Fractional reserve banking is in check mate.

The powers that be, the great and the good, and so on, keep paying pay lip service to the principle that commercial banks should not be subsidised. So do they advocate that government should announce loud and clear that under no circumstances will there be any sort of taxpayer funded support or backup for banks in trouble? You bet they don’t.

Reason is that they want to have their cake and eat it: that is, the banker / politician nexus, the revolving door brigade and associated hangers on want to appear virtuous in the form of being seen to earn their keep in a genuine free market, at the same times as ensuring that their “keep” is safeguarded by taxpayer funded subsidies and backups.

But if government WERE TO ANNOUNCE loud and clear that under no circumstances would private banks get any sort of taxpayer funded assistance when banks have problems, then all of those who fund banks (including depositors and bondholders) would ipso facto become bank shareholders: at least shareholders as in “someone who at worst stands to lose everything when the relevant bank is bust”. And a bank system under which banks are funded just by shareholders is what’s called “full reserve banking”.

It COULD BE argued that we could retain depositors and bondholders in the conventional sense of the words if banks are backed up by some sort of COMMERCIALLY VIABLE insurance system (like the US FDIC system). But there’s a big problem there, as follows.

Shareholders are people who by definition insure themselves. In contrast, it’s perfectly possible to have depositors and bondholders who are insured by some third party like FDIC (as suggested just above). But assuming an FDIC type insurer gauges the insurance premium correctly and assuming shareholders also charge the right implicit insurance premium, then the total cost of funding banks will be the same in each case, except that there actually several problems with “third party” insurance, as follows.

1. There are administration costs involved in “third party” insurance.

2. There’s always a temptation under third party insurance to cheat the insurer: 10% of claims in the UK relating to house and car insurance involve an element of fraud. And both “1” and “2” involve REAL COSTS.

3. Under third party insurance, bankster / criminals will NEVER EVER give up bribing and cajoling politicians into charging a less than fully commercial premium, assisted by sob stories about the economy suffering if allegedly onerous impositions are placed on banks.

So which of the following two is better. A fractional reserve system with the latter three defects or a system where banks are funded just by shareholders, which equals full reserve banking?

No contest.

Fractional reserve is in check mate.