The creation and lodging of money by commercial banks can’t be done without taxpayer funded subsidies.

Summary. 

The creation of money by commercial banks and the lodging of money at commercial banks cannot be done in a manner that is safe enough for most depositors without state backing: i.e. taxpayer funded subsidies. Subsidies do not make economic sense. Ergo the creation of money by commercial banks and the lodging of money which is supposed to be totally safe at commercial banks do not make economic sense.

There is no reason banks shouldn’t act as intermediaries between lenders and borrowers, but deposits (that is money which people want to be totally safe) should be lodged with the state. There is also no reason private banks cannot act as agents for the state there: i.e. accept deposits and pass relevant monies on the state, or central bank. 

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Commercial banks both create money and lodge money for depositors. For more details on money creation by commercial banks see this Bank of England publication, the opening sentences in particular.

Money is a liability of a bank. And, it’s a liability which is fixed in value (inflation apart). That’s  in contrast to shares, houses, second hand cars etc , all of which can fluctuate substantially in value.

Incidentally and in objection to the above claim that money is a liability of a bank,  it can be argued that base money is not really a liability a CENTRAL bank. There’s something in that objection, but that point is peripheral to the central argument here. So I’ll give a not entirely adequate answer to that objection and point out that base money appears on the liability side of central banks’ balance sheets).

Anyway, returning to COMMERCIAL banks (henceforth just “banks”), the above “fixed in value liability” of banks is a farce in that if the bank goes bust, it may not be able to meet the liability: that is, it may not be able to repay depositors in full, or may not be able to repay them at all. Think Cyprus. Or as Prof Adam Levitin put in in the first sentence of the abstract of a paper of his, “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and re-lending of deposits.”

So to solve that problem we have government or “the state” stand behind banks. But that equals a subsidy of banks and it is widely accepted in economics that subsidies do not make sense, unless there is a very good social reason for the subsidy, as is probably the case for example with education for kids.

So it would seem that the creation of money by banks and the lodging of money by depositors at banks does not make economic sense.


Is  FDIC an escape from that argument?

The only possible escape from that conclusion is thus. Deposits can possibly be made safe by some sort of FDIC type self-funding insurance system. And as long as that is genuinely self-funding, then no subsidy is involved.

And as to preventing a collapse of the entire bank system, that can be done via lender of last resort (LLR). As long as LLR loans are at Walter Bagehot’s “penalty rates”, then that presumably does not amount to a subsidy.

Unfortunately, the latter “FDIC / LLR” argument has numerous problems, as follows.

1. While LLR loans, as just stated, are supposed to be at penalty rates, in practice they aren’t. Exactly what constitutes penalty rates is debatable of course. But as a rough guide, Warren Buffet loaned £5bn to Goldman Sachs at 10% at the height of the crisis. That was a loan between two private sector entities, so presumably 10% was a realistic market price. In contrast, the $13tr or so loaned by the Fed was at nowhere near that rate.

As for deposit insurance, in the UK, that is funded by taxpayers, not by commercial banks.

All in all, the idea that state backing for commercial banks will ever be on a strictly commercial basis is very debatable. Come a crisis and in the heat of the moment, the temptation is to throw near limitless amounts of public money at the problem and at sweetheart rates of interest. And where the AMOUNT involved ($13tr) is about three quarters of US GDP, we are talking a HUGE subsidy.

2. Why should money lenders (aka banks) be saved with public money when they’re in difficulty and not butchers, bakers and candlestick makers?

One apparent answer to that is that if commercial banks collapse, the consequences are more serious than if some other industry suffers a serious setback.

Well that’s actually a circular argument, in the following sense. Banks collapse precisely because they are funded by or lodge deposits. That is, if a bank are funded wholly or largely by equity, it’s near impossible for them to collapse.

That circular argument is a bit like saying that the solution to defective scaffolding round a building is lots of mattresses around the building so that if anyone falls off, they won’t be injured. A much better solution is decent scaffolding including guard-rails which ensure that no one falls off!

3. Having banks funded wholly or largely by equity will not raise the cost of funding banks as compared to funding them wholly or largely via debt (e.g. deposits) and for the following reasons.

Lender / investors demand a return for two reasons. First there’s the fact that they abstain from consuming a chunck of wealth, and instead, let the borrower or “investee” use that wealth. And it’s reasonable to demand a reward for that service.

Second, lender / investors run the risk that the borrower / investee will not repay the loan. And it is reasonable to demand compensation for running that risk.

In the case of depositors who are guaranteed total safety by the state or by an FDIC type system, depositors just perform the “abstain from consumption” service, while the risk of default is carried by taxpayers or the FDIC type system.

In contrast, those with shares in a bank insure themselves. That is, the return they demand includes something in respect of the risk they run.

Now assuming both of the above types of insurers pitch the insurance premium at the right level, then both types of insurer will charge the same rate!


Underestimating the risk.

Moreover, if shareholders understimate the risk and a bank runs into difficulty, there is no subsidy: that is, shareholders take a hair cut regardless of whether they get the insurance premium right or not.

In contrast, if an FDIC type insurer underestimates the risks, the long suffering taxpayer comes to the rescue! And that constitutes a subsidy.

4. If you get someone else to insure you, there is always a temptation to cheat the insurer. That is, there is a temptation to run excessive risks in the knowledge that if the risk does not pay off, the insurer will foot the bill. (10% of car and house insurance claims in the UK involve an element of fraud)

5. Contrary to popular perception, Walter Bagehot did not approve of LLR. In the last chapter of his book “Lombard Street”, he expressed disapproval of it, but said he thought it was so ingrained in the system that it would be too difficult to remove.

 6. A possible objection to having banks funded wholly or largely by shareholders is that when it transpires that bank assets (i.e. loans) are worth considerably less than book value, there will be a significant reduction in lending.

Well the answer to that is: “good thing too”. That is, if any business has over extended itself, that is over estimated the amount it can sell, then a reduction in the size of the industry is exactly what is needed.

In contrast, the whole thrust of LLR and deposit insurance is to get banks back to where they were prior to the credit crunch or bank induced downturn.  For example, with deposit insurance, if one bank lends out depositors’ money and loses the whole lot, no matter: the insurance system reimburses depositors, who then deposit their money at some other bank, which is a temptation for the latter bank to lend that money out.

7. As the former governor of the Bank of England, Mervyn King put it:

“..we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”

In short, a system where banks are funded by equity is more resilient than where they are funded by debt (e.g. deposits).

To paraphrase Mervyn King, under the existing bank system (aka fractional reserve), bank failures can lead to chaos despite the protection allegedly offered by the two backups, LLR and deposit insurance.

However, that “Mervyn King” argument is possibly flawed. That is, it could be argued that the length of the recession that followed the crunch in 2007/8 was primarily down to inadequate fiscal stimulus. In other words, given the right amount of stimulus, it’s arguable that there’s not much difference between the speed of recovery after a crunch where banks are funded mainly by equity, and one where they are funded mainly by debt.

However, I’ve included that Mervyn King point for what it is worth.

8. Once it’s accepted that there should be no state support for private money lenders, those who fund those lenders in effect become shareholders: that’s “shareholder” as in “someone who at worst stands to lose everything”. That is, such a lender can claim to accept deposits, however such deposits in the absence of state backing for banks are clearly more in the nature of shares.

Thus once all forms of state backing for money lenders is removed, those banks then ipso facto have a 100% capital ratio in the broadest sense of the word “capital”,  i.e. banks no longer create or lodge money.