Full reserve puts conventional banking in check mate.

Here’s why.

If government so much as hints that it might rescue banks or depositors, that constitutes a subsidy of banks, and subsidies do not make economic sense. They reduce GDP.

Alternatively, if government explicitly declares it will never ever rescue banks or depositors, then all of those who fund banks, including depositors, effectively become shareholders: that’s shareholders as in “someone who at worst stands to lose everything”.

But that leaves a problem: what about people who want money lodged in a totally safe manner? Well they’re easily catered for by entities, banks, or bank subsidiaries which accept deposits and keep the money in a totally safe manner: i.e. don’t lend it on or invest it, except perhaps lend the money, short term, to government.  (Money market mutual funds in the US that claim depositors’ money is totally safe will soon have to abide by that rule.)

To summarise, those who want total safety can get it, while the bank system is no longer subsidised. GDP should rise as a result. And that all equals full reserve banking.


Can self funding insurance save conventional banking?

However there is what looks like an escape from that check mate position for conventional banking, as follows. If the state saves banks and depositors from possible extinction or ruin via some sort of self funding insurance system (like FDIC in the US), then the conventional arrangement of lending on depositors’ money can be retained, while at the same time no subsidy is involved.

Unfortunately there are problems there, as follows.

1. All forms of insurance involve the temptation to so to speak “cheat the insurer”.  That is, if you can take extra risks and keep the profit when the risk pays off, while passing the bill on to the insurer when they don’t pay off, then you’ll benefit.  Obviously all types of insurers take steps to minimise that problem, but the problem can never be wholly eliminated. (10% of claims in respect of house and car insurance in the UK involve an element of fraud).

So to that extent, the costs of funding a bank just via shareholders (who are in effect “self insurers”) must be lower than funding a bank via depositors who are insured by the state (or some other organisation).

2. If the state insures banks and/or depositors, it’s always possible the state UNDERESTIMATES the suitable premium. In that case we all know who comes to the rescue: the long suffering taxpayer. In contrast, under a “shareholder / self insurance” system, if shareholders underestimate the risks, then those shareholders, not taxpayers pay a penalty. I.e. no subsidy is involved.

3. Re government saving banks as opposed to saving depositors, while lender of last resort loans are supposed to be at penalty or commercial 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 “penalty rate”. 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 a joke. Come a crisis and in the heat of the moment, the temptation is to throw huge amounts of public money at the problem and at sweetheart rates of interest. And where the AMOUNT involved ($13trillion) is about three quarters of US GDP, we are talking a HUGE subsidy.

4. Contrary to popular perception, Walter Bagehot did not approve of lender of last resort loans. 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.


Conclusion.

While it might seem that self-funding insurance can come to the rescue of conventional banking, that idea is badly flawed. So the conclusion is that conventional banking is well and truly in check mate.