Sunday, 3 July 2011

The UK Independent Banking Commission’s views on narrow banking and full reserve banking.

The UK’s Independent Banking Commission’s Interim Report is quality stuff, though the section entitled “Other Structural Reform Ideas” (p.97) leaves room for improvement.

This section deals with narrow banking, full reserve banking and the like. The weaknesses in this section are as follows, starting with “narrow banking”.

Narrow banking. Sections 4.116-8.

Under narrow banking, institutions accepting retail deposits can only invest such deposits in ultra-safe assets, like monetary base and government securities. Lending is done by other institutions funded by share holders.

The paragraph starting “The social costs…” (section 4.117) claims that narrow banking would reduce the total amount of lending and borrowing. My objections to that idea are thus.

First, the lower interest rates for borrowers are a mixed blessing: these low rates partially explain NINJA mortgages, asset bubbles and the chaos that is Greece.

Second, it is not true that because bank activity is restricted, that therefor economic activity is restricted. This paragraph does not EXPLICITY make the latter point, but it is hard to see why anyone would object to raised borrowing costs or to the “credit restrictions” to which this paragraph objects OTHER THAN for the reason that economic activity is restricted in consequence.

And the REASON why restricting bank activity does not restrict economic activity is that that there are ways of funding economic activity OTHER than via borrowing (as indeed the report itself makes clear in a different section). That is, if there is a reduction in commercial bank created money, this can perfectly well be made good by an increase in central bank created money (monetary base). The net result would be more equity funded economic activity and less loan financed activity. Anything wrong with that?

Third, allowing banks to use retail deposit money for commercial purposes, particularly where this is geared up via fractional reserve and “intermediation” in the form of maturity transformation (MT) involves risks.

MT equals “borrow short and lend long”, and the big risk with this is that short term interest rates rise too far, or short term money becomes hard to find. This is what brought Northern Rock down.

If the WHOLE of that risk is born by the relevant banks, shareholders and depositors, that disposes of some of the objections to MT. But the problem is that in practice, bank losses are often socialised. To that extent, society is entitled to a say in how and when banks engage in MT.

And for a start, “society” can cite the generally accepted principle that it is not the job of taxpayers to underwrite commercial activities, like lending money to businesses garnered from retail depositors (or anywhere else, come to that).

If banks use retail deposit money for commercial purposes, they cannot earn much interest on such money, thus they cannot pay depositors much by way of interest. No doubt paying retail depositors little or no interest could be politically difficult. But this is just a measure of the extent to which commercial banks, depositors and those borrowing from banks have invegaled their way into the public purse and helped themselves to its contents.

4.117, paragraph starting “Government guarantees..”

This paragraph seems to claim that because in a crisis government will not allow ANY sort of deposit taker to fail, therefor government will still have to stand behind narrow banks or full reserve banks. Thus the potential costs to taxpayers remain unaltered.

The answer to that is that the retail deposit accepting institutions are far safer under narrow banking than under conventional banking. Thus the potential costs to government are lower. But of course the dangers from the shareholder funded institutions under narrow banking remain. However those dangers can be largely removed under full reserve banking, of which more below.

Section 4.118.

The first paragraph here claims that narrow banks would “remain exposed to interest rate fluctuations”.

The answer to that is that for centuries, credit crunches or recessions have NOT been sparked off by interest rate changes as far as I know. “Irrational exuberance” and sloppy lending practices are two of the main culprits. Another common culprit is a determination by governments be “responsible” and run surpluses rather than deficits.

If anything makes a bank vulnerable to interest rate changes, it is the standard bank practice of “borrow short and lend long” (i.e. MT). This model is obviously vulnerable to a sudden increase in short term interest rates. Indeed, and to repeat, it is exactly this brought Northern Rock down.

Of course the standard explanation for Northern Rock’s failure was the-non availability of short term money at the height of the credit crunch rather than high short term interest rates. However, had Northern Rock offered a sufficiently high interest rate for the money it wanted, that would have saved it for a time. But of course those high rates would probably have broken it.

Thus “non-availability” and “high interest rates” are much the same thing.

4.118: Panics.

The next claim made in 4.118 is that depositors might quit the narrow banking system “en masse” during a crisis. As regards the equity funded lending institutions under narrow banking, there just aren’t any depositors. There are just shareholders. And as regards the deposit taking institutions, everyone would know that these institutions were backed by more reliable assets than is the case with current or traditional banks.

