Bundesbank criticises 100% reserve banking.

That’s in an annex starting on p.30 of a Bundesbank article entitled “The role of banks, non-banks and the central bank in the money creation process.”

The article starts by explaining a point set out in a Bank of England article recently namely that money is created when a commercial bank grants a loan. I.e. “loans create deposits” as the saying goes.

Then in the above mentioned annex, the Bundesbank article criticises 100% reserve banking. One of the first points made is that the existing bank system involves economies of scale. It is not entirely clear whether that is supposed to be a criticism of 100% reserves: i.e. it is not clear whether the implication is supposed to be that 100% reserves DOES NOT involve economies of scale. As the article puts it:

“Lending business involves reviewing loan requests, granting the actual loans and, given the information asymmetries that exist between the lender and the borrower, requires monitoring of the projects being funded through the loans. In performing this monitoring task, banks have one particular advantage in that they harness economies of scale and so reduce the monitoring costs.”

But if the latter point is indeed supposed to be a criticism of 100% reserves, then the simple answer is that 100% reserves involves what might be called “large lending organisations” in much the same way as the existing bank system involves such large organisations. Thus there is no loss of economies of scale under 100% reserves. Alternatively if anyone thinks it is worthwhile setting up a small local “lending organisation” under 100% reserve, then the obstacles to doing so are no more under 100% reserves than under the existing system.


Maturity transformation.

The Bundesbank article then praises an apparent merit of the existing bank system, a merit that would not exist under 100% reserves, which is that under the existing system banks can borrow short and lend long or engage in “maturity transformation” as it is called. As the Bundesbank puts it:

“By making sight deposits available while “simultaneously” investing in illiquid projects, banks provide a maturity transformation service. They create liquidity and give depositors the ability to consume intertemporally, whenever they want to.”

Unfortunately the advantages of maturity transformation (MT) are illusory, as I have explained before, e.g. here and here.

But I’ll repeat and summarise the argument against MT.

As the Bundesbank rightly points out, MT “liquifies” (to coin a phrase) relatively illiquid assets. That is, it turns an illiquid investment or asset into money or near money, which all else equal is convenient for the asset holder.

So if MT is banned, the initial effect is deflationary, as the Bundesbank implies, because the private sector then has a smaller stock of money or “near money liquid assets”. But the latter problem is easily dealt with by having government and the central bank print money and spend it into the private sector until the private sector again has the stock of money that induces it to spend at a rate that keeps the economy at capacity. And doing that costs nothing in real terms. As Milton Friedman put it, "It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances."


Bank runs and credit crunches.

Then, in reference to the alleged advantages of MT, the Bundesbank says:

“However, this advantage is offset by the risk of a liquidity problem arising in the event that a bank cannot meet demands to repay deposits. If more depositors than anticipated withdraw their sight deposits – not because they need liquidity unexpectedly but because they fear that other depositors may withdraw their money and cause the bank to collapse – this form of coordination among consumers can trigger a run on banks.”

That’s a good point. Indeed, Messers Diamond and Rajan make much the same point in their paper “Liquidity risk, liquidity creation and financial fragility: a theory of banking.”.

As D & R put it in their abstract and in reference to the liquidity creating characteristics of banks under the existing bank system, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”

So to summarise, what does MT achieve on balance? The answer is “absolutely nothing”. Or to be more accurate, it creates liquidity / money but at the expense of bank runs, credit crunches etc, when liquidity / money can perfectly well be created in whatever amount is needed to keep the economy working at capacity at zero cost and without incurring the risk of bank runs!

Maturity transformation is a farce!


The net effect of 100% reserves on lending.

The next criticism the Bundesbank makes of 100% reserves is that it does not increase lending by banks. For example on p.32 the article says, “The stricter the regulatory requirements regarding the collateral framework are, the likelier it is that a reserve ratio hike to 100% will be accompanied by a corresponding tightening of the provision of credit and liquidity.”

