Wednesday, 10 August 2016

Admati and Hellwig criticise full reserve / narrow banking.

I criticised part of an article by Admati & Hellwig a day or two ago. This present article criticises another part of the same article of theirs.

A&H’s article is entitled “The Parade of the Bankers’ New Clothes Continues:  31 Flawed Claims Debunked”. Their criticism of the full reserve banking (FR) comes in TWO sections, Nos 26 & 27.

No.26 refers specifically to “narrow banking”, while 27 refers to FR or something very close to what is normally understood by the phrase FR. In fact the two amount to the same thing. The only difference is that narrow banking BY IMPLICATION leaves lending to entities that are funded by equity, whereas FR EXPLICITLY does that. Thus I’ll treat the two as the same thing.

What A&H describe as “Flawed claim No.26” is thus.

“The  best  way  to  make  banking  safer  is  to  require  banks  to  put  funds  from  deposits into reserves of central bank money or Treasury Bills (so-called narrow banking or the Chicago Plan for 100% reserve banking). Narrow banking will give us a stable financial system, and there would be less need to impose equity requirements.”

As to what’s wrong with the latter claim, A&H start their explanation by saying:

“What’s wrong with this claim? Requiring banks to put all funds into cash or Treasury Bills will make these banks safer but the financial system as a whole may become less efficient and/or less safe.”

Well it’s quite untrue to say that under FR, “all funds” go into cash or Treasury Bills. The reality is (as mentioned above) that bank customers / depositors have the CHOICE of putting their money in to ultra safe stuff like Treasury Bills, or if they want something more risky, that’s up to them.

As for the “less efficient and/or less safe” claim, the authors make no attempt to substantiate that claim, so that’s not much use.

 A&H continue:

“If  final  investors  maintain  current  funding  patterns,  banks  will  provide  a  lot  of  funding  to  the  government;  which  may  well  come  at  the  expense  of  funding  of  nonfinancial  firms.  The  experience of southern European countries in the decades before 1990 shows such crowding out of  private  borrowing  by  government  borrowing  can  have  substantial  negative  effects  on  economic growth.”

So what makes A&H think that most bank depositors given the choice between the above safe but low interest option and the riskier but higher interest yielding option will mainly choose the first? A&H provide no evidence.

However, there is actually some very clear evidence. In the case of money market mutual funds in the US which are currently being forced to obey the rules of FR, depositors are mainly opting for the safer option, as it happens. So A&H are right there, but because of good luck rather than good management I suggest. However, that doesn’t get their argument very far.

First, by way of trying to back up their claim about “experience of southern Europe”, they cite a work I cannot find. The citation is “Camina l et al., and Borges in Dermine (1990)”.

Second, the broad claim that more government borrowing suppresses growth clearly does not hold water if government borrowing funds relatively productive infrastructure or other investments.

As I’ve pointed out before on this blog, government funded infrastructure investments should compete on equal terms with privately funded infrastructure investments: i.e. there should be a realistic chance of investors losing their money (as happened with the English / French channel tunnel). And if that’s the case, then there shouldn’t be any sort of artificial preference for non-viable public investments where funders are safe because they are backed by taxpayers.

Put another way, if government is offering totally safe bonds which fund non-viable investments, and which pay a decent rate of interest, and those bonds are safe only because of entirely artificial taxpayer support, that’s an obvious fiddle or distortion. I.e. government is making a “too good to be true” offer, and it’s hardly the fault of FR if everyone makes a dash for that too good to be true offer.

A&H continue:

“More  likely,  narrow  banking  would  lead  investors  to  put  substantially  more  of  their  money  in    other  institutions,  for  example  money  market    funds (MMMFs)  which  are  “bank-like”  without  being    subjected  to  the  same  regulation  as  banks.  As we  have  seen    in  the  weeks  after  the  Lehman    bankruptcy, such institutions can also be subject to   runs and can be a major source of systemic  risk. Financial instability would merely shift from   banks to those “bank-like” institutions.”

Well as already intimated, the authors don’t seem to have caught up with the fact that (at least in the US), MMMFs are being made to obey the rules of FR.

As for the idea that savers would try to get their savings into entities which are “bank like”, but which manage to evade bank regulations, the solution to that, as pointed out by the former head of the UK’s Financial Services Authority, Adair Turner, is to apply the same regulations to ANY ENTITY which is effectively a bank.

Garages have to obey regulations. If a small firm claims not to be a garage, when it is quite clearly repairing cars, selling used cars and so on, that does not cut any ice with garage regulators, and quite right.

Moreover, much the same problem applies to A&H’s preferred solution to bank problems: much higher capital requirements. That is, if the latter were imposed on banks, do doubt numerous small “bank-like” entities would try to evade the rules.