Thus during a panic, far from funds flowing out of narrow banks, funds would flow out of traditional banks and INTO the narrow banking or full reserve banks. Indeed precisely this phenomenon occurred in the recent credit crunch. As the report rightly points out, the UK National Savings system is a form of full reserve bank. During the “flight to safety” that took place in the credit crunch, National Savings experienced a higher than usual inflow of funds.

Narrow banks and government bonds.

The final sentence of 4.118 claims that “There are also practical problems in finding sufficient UK government bonds to back retail deposits.”

My answer to that is that, apart from the ultra safe bonds held by such a bank, a full reserve bank or a retail deposit accepting institution under “narrow banking” is not capable of holding anything other than monetary base. Thus if, to take the extreme case, government borrowed nothing, i.e. there was no such thing as government securities, it would not matter, because monetary base is tip top reserve material: it is backed by government / central bank machine as are government securities.

Why full reserve banks only hold monetary base.

The REASON a full reserve bank (at least after settling up at the end of the day’s trading) cannot hold anything other than monetary base is thus.

Where a cheque is deposited at a full reserve bank for £X, its account at the central bank will be credited at the central bank by £X more than would otherwise have been the case. Ergo all deposits at a full reserve bank are backed by monetary base (except, to repeat, to the extent that the full reserve bank buys government securities, etc).

In contrast, in the case of a normal commercial bank, where a cheque for £X is deposited, that will often as not be more or less cancelled out by money that the commercial bank has created out of thin air, money which is deposited at some other bank.

Of course the cheque for £X will not necessarily be balanced by EXACTLY by £X created out thin air on a PARTICULAR DAY. But over the long run, money created out of thin air by one normal bank and deposited at another is more or less cancelled out by money created out of thin air at the second bank and deposited at the first. The net result is that the bulk of deposits at normal commercial banks are not backed by monetary base. Or put another way, their deposits are backed by reserves which are a small “fraction” of their total deposits: they engage in “fractional reserve banking”.

Full Reserve Banks - Section 4.120.

Under full reserve, ALL banks or lending institutions have to back their deposits with an equivalent amount of monetary base, though presumably government debt is also allowed by way of backing.

The report claims that, as with narrow banking, the amount of lending or credit would be curtailed. Well it wouldn’t (to repeat) if the amount of central bank created money (monetary base) was expanded to make up for the loss of commercial bank created money.

But the real beauty of full reserve is that it drastically reduces the chances of a re-run of the recent credit crunch and the CATASTROPHIC economic damage done by it.

Put another way, as I admitted above under the “narrow banking” heading, the shareholder funded institutions are still liable to fail en masse: they are still a systemic danger. But this problem almost vanishes under full reserve.

The basic explanation for the recent credit crunch, and indeed all unsustainable booms, is thus. There is a rise in demand for property, or some other asset. That causes the price of the asset to rise. That in turn means the relevant asset class can be used as collateral for further borrowing. And since commercial banks can create money out of thin air to lend, they do so. That causes the relevant asset/s to rise in price still further.

This all sounds too good to be true, and it is. We all know the end result.

In contrast, under full reserve, the quantity of money is fixed, or at least it is determined by central bank. To be more accurate, to fix the quantity of money at exactly the same figure for all time would not be desirable: expanding economies need an expanding money supply. But at least central banks can organise a regular annual increase, instead of the wild gyrations in the money supply that occur under fractional reserve banking.

This is not to suggest that central banks can ever have TOTAL CONTROL over the money supply. After all there is no sharp dividing line between money and non-money. But curtailing the EXTENT of fractional reserve activities would not be difficult.

Some readers might be tempted rebut the argument just above on central bank control of the money supply by pointing out that central banks a few year ago tried to control inflation by controlling the money supply (on instructions from Milton Friedman!). And as it turned out, this didn’t work too well.

The answer to the latter point is that I’m not claiming that central bank control of the money supply solves EVERY problem. I’m just claiming that curtailing fractional reserve, and replacing the money that fractional reserve creates with monetary base would be a more stable system.

Section 4.121

This section claims “There is no prohibition on the establishment of a full reserve bank (or a narrow bank)…” The suggestion being that if there were a demand for such institutions, they would have come into being.

The answer to that is that the reason such banks scarcely exist is that they can’t compete with banks that engage in profitable but very questionable activities, like MT.

And the final sentence of this paragraph says “In light of deposit insurance, mandating that all depositors have such an option appears unnecessary.” (“The option” is of course the option of having narrow or full reserve banking facilities available to those who want same.)

