Friday, 5 December 2014
Lenders should not be funded by depositors.
Or put another way, lending entities (e.g. banks, money market mutual funds, etc) should be funded just by capital, not by depositors or other types of debt.
Banks engage in two activities: accepting deposits and lending. Those two activities do not need to be conducted by the same organisations or entities. Or as James Tobin put it, “The linking of deposit money and commercial banking is an accident of history..”.
Having the same entity accept deposits and make loans is certainly PROFITABLE amongst other reasons because it enables the entity to engage in a fraud, which is thus. A deposit by definition is a promise to return to the depositor sums deposited (maybe plus some interest and maybe less some bank charges). But lending is inherently risky: it is indisputable that banks have gone bust regular as clockwork for centuries because of bad luck or incompetence. Thus lending out depositors’ money is inherently fraudulent. Indeed, it is widely accepted that what is sometimes called “fractional reserve” banking is fraudulent. Or as Martin Wolf put it, “If we were not so familiar with banking, we would surely regard it as fraudulent”.
The attraction of this fraud is that it enables banks to fund themselves more cheaply. That is, if you tell depositors their money is totally safe, most of them will believe you, thus they lodge their money with you at a lower rate of interest than if you tell depositors they may lose their money.
The latter fraudulent element in traditonal banking can be removed if the agreement between bank and depositor, instead of promising to return money deposited, says something like, “we, the bank, will return your money only if all goes well.” But in that case, depositors effectively become a type of shareholder. That’s shareholder as in “someone who shares in profits and losses”.
An alternative is for depositors to be backed by taxpayers, as is currently the case in the UK. But that amounts to a subsidy of banking, so that makes no sense.
Another alternative is for depositors to be protected by some sort of self-funding insurance (like FDIC in the US). But the costs of that insurance will be passed on to borrowers, so lenders do not get funded any more cheaply that way. (I’ll use the word “lender” to refer to any bank-like entity that lends to mortgagors, businesses, etc)
To expand on that, if the chance of those who fund a lender losing all their money is 1:30 and that’s the only risk, then the logical insurance premium is 1/30th of sums deposited, which gets passed on to borrowers. But if as an alternative a lender is funded just by shareholders (that’s people who ACCEPT risk, or if you like, “self-insure”), the charge made to mortgagors and other borrowers will be exactly the same.
A further weakness in having lenders funded by depositors or other types of debt, is that insolvency is possible. Or as George Selgin put it in his book “The Theory of Free Banking”, “For a balance sheet without debt liabilities, insolvency is ruled out…”.
Now what exactly is achieved by insolvency? The answer is: precious little. To illustrate, if a lender is funded just by capital and its assets fall to say 90% of book value, then its shares will fall to about 90% of initial value. But if the lender is funded entirely or almost entirely by debt, and assets fall to 90% of book value, and the lender is made insolvent, then depositors and other debt holders will get about 90 cents in the dollar.
And what’s the big difference between those two scenarios? The only real difference is that in the first case the lender does not go out of business, while in the second, the lender DOES GO out of business. Now if there’s some big merit in having firms go out of business, I long to know what it is.
Money market mutual funds.
Now what do you know? The above suggestion or rule, namely that lenders should be funded just by shareholders is actually being imposed on money market mutual funds in the US. (See Forbes article entitled “Will New Money Market Rules Break Money Markets?”
That is, MMFs which invest money in anything more risky that base money or government debt will not be allowed to promise not to break the buck. That is, the wont be allowed to promise depositors $X back for every $X depositors. That means those depositors effectively become shareholders.
A final and obvious question arising from all the above is: if would be depositors can’t place their money with a lenders, where do they place it? Well the answer is in the above couple of paragraphs. That is, they place it with entities that invest ONLY in ultra-safe stuff, i.e. base money and/or government debt (preferably short term government debt). And that all equals full reserve banking!