Friday, 11 March 2016

Full reserve banking is almost a panacea.

According to the Modigliani Miller theory, raising a bank’s capital ratio – even to 100% - should have no effect on the cost of funding the bank. MM has been criticised, but far as I can see, the criticisms don’t amount to much. See under “Flawed Criticisms of Modigliani Miller” here.

However, one possible reason why bank capital might be expensive is that banks allow clever clever traders (often as not in their twenties) to risk the bank’s solvency by using shareholders’ money to make silly derivative bets. That is, bank shareholders never quite know when the value of their shares will suddenly halve in value or even become worthless. That being the case, potential shareholders will want a significant return for the risk they run.

That problem is automatically solved by full reserve banking, because under FR banking, or at least most versions of it, bank shareholders have a CHOICE as to how their money is used. That is, those who simply want to fund conservative mortgages and have nothing to do with derivatives can do so, while those who want to fund clever clever stuff like NINJA mortgages (with derivatives mixed in for good measure perhaps) can do so. And if they lose their money, why should we care?

The net result would probably be lower mortgage costs for responsible mortgagors, and higher mortgage costs for risk takers, and quite right.

But of course that’s not what banks want at all: what they want (to repeat) is the freedom to use grandma’s savings and taxpayers’ money to gamble in casinos; and keep the profit when that works and send the bill to the taxpayer when it doesn’t.

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