The answer to that is that those perpetrating an anti-social activity should ideally not be allowed to continue with it, even if they ARE insured. To illustrate, the fact that all car drivers are insured (or should be) is not a reason to turn a blind eye to drunk driving. Nor is it a reason to abstain from encouraging safe driving.

Put another way, unsafe banking, just like unsafe car driving, imposes very real costs on the community, even if these unsafe activities are insured.



  1. The Independent Commission on Banking still doesn't appear to understand how modern banks actually operate.
    When a bank makes a loan it does not take other people's deposits and lend them out. This would imply that no new bank deposits are created in the economy when a bank makes a loan.
    The truth is that when a bank makes a 'loan' it simply types in to its account that the borrower owes it a sum of money – this is the bank’s asset. It also types into the customer’s account that he has a bank deposit.
    Unless the ICB, the Bank of England and the Treasury start to take more seriously the true role of banks as the creators of the overwhelming majority of new purchasing power in the economy, there is little hope for effective reform. Focus instead will remain on propping up a banking model that specialises in speculative credit creation and has become so big that it is underwritten by the taxpayer.
    I highly recommend the readers to look at the website which explains further.

  2. Mira, Thanks for your comment which I agree with. Re Positive Money, I do the occasional blog post for them.

    Money and banking ought to be easy enough to understand, but in fact I find them horrendously difficult to understand, as do others. These two individuals are clued up on the subject, in case you haven’t come across them.

    1. Bill Mitchell. Blog:
    2. Warren Mosler. Blog:

  3. Ralph, sorry to be off topic but I've got a general MMT question.

    Consider the typical banking/government/central bank relationships. For simplicity's sake, we'll say there's $1000 net reserves in the private banking sector (and the government sector is running a balanced budget and therefore not adding to or subtracting from net private assets).

    Now, add two new banks -- Bank 1 and Bank 2 -- each with $10 in reserves to start with, and an assortment of shell corporations owned by the directors of the banks. I think these two banks and their shell companies can act effectively as a government, so long as the discount window is open to them.

    Here's how I think this is possible:

    Bank 1 issues some arbitrary amount of loans to the shell corporations (say, $50). Then, Bank 1 goes to the discount window to borrow additional reserves because it anticipates some liquidity problems. It collateralizes the loans it just made, and received $50 in loaned reserves.

    The shell corporations then spend $50 to purchase labor, goods, etc, from the private sector. That $50 is then effectively added to the net financial asset position of the private sector. Of course, the shell corporations now need a way to repay their loans, with interest, to Bank 1.

    Bank 2 steps in here and issues them $60 in loans. Bank 2 then goes to the discount window to request additional reserves, and borrows $60 in reserves from the central bank.

    The shell corporations then repay their loans, with interest, transferring $60 in reserves from Bank 2 to Bank 1. This allows Bank 1 to repay the central bank, and retain some reserves as retained earnings to meet capital requirements, so it can extend larger loans to the shell corporations in the future.

    Of course the net position of Banks 1 and 2 combined is now negative, and will continue to deepen as they borrow from the central bank to repay the central bank, but as their combined balance sheet drives lower and lower, they'll be effectively adding to the net asset position of the private sector (excluding the little closed system of banks 1 and 2 and their shell companies).

    In this way, the closed system of Banks 1 and 2 becomes equivalent to a government sector -- their net negative asset position to the central bank is equal to the net positive change in assets in the private sector.

    Is this correct?

  4. Anon, I don’t understand your point about shell corporations, but I suspect I agree with you for the following very vague reasons. In the absence of a central bank, private banks would take on some of the roles of central banks. That is, those private banks, if they keep their house in order, can issue money or loans out of thin air on which they earn interest on a permanent basis. (Nice work if you can get it.)

    That is in contrast to commercial bank created money which to some extent is deleveraged or extinguished in a recession.

    Next point, private banks are always trying to muscle in on the activities of central banks. Thus it would’nt surprise me if there was some form of “semi-muscling in” wheeze that commercial banks could engage in, like your shell corporation idea.

  5. The only purpose of the shell corporations in the hypothetical is so that the two banks in question can control their outflows and inflows more precisely, similar to how government can.

    If the bank owns all the depositors at its own institution, it makes it easier to tweak the net asset position of the rest of the banking sector.

    Also the two proposed banks use the shell corporations to loan money back and forth to each other, since presumably the central bank wouldn't lend a bank money to pay back a previous loan to the central bank.

    While this whole process would muscle in on central bank activities -- basically by forcing the central bank to issue more currency, as the net position of the two banks combined dips ever lower -- I think of it mainly in terms of looking very much like government, when government sells its securities to the central bank in order to deficit spend.


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