Adair Turner’s main objection to full reserve banking.

Chapter 12 of Turner’s recently published book, “Between Debt and the Devil” claims that full reserve banking (FR) is flawed. I dealt with what I think are some weaknesses in Turner’s criticisms of FR here yesterday.

What he calls his “most fundamental” reservation about FR is that “..there may be some positive benefits to private rather than public creation of purchasing power.”

He continues, “..it could still be true that not only debt contracts but also banks can play a useful role in mobilizing capital investment that would not otherwise occur.”

Well the answer to that is that under FR, banks “mobilize capital investment” just as they do under the existing system. That is, under FR, banks collect the savings of millions of savers and lend them out to borrowers. All that changes is the EXACT WAY banks do that job.


Maturity transformation.

Turner’s next sentence reads, “Maturity-transforming banks enable long-term investments to be funded with short-term savings: that might seem like an illusion, a sort of confidence trick, but it may be a useful one. Inevitably it creates instability risks, but some instability may be the inevitable and reasonable price to pay to gain the benefits of investment mobilization and thus economic growth.”

Well there is more than one flaw in that sentence. First, if by “investment” Turner means industrial and commercial investment, the bulk of that is funded by equity and bonds. I.e. bank loans play a relatively small part, at least in the UK.

Second, maturity transformation (i.e. “borrow short and lend long”) is a mirage, and for the following reasons.

Assume an economy where maturity transformation (MT) is not allowed, and assume the economy is at capacity, i.e. at the full employment level.

You might think that where MT is banned, private money creation is necessarily also banned or at least severely curtailed, and hence the economy couldn’t possibly attain full employment. In fact if private banks don’t issue enough money, central banks can easily issue whatever amount of money is needed to keep the economy at full employment. Indeed, as Robert Mugabe so ably demonstrated, the state or central banks can take that process too far and cause hyperinflation.

Also assume that in our hypothetical economy, everyone has the assortment of assets they want, liquid and illiquid assets in particular.  Next, assume the law on banking is changed and MT is allowed. The effect will be to turn a proportion of savers’ relatively ILLIQUID assets into much more liquid assets, if not into actual money.

But that will cause savers to try to spend away their surplus stock of money / liquid assets. Thus demand rises. But a rise in demand is not permissible because the economy is already at capacity. Thus government will need to raise taxes and confiscate a proportion of the private sector’s stock of cash, or impose some other deflationary measure. In short, little or no extra investment spending takes place!


Subsidies.

Another problem with Turner’s theory has to do with the “instability” to which he refers. As he rightly says, MT involves risks. And how have we dealt with that risk (at least in the UK over recent decades)? Well government, out of the kindness of its heart (i.e. the long suffering taxpayer) has had to foot the bill when banks collapse. In short, any extra investment that may have come about as a result of MT has been gratis a SUBSIDY. And subsidies not make economic sense (except where there is a good social case for them, as there doubtless is in the case for example of kid’s education).

In short, subsidies reduce GDP, thus the idea that “MT plus subsidies” promotes growth is very questionable.


FDIC type insurance.

Of course instead of blatant subsidies, depositors can be safeguarded by some sort of FDIC type insurance. And assuming that’s on a self-funding or commercially viable basis, then there is no subsidy.

But that idea has weaknesses as well which I dealt with in detail here. One weakness is that if bank shareholders and the FDIC insurer both gauge the risk correctly, they’ll charge the same for bearing the risk. Thus in theory there shouldn’t be any difference as between funding a bank by depositors protected by FDIC type insurance on the one hand, and via shareholders on the other. (A bank funded just by shareholders does not of course do any MT).

Incidentally, I was using the word “shareholder” in a loose sense just above. That is, under some versions of FR, those who want their money to be loaned on would buy into a unit trust / mutual fund of their choice. But mutual fund stakeholders are effectively shareholders.

Another problem with FDIC type insurance which a “shareholder funded” bank (i.e. an FR bank) does not have: it’s that bankers will never stop lobbying politicians to have the state insure banks at an unrealistically cheap rate. To date (as pointed out above), bankers have been very successful in that regard.

Yet another problem is that if you are insured by some FDIC type third party rather than going for self-insurance as per FR, there’s a temptation to take excessive risk and keep the profits when that works, and in the knowledge that the insurer will foot the bill when the risks don’t work out. And that phenomenon partly explained the 2007/8 crisis.


Conclusion.

The pros and cons of MT are complicated. Turner’s analysis is too simple. The analysis in the above paragraphs is hopefully better, and those paragraphs indicate that the merits of MT are largely or entirely an illusion.