Of course the authorities will never keep tabs on every small shadow bank, but that doesn’t really matter. One reason is that one of the main aims of FR is to bar private money creation, and money is by definition anything which is widely accepted in payment for goods and services. And the liabilities of a SMALL shadow bank are not “widely accepted”.

Flawed claim No. 27

A&H’s flawed claim No.27 is:

“The  financial  system  would  be  safe  if banks  are  subject to  a  100%  reserve  requirement  so  they  can  take  no  risk  with  depositors'  money,  while  non-bank  financial  institutions are entirely prohibited from borrowing.”

In the first paragraph after setting out the latter claim (p.28) the authors claim that under FR, where someone wants a larger than normal dollop of cash, they’d have to sell mutual fund units, and the value of those units might not be entirely clear if there is not a ready market in them. Well there are several flaws in that argument, as follows.

1. In the US and other large / medium size countries ALREADY HAVE HUNDREDS of mutual funds, and the mutual fund industry seems to work very smoothly. Certainly mutual funds do not go insolvent, like banks do. Plus those investing in them do not seem too bothered by the fact that when cashing in their fund units, what they get in cash terms is not entirely predictable.

2. As for the fact that there is not a ready market when it comes to a relatively small fund, well that’s a problem with which the mutual fund industry already copes with perfectly OK. Indeed much the same goes for shares in a small firm where there is not a ready market in its shares. But somehow or other that doesn’t stop smallish firms issuing shares.

3. The idea that people should be GUARANTEED to get their money back when they have a bank lend on their money sounds wonderful. But someone, somewhere is accepting the risk that that money goes West. And we all know who that “generous risk acceptor” is: it’s the taxpayer!!!

4. A&H’s claim, “Trading in stock markets exposes individuals who need to trade for liquidity reasons to losses from better-informed investors.”
Well that’s a problem already with the entire stock market and mutual fund industry. It’s also a problem in the used car industry and with housing. If that is indeed a problem, it’s a problem of astronomical proportions. I.E., the world is awash with instances of the “better informed” outsmarting the less well informed, whether it’s in the used car market, or any other market. But for some reason no one seems too bothered by the fact that the “better informed” manage outsmart others in almost EVERY human activity.

5. Even under the existing system, anyone with a sudden and large need for cash faces a problem. One option for them is to sell assets, which as A&H rightly say may mean selling at a loss. Another option is to borrow. In the case of the less credit-worthy that often means recourse to payday lenders who charge extortionate rates of interest. As to those who ARE credit-worthy, and who can borrow from regular banks, bank managers take a dim view of people who suddenly turn up saying they have an unforeseen need for cash. Those sort of people are normally charged high rates of interest.

6. Under FR, people are free, as they are under the existing system, to hold a relatively large stock of cash so as to deal with “rainy days”. Indeed, that’s the so called “precautionary” motive for holding cash referred to in most introductory economics textbooks.

Summarising so far.

To summarise so far, A&H list various ADVANTAGES of funding banks via debt, but they do not consider some of the costs (particularly the costs to taxpayers) of those advantages. So how do we know which system is overall the best? Well there’s a widely accepted principle in economics that gives the answer there.

It’s the principle that subsidies do not make sense, i.e. subsidies distort the market and reduce GDP, unless there is a very good SOCIAL reason for a subsidy (or indeed for a tax). Think kid’s education and alcoholic drinks respectively.

Briefly, a bank which is funded to any extent by debt is a bank that is able to print or create money. And the freedom to create money is clearly a subsidy: the most obvious case being a backstreet counterfeiter who prints inherently worthless bits of paper and uses them to purchase goods and services of real value. The counterfeiter is being subsidised by the community as a whole.

Private banks which create/print money do not of course do exactly the same thing as backstreet counterfeiters: banks LEND their money rather than buy stuff with it. Nevertheless if you are a money lender and are able to print some of the money you lend out, that’s a nice little boost or subsidy for your business.

Certainly, to the extent that you don’t need to pay interest on the money you print (and people do not get interest on £10 notes and $100 bills), you are being subsidised by the community at large.


  1. "So what makes A&H think that most bank depositors given the choice between the above safe but low interest option and the riskier but higher interest yielding option will mainly choose the first?"

    What work has been done on determining the extent to which people will choose the different options. Surely this is vital in determining the scale of the macro effects of FR which need to make up any coherent policy proposal on the subject.

    Will it be deflationary to the extent that the government can spend £100bn a year or printed money or would the effects be much weaker?

    1. Yes, it’s an important point, but the net effect on demand will be zero (as both you and I suggest above) if government simply compensates by printing and spending enough money (and/or cutting taxes). In contrast, there would be a very definite net effect on the proportion of private sector investment funded out of each household and each firm’s own resources as compared to funding via borrowing. That is, under FR, interest rates are higher, but to compensate, each household and firm has a larger stock of money, and thus needs to borrow less.


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