Well the answer to that is that 100% reserves certainly makes lending a bit more difficult for banks, as indeed the UK’s Vickers commission pointed out (sections 3.20-3.21). I.e. speaking as an advocate of 100% reserve, I have never claimed that it increases bank lending, and far as I can see, same applies to other advocates of 100% reserve, though obviously I cannot claim to have read every single sentence ever written on the subject.

But to claim that increased bank lending is necessarily beneficial is to assume that the existing amount of lending is sub-optimal. Well the first point that casts doubt on that claim is the popular idea that the total amount of private debt is excessive. Indeed, all too often people in high places claim that bank lending needs to be increased, and then in the next sentence or shortly after that, the same self-appointed experts claim private debts are excessive. If those self-appointed experts cannot see the glaring self-contradiction there, they should stop expressing opinions on the subject.

As to exactly what the optimum amount of bank lending is, and what the optimum rate of interest is, I argued for a very conventional answer to that question in this article, namely that the optimum is attained in the same way as the optimum amount of apple or steel production is attained: market forces. More specifically the argument in the latter article is that 100% reserves actually amounts to a free market or something nearer a free market than the existing bank system. The title of that article is “Privately Issued Money Reduces GDP”.

Unfortunately, as I’ve pointed out several times before on this blog, the concept “optimum” seems to be too difficult for many self-appointed experts in high places.


Macroeconomic stabilisation.

The final page of the annex in the Bundesbank article claims that 100% reserve would not bring macroeconomic stabilisation. Well certainly the advocates of 100% reserves have never claimed it would bring perfect stabilisation. For example this work entitled “Towards a twenty-first century banking and monetary system” which advocates 100% reserves, makes it perfectly clear that varying degrees of stimulus and “anti-stimulus” would be needed under 100% reserve, just as they are at present.

However, there is one way in which 100% reserves brings a HUGE increase in stability not mentioned by the Bundesbank, and that is that bank failures are all but impossible under 100% reserve. The reason is thus.

Under 100% reserve, the bank industry is split in two. One half accepts deposits but does not lend on those deposits because they are lodged in a totally safe manner at the central bank. That is eminently logical and (unlike the existing system) totally honest. Reason is that a bank deposit is supposed to be totally safe. That is plain incompatible with lending on relevant monies, because borrowers are not totally reliable.

So that half of the bank industry cannot fail.

The other half of the bank industry lends, but is funded by equity or something similar, e.g. bonds that can be bailed in. That half of the industry cannot fail either. Reason is that if loans made turn out to be worth say only half of book value, then all that happens is that shares in the bank approximately halve in value: the bank does not go insolvent.


 Shadow banks.

One of the final criticisms of 100% reserves made by the Bundesbank is one that has been made many times before, and rebutted an approximately equal number of times. That is the claim that if money creation by commercial banks is banned (i.e if MT is banned) small organisations, shadow banks perhaps, will spring up to exploit the newly available gap in the market. As the Bundesbank article puts it, “Moreover, there is a risk of evasive action being taken in that new, non-regulated institutions could be set up to fill the gap.”

Well one answer to that point was given by Adair Turner, former head of the UK’s Financial Services Authority. As he put it, “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards.”

Much the same applies for example when it comes to safety rules in the construction industry. It does not matter whether a construction firm employs three or three thousand people: all construction firms have to obey the same safety rules.

Second, the idea that banks, small or large will try to evade regulations is not exactly an original observation: it makes no difference what banking laws are put in place, one thing is 100% certain and that is that banks will try to evade those laws. But the big merit there of 100% reserves is the extreme simplicity of the laws or rules. Simple laws are relatively easy to enforce. The basic rules of 100% reserves can be written on the back of a small envelope, unlike Dodd-Frank which occupies a good ten thousand pages. The basic rules are:

1. Loans can only be funded via equity or similar. 2. Deposits must be lodged in a totally safe manner. That’s it!

Third, it is not easy for very small banks to create money or near money. If you were offered a cheque drawn on a bank you’d never heard of, would you accept it? Probably not. Thus if for example the hundred largest banks (regular banks and shadow banks) in a medium or large country are forced to obey the rules of 100% reserve, that probably solves the problem. A few small banks or quasi banks trying to evade the rules is unlikely to be a significant problem.