Warren Mosler’s bank reform ideas.

Introduction.

Warren Mosler produced some ideas for bank reform in a Huffington article in 2011. Title of the article is “Proposals for the banking system.”

While I agree with many of WM’s ideas (e.g. I support MMT which I think he founded), I’m not sure about his ideas on bank reform. The basic weakness in his proposals is that they amount to a subsidy of private banks. For example he argues that deposit insurance should be funded by taxpayers, not as at present, by commercial banks. (Incidentally WM spent much of his career working in the financial sector, so that may help explain his sympathetic attitude to that sector.)


Deposit  insurance.

Anyway, the first paragraph reads, “U.S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. Hence most of the world’s banking systems include some form of government deposit insurance, as well as a central bank standing by to loan to its member banks.”

The second half of that para suggests that the purpose of deposit insurance is to ensure borrowers’ access to credit is not interrupted. In fact the basic purpose of deposit insurance is as per the description on the tin: it’s to insure deposits.

Indeed the failure of one or two small or medium size banks would not seriously interrupt borrowers’ access to credit: they can simply apply to other banks for loans. Obviously if the bank you normally deal with gets into trouble that may involve a finite interruption to your access to credit, but other banks are not going to turn you away when you apply for credit: no bank or any other business turns down extra sales.

In contrast, there is the possibility of the entire bank system collapsing, as seemed likely in the recent crisis. That clearly would interrupt borrowers’ access to credit. But that problem is not dealt with via deposit insurance in the normal sense of the word: it’s dealt with by central bank “lender of last resort” facilities (mentioned in WM’s above para).

Now the big problem with last resort loans is that while such loans are supposed to be at Walter Bagehot’s famous “penalty rate”, in the real world (no doubt party due to political pressure and bribes paid by banksters to politicians) the actual rate is a sweetheart rate, to put it mildly. The actual rate for the hundreds of billions worth of loans made by the Fed to banks in the recent crisis was near enough zero, which is a MONSTER subsidy for private banks. As it explains in the introductory economics text books, GDP is not maximised where an industry is subsidised, unless there is a good social case for a subsidy, as there is for example in the case of kid’s education.

WM returns to the question as to how to treat large banks in trouble later in his article. I’m dealing with his points in the order in which they appear in his article, so I’ll deal with his other points about large banks in trouble a few paragraphs hence.


100% reserves.

WM’s next para contains a slight mistake where it says “No bank can operate with 100% reserves.” Well that depends on your definition of the word “bank”. If you mean an institution which funds loans via deposits, then WM is correct. On the other hand there is such a thing as “100% reserve banking” (advocated by Milton Friedman and others). Under that system, deposits are all lodged at the central bank, while loans are funded via equity. (That’s “deposits” in the sense of: “money which is supposed to be totally safe”.)

A few sentences later, WM says “The hard lesson of banking history is that the liability side of banking is not the place for market discipline. Therefore, with banks funded without limit by government insured deposits and loans from the central bank, discipline is entirely on the asset side.”

Well the first problem with that idea is that WM does not provide any actual examples of “discipline” being imposed via the liability side and that being a disaster. Moreover, every bank regulator in the World far as I can see believes that some regulation of the liability side of banks’ balance sheets is justified: for example all recent attempts to re-jig bank regulations involve increasing banks’ capital ratios, or at least discuss the possibility of increasing those ratios.


Eight restrictions.

Next, WM lists eight restrictions which he thinks should be imposed on banks, some of which I like and some not. For example he opposes “off balance sheet” stuff and quite right: the purpose of a balance sheet is to give an accurate picture of a corporation’s assets and liabilities at some point in time. Thus off balance sheet items are plain simple deception, far as I can see. I gather off balance sheet stuff is virtually banned in Spain.

In contrast, restriction No.5 is that US banks should not be allowed to lend offshore. That’s a strange idea: banking is very much an international business.

But more important than the merits of individual restrictions suggested by WM is the point that all these restrictions amount to a move in the direction of full reserve banking. Reasons are thus.

Under full reserve (or 100% reserves as Milton Friedman called it), entities which accept deposits cannot take any risks at all with those deposits: an idea which is entirely logical. A deposit is supposed to be totally safe, but that is plain incompatible with lending on deposited money because loaned out money is NEVER entirely safe.

As to risky activities under full reserve, those are funded via equity. Now WM is saying that entities funded by deposits or mainly via deposits should not be allowed to engage in sundry risky activities. That in turn means that those activities will inevitably be funded by other entities which are funded via equity.

