMALL BANKS, but it is much less likely in the case of LARGE BANKS. However, there is a problem there, as follows.

It is widely accepted by advocates of FR that stakeholders in lending entities should have a CHOICE as to how their money is used. Indeed in Kotlikoff’s system that is quite explicit: that is stakeholders have a choice of mutual funds to invest in. Now that means in effect that lending entities are split up into a series of “mini lending entities”. Ergo the above “small bank / large bank” point collapses.

Would a 75% capital ratio do?

Having argued that a 50% capital ratio might not be good enough, what about a 75% ratio? Well that might do, but having gone that far, why not just go for 100%? The latter is a clear line in the sand. Moreover, given a 75% ratio, banksters can be guaranteed to lobby for a never ending series of reductions in that 75% ratio.

In fact there’s a passage in Irving Fisher’s book “100% Money and the National Debt” which warns of banksters lobbying efforts in this connection. He is actually concerned with reserves rather than capital in this passage, but the same principle applies. The passage is thus (in green).

“Furthermore, the 100% plan is the only way to make this separation complete. One of my half-converted correspondents proposes that we require an 80% but not a 100% reserve, "Surely 80% is enough." No, not enough to disentangle money from banking, not enough to give Government undisputed sway over the former and bankers' undisputed sway over the latter. Even 99% would not quite do that. Why not make the divorce complete? Moreover, a 100% system would be far less likely to be broken down. We had a 100% system for gold certificates and it never broke down, though 80% or 40% would have been sufficient for convertibility. But once anything less than 100% is used, the tendency is always to pare it down further; the same argument, "so large a reserve is not required," will again be heard. Witness the progressive weakening of reserves under our Federal Reserve System which was established to strengthen reserves.”  

 Conclusion.

Under full reserve, lending entities should be funded just by bog standard ordinary shareholders or something similar, as advocated by Laurence Kotlikoff. If bonds or deposits are used to any extent to fund money lenders / lending entities, then that just partially re-introduces the very problems that splitting the bank industry in two was designed to solve. Second, letting bonds or deposits fund a lending entity DOES NOT reduce the cost of funding the entity. Third, having lending entities / banks funded just by shareholders makes it easier to dispose of the lender of last resort subsidy. Fourth, in the case of an incompetently run lending entity, bonds and deposits make insolvency possible, but that insolvency gets bond-holders and depositors nowhere: they won’t salvage any more of their investment than had the entity been funded by shares.