Nonsensical conventional wisdom on banking.

Sir John Vickers on the left  (I think) sits under a slide, the heading of which is complete nonsense: that’s the idea that there is a trade-off between growth and risk when it comes to bank regulation.

That trade off APPEARS TO BE the case for an apparently very plausible reason, namely that the lighter is regulation, the more banks will lend and at a lower rate of interest. And of course more bank lending means more demand, all else equal.

The flaw in that argument is that governments have complete control of aggregate demand via stimulus (monetary and or fiscal), thus any fall in demand stemming from less commercial bank activity is easily compensated for via stimulus. Ergo there is no reason for tighter bank regulation to have any effect on demand or numbers employed.

Thus the KEY question is: what’s the OPTIMUM or GDP maximising amount of bank regulation. As I’ve pointed out time and again on this blog, the concept “optimum” seems to be beyond the comprehension of the simple folk who make up much of the economics profession. Certainly a failure to understand that concept would explain falling for the above “trade-off” fallacy.

Well there is a simple and widely accepted principle in economics namely that subsidies do not result in GDP being maximised, and that applies to banks. Thus there is a big problem with the idea that lighter bank regulation raises GDP which is that the lighter the regulation, the more the banking industry has to be backed by, i.e. subsidised by taxpayers. For example, the riskier banks are, the more expensive will deposit insurance be – never mind the half dozen other subsidies that banks get, like the TBTF subsidy.

So…how do we bring about a entirely subsidy free bank industry? Well it’s quite easy: just make sure that banks and those who have any sort of relationship with banks carry the full costs of bank failures when they occur, rather than have taxpayers foot the bill.

And that’s easily done by stipulating that anyone who wants to have a bank lend on their money with a view to earning interest carries the cost when those loans go wrong. After all, anyone who wants their money lending out is into commerce, and IT IS A WIDELY ACCEPTED PRINCIPLE THAT IS IS NOT THE JOB OF TAXPAYERS TO STAND BEHIND COMMERCIAL TRANSACTIONS.

In short, having banks fund loans via deposits is plain straightforward fraud. It involves telling depositors their money is totally safe, when the mere fact of lending it on by its very nature means that money IS NOT SAFE.

Ergo loans should be funded via equity or similar. And having done that, there is no need for deposit insurance because banks do not promise equity holders they’ll get $X back for every $X placed with the bank.

Taxpayers do not stand behind people who start up a small business or who invest in the stock exchange. There is no reason for taxpayers to stand behind a slightly different form of commercial activity: having a bank lend on your money.