So why not go the whole hog and just ban entities funded via deposits from all risky activities? Well the standard answer to that given by supporters of the existing bank system is that that ban would reduce the amount of credit creation: i.e. reduce the amount of money created by commercial banks. But there’s a simple answer to that: have the state supply whatever amount of money is needed to lubricate the economy, which is a job the state (i.e. central bank plus government) already does to some extent. (Roughly 10% of the money supply is currently central bank rather than commercial bank issued money.)

Moreover, as I explain here, the right that commercial banks to fund loans via deposits actually amounts to letting them print or “create” money, and that’s a subsidy of commercial / private banks. (My article is entitled “Taxpayers subsidise private money creation.” (Journal of Economics Bibliography).


Proposals for the FDIC.

The next section of WM’s article is entitled as above, i.e. “Proposals for the FDIC” and it consists of three items.

Item No.2 is odd: WM argues that deposit insurance should not be charged to banks, i.e. he claims that taxpayers in general should fund deposit insurance. There again, I imagine every bank regulator in the world disagrees with that idea.

In short, having taxpayers fund deposit insurance is a blatant subsidy of the bank industry. The shipping industry carries the cost of insuring its ships. Banks should act likewise.


Proposals for the Federal Reserve.

Under the heading “Proposals for the Federal Reserve”, WM says:

“The Fed should lend unsecured to member banks, and in unlimited quantities at its target fed funds rate, by simply trading in the fed funds market. There is no reason to do otherwise. Currently the Fed will only loan to its banks on a fully collateralized basis. However, this is both redundant and disruptive. The Fed demanding collateral when it lends is redundant because all bank assets are already fully regulated by Federal regulators.”

Well the first problem there is the latter sentence: if bank assets really were “fully regulated”, no bank would every make silly loans I assume (thought that depends on exactly what “fully regulated” means).

As to the idea that the Fed should lend at the Fed funds rate, the problem there is that that rate is a sweetheart rate given that the corporations doing the borrowing are in trouble. (Banks themselves charge relatively high rates to any customer which appears to be in  trouble, and quite right.)

For an idea of what would constitute a realistic free market rate for a large loan to a large bank during the recent crisis we need look no further than the $5bn loan made by Warren Buffet to Goldman Sachs in September 2008. The loan involved an interest rate of 10%. In contrast, the Fed funds rate at that date was around 2% and sank to 0% shortly afterwards. To put it mildly, there’s a bit of a difference there!

WM also claims banks should not have to provide collateral in exchange for such loans. In contrast Warren Buffet (as you’d expect) did demand collateral. To summarise, we seem to have three options here. First the ultra-generous treatment of banks advocated by WM. Second, there’s the less generous treatment actually implemented by the Fed during the recent crisis. Third, there is what might be called the “brutal free market” treatment advocated by Walter Bagehot and Warren Buffet.

To repeat, the standard view in economics is that market forces should prevail, unless there are very clear reasons for thinking otherwise. And certainly in the case of large banks, there appears to be a good “reason for thinking otherwise”, namely that if large banks are given the “Buffet” treatment during a crisis, that may drive banks to insolvency.

However that insolvency only arises because of the basic nature of the existing bank system, sometimes called fractional reserve banking. That system allows commercial banks to use debt (deposits and bonds) to fund loans. And that is simply asking for trouble: it involves having liabilities that are fixed in value combined with assets (i.e. loans) which can fall dramatically in value when it turns out that silly loans have been made.

The attraction of using debt to fund a bank (or indeed any business) is that debt holders demand a slightly smaller return on their money than shareholders. But if the corollary is that taxpayers have to rescue large banks periodically, then in effect we have a system where banks are allowed to reap extra profits by taking extra risks, while the taxpayer picks up the pieces when the risks do not pay off. That is a nonsensical arrangement.

A better system is one where banks have to use equity to fund loans: that way it’s impossible for banks to go insolvent. I.e. if a bank makes silly loans and it turns out the value of those loans is only say 80% of book value, all that happens is that the value of the equity falls to about 80% of book value. That bank does not go bust.

At the same time, depositors who want their money to be totally safe are offered accounts where relevant monies really are totally safe: the money is simply lodged with the central bank or government. And that is the 100% reserve system advocated by Milton Friedman and others.

That system may well mean interest rates rise, but assuming they rise to a genuine free market level, then GDP ought to be higher at that higher rate than at the ultra-low rates that have prevailed for the last decade. And as for any deflationary effect of higher interest rates, that is easily dealt with by running a larger deficit.

And finally, low interest rates are not an unmixed blessing. Low rates mean more loans and hence more debt: and every socially concerned do-gooder has been complaining about the excessive amount of debt for the last five years or so. Plus low rates tend to encourage bubbles.