Friday, 4 December 2015

Regulate the asset or liability side of banks’ balance sheets?

Warren Mosler says in this Huffington article, “The hard lesson of banking history is that the liability side of banking is not the place for market discipline.” Normally I agree with Warren, but no this occasion.

First he doesn’t tell us what the “hard lessons” are or whereabouts in history those lessons are.

Second, regulating the asset side is complicated: witness Warren’s own list of ideas for regulating the asset side in the above Huffington article. But if you want REAL complexity, look at Dodd-Frank: it consists of about 10,000 pages and counting.

In contrast, regulating the liability side is simple. One popular form of “liability side” regulation is raising bank capital ratios. The rule “Banks shall have a capital ratio of 25%” (as advocated by Anat Admati and Martin Wolf) is simple enough.

And taking that further, the basic rules of full reserve banking (which involves a 100% capital ratio) can be written on the back of an envelope. They are:

1. Entities accepting deposits which are supposed to be totally safe can only lodge that money at the central bank (and/or perhaps invest in government debt).

2. Those funding money lenders must accept the risk involved in doing that (rather than having the taxpayer carry the risk).

3. Money lenders must offer a variety of types of loan that “lender funders” can fund. I.e. savers must have the choice of putting their money into safe mortgages, NINJA mortgages, small firms, etc.

And that’s it.

A third problem with regulating the asset side is that the obvious way to make banks / lenders safer is to make the nature of the loans they make safer, e.g. insist that mortgagors have some minimum equity stake in their houses.

But doing that rules out risky loans, and some risky loans turn out to be winners: they’re the basis for starting up businesses which subsequently prosper.

So…. why not allow lenders make any loans they want, as long as those funding those loans carry any loss (rather than taxpayers carrying the loss), and as long as lenders are open and honest with funders as to what’s involved?

And what do you know? The above sort of “regulate the liability” side is what’s involved in full reserve banking, at least as per Lawrence Kotlikoff and Positive Money.


  1. Are you confusing assets and liabilities here? You say:
    "One popular form of “liability side” regulation is raising bank capital ratios ... The above sort of “regulate the liability” side is what’s involved in full reserve banking."

    However, a requirement that bank deposits should be 25% or 100% backed by very safe assets or reserves at the CB is a requirement regarding bank ASSETS. It is not a requirement regarding bank liabilities (deposits).

    As you emphasise, the ASSET regulations required for Full Reserve banking are far simpler than those advocated by Mosler, Dodd-Frank, etc.
    Moreover, there would no longer be a need for any of the deposit insurance, lender-of-last resort and bailout facilities advocated by Mosler.

    1. Fair point. Warren Mosler wants to regulate JUST the asset side. Then there’s simply raising capital ratios and leaving it at that, which amounts to regulating just the liability side.

      Then there is full reserve which regulates BOTH sides. At least full reserve consists of saying “if assets have characteristics A,B etc, then liabilities must have characteristics C,D etc.”. I.e. if liabilities are supposed to be totally safe, then assets must be totally safe. And if assets (i.e. loans etc) are liable to fall in value, then it must be possible for liabilities to fall in value as well, that is, those liabilities must consist of shares or similar.

  2. I suspect you were confused by the weird proposals of Positive Money when you first wrote this post.
    Positive Money's proposals would indeed regulate bank LIABILITIES (deposits), as you wrote in this post.

    PM propose regulations to make all bank deposits become liabilities of the Central Bank. Private banks would then be merely be agents of the CB in administering the payments system, so they would not need to have any assets to back up deposits at the CB, and there would be no need for any regulation of their assets to ensure the stability of the payments system.

    In sharp contrast to PM, with Full Reserve banking there would be regulations regarding bank ASSETS to ensure that bank deposits be 100% backed by very safe liquid assets (reserves at the CB or by very safe short-term assets).

    I agree with the comment you made elsewhere that compared with Full Reserve banking the weird proposals of PM would be "unnecessarily bureaucratic".


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