Wednesday, 6 July 2011

Should retail banks be ring-fenced?

The UK’s Independent Banking Commission Interim Report suggests ring-fencing retail banks. I suggest that instead of dividing banks into different types and putting a fence between them, the fence should be between ACCOUNTS which are government backed and supposed to be 100% safe, and in contrast, ACCOUNTS where the relevant money is used for commercial purposes.

There is a fundamental principle that has been broken in the banking system for many years, and which helps explain the horrendous costs of the recent bank bail outs. This is that money in deposit accounts that is government backed and which are supposed to be 100% safe have been used for commercial purposes. This is wrong because it is not the job of taxpayers to subsidise commercial activity.

Put another way, such accounts should be “full reserve”, that is, fully backed by monetary base or government securities.

Thus the “fence” needs to be put between, 1, 100% safe / non-commercial accounts, and 2, all other accounts.

To put the fence between retail and commercial INSTITUTIONS almost seems to imply that retail customers should not engage in commercial activities, which is obviously not true: millions of retail customers engage in blatantly commercial activity like making stock market investments.

Moreover, there is no reason why a retail customer should not put their money into a relatively risky deposit account.

Plus there is no reason why a commercial entity should not put its money into a 100% safe account. This WOULD amount to subsidising the commercial entity IF the 100% safe account system as a whole was subsidised. But there is no good reason for the latter subsidy.

The subsidy.

There might seem to be a contradiction between the latter claim that the 100% safe system should not be subsidised and the claim a few paragraphs above that using 100% safe deposit account money for commercial purposes amounts to a subsidy of commerce. The two statements are however compatible for the following reasons.

Where 100% safe deposit account money is used for commercial purposes, government will periodically have to come to the rescue when the “commerce” goes wrong, thus there is definitely a subsidy involved here. In contrast, where 100% safe deposit account money is invested in government securities and the like, government/taxpayers will scarcely ever have to come to the rescue. Thus little or no subsidy would be involved.


Given that the contents of 100% safe accounts are invested in interest earning government securities, it is POSSIBLE that those putting money into such accounts could be rewarded with some interest. But it is equally possible that the costs of the 100% safe system would exceed the interest earned from government securities: in which case depositors would get no interest AND, worse still from their point of view, might have to pay periodic bank charges.

Now, is this “fair” on small depositors? The answer is “yes”, and because while it is no doubt a basic human right that small retail depositors should have available to them some form of 100% safe saving account, there is no reason why taxpayers in general should subsidise those wanting to save (unless it can be shown that there is market failure in this area, i.e. that the total amount of saving is less than optimum).

To summarise so far, the important distinction is between accounts which are supposed to be 100% safe and which will probably earn little or no interest, and on the other hand, accounts where the account holder is made fully aware that their money will be used for commercial purposes thus rendering the account less than 100% safe. Since banks can use the money from the latter accounts for commercial purposes, obviously banks can afford to offer a higher rate of interest on such accounts.

Failure to put the proposed fence at right point leads the commission to get bogged down in a number of questions that it would not need to consider if the fence were put at the right place.

To illustrate, p.191 of the report is not clear on whether a variety of activities should take place within their proposed retail banks. These activities include business loans, trade finance, project finance, mortgages, and credit cards.

All the latter activities strike me as being blatantly commercial. But that question becomes irrelevant if the fence is put round safe accounts rather than round allegedly safe institutions.

Of course allowing any bank to offer 100% safe deposit accounts would require periodic audits to ensure that the contents of those accounts were actually backed by monetary base or government securities. But if the fence is put round institutions rather than accounts, those institutions would need auditing also, so putting the fence round accounts rather than institutions ought not to involve greater costs on the auditing front.
Also, as regards bank failures, the law would need to stipulate that those with 100% safe accounts have first call on the safe assets backing those accounts.


Afterthought, 11th July 2011. The above idea about ring-fencing is also advocated in a submission to the UK’s Independent Banking Commission by Positive Money, Prof R.A.Werner and others.



  1. Some vague comments:

    I have a bit of trouble understanding how it's a good idea to let these safe deposits be backed by securities. It's easier to understand backing by reserves -- each "safe deposit" would be "backed" by an exactly equal amount of reserves.

    But what about bonds? How much bonds (of various maturities) is needed to back a safe deposit? The market value of these bonds is not known until after the fact. So in order for the deposit to be 100% safe.. well, isn't a one-for-one backing by reserves the only option really?

    Also, I think the notion of the bank "holding 100% reserves" is weird. It has a gold standard feeling to it, doesn't it? Consider this as a thought experiment:

    A depositor deposits 100 moeny units to a "safe" deposit account. I guess the rule could then be that the bank must deposit 100 reserve units to a special reserve account at the central bank. These reserves must remain there, unused by the bank, until the deposit is withdrawn.

    In fact, these "special reserves" could be "managed" by the central bank, out of reach for the (private) bank. There would not need to be any "auditing".

    Indeed, when a deposit is made by a cusomer to a "safe deposit account", one could equally well think of the money as being deposited directly into the central bank.

    The central bank could even be keeping the books.

    I'm not sure if there is a role to play at all for private banks when it comes to 100% safe deposits.

    You said that it is no doubt a basic human right that small retail depositors should have available to them some form of 100% safe saving account and perhaps this should be implemented in the public sector?

    William F. Hummel is thinking along these lines:

  2. Hugo, You make some good points. To be absolutely sure there is $1 immediately available for every $1 deposited, ALL deposited money would have to be put into monetary base. When writing the above I was under the impression that currently, bank reserves to a limited extent could be made up of government securities. I’m probably wrong.

    You then say that the whole “safe deposit account” system might as well be administered by the central bank. You have a point. But central banks have probably got enough on their hands, and are happy to employ existing high street banks as agents. Plus existing high street banks (by definition) have branches in every high street: those branches might as well be used as agents. This makes safe accounts easily available to the average household.

    Thanks for directing me to William Hummel. I might refer to him in a post I’m hoping to publish today or tomorrow.

  3. Alright, I'll keep my eyes open.

  4. Ralph, there's no reason not to let the central bank handle it. It just eliminates the middle man and completely eliminates bank failure risk for savers. The problem with such a move would be, as you say, to get these accounts out to everyone and easily accessible.


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