Saturday, 8 September 2012

Bank regulation is going nowhere.

Bank regulation of the Basle, Vickers and Dodd-Frank type is getting nowhere.

The complexity of the regulations suggested by the above three is ridiculous, as pointed out by Andrew Haldane in his introduction, and John Kay (p. 9-10) and by Sebastian Mallaby in the Financial Times, and by Kenneth Rogoff. Also the need for simplification is referred to in the preface of a paper by Jan Kregel.

Moreover, the proposed changes to bank regulations do not even look like making the banking system much safer. As Mervyn King said, “Basel III on its own will not prevent another crisis…”. Or as Kenneth Rogoff put it, “Legislation and regulation produced in the wake of the crisis have mostly served as a patch to preserve the status quo.”

The solution: outlaw banks’ false prospectus.

The root problem, not spotted by regulators, is that the basic set of activities carried out by banks in their current form is fraudulent: it’s a false prospectus. This set of activities is, 1, to accept deposits, 2, to put depositors’ money in less than 100% safe loans and investments, and 3, to promise depositors their money back.

Well that just doesn’t add up: sooner or later any bank is bound to make a series of bad loans and investments, and when it does, depositors JUST DON’T GET THEIR MONEY BACK. That has happened hundreds of times in every country in the world over the centuries. And it just flies in the face of the facts and of history for regulators to claim they can prevent it happening again. The regulators have not spotted the elephant in the room.

The only occasion on which depositors DO GET their money back, given a bank failure, is when the taxpayer stands behind deposits. But that amounts to a subsidy of the bank industry: an industry which is supposed to stand on its own two feet - an industry which is supposed to be commercially viable.

To summarise, the bank industry as currently set up is quite simply in check mate: it is guaranteed at some point to fail, while the only way of preventing failure is an unjustified taxpayer funded subsidy.

Let’s outlaw the false prospectus.

The solution to the above problem is to bar banks from promising depositors their money back WHERE DEPOSITORS CHOOSE TO HAVE THEIR MONEY USED IN A COMMERCIAL FASHION. I’ll explain.

Where a bank pays interest to a depositor, the bank can only fund that interest by placing the depositor’s money in a less than 100% safe loan or investment. I.e. any depositor who wants interest on their money is acting in a commercial fashion. And it is not normal practice to have taxpayer backing for commerce. Thus where a loan or investment made by a bank goes wrong, the relevant depositors should foot the bill.

And that in turn means that “interest demanding” depositors cannot have INSTANT ACCESS to their money. That is, they can only have their money back when the underlying assets have been sold, in exactly the same way as you cannot get the money you’ve put into shares back till the shares have been sold.

In contrast, where depositors want instant access and 100% safety, they are certainly entitled to it. In fact it is arguably a basic human right to have access to a 100% safe bank account. But the only way of ensuring 100% safety is NOT TO INVEST the money. Thus no interest will be earned. So those who want complete safety must forgo interest.

That way, it’s almost impossible for a bank to go bust. The worst that can happen is a series of bad investments and loans made by banks, which in turn results in “interest demanding” depositors losing out. The net effect would be no worse than a stock market set back. As Mervyn King put it, “…we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis.”

In fact a system of very much the latter sort has been advocated first by Richard Werner, Positive Money and the New Economics Foundation, and secondly by Laurence Kotlikoff.

The above set of rules or regulations is of course VASTLY SIMPLER than anything dreamed up by Basle, Vickers, etc.

Money creation and loans.

The criminals, fraudsters and incompetents running our existing banking industry will of course produce a string of objections to the above idea. One is that if bank lending is constrained as above, the effect will be deflationary. Well the simple answer to that is that the government / central bank machine can counter that deflationary effect by printing and spending extra money into the economy (as pointed out by Werner and Kotlikoff).

The net result would be an economy where firms and households have a bigger stock of cash and would thus need to borrow less. The bank industry has expanded no less than TEN FOLD in the UK over the last fifty years relative to GDP. (See p.3 of this paper by Mervyn King). Anyone know what the big advantage of this has been – apart from the credit crunch and catastrophic unemployment levels? A CONTRACTION of the bank industry would probably do no harm at all.

Moreover, loans do not need to come from institutions which have made the absurd promise to their creditors that the latter are guaranteed their money back. For example if someone lends to a non-bank corporation by buying its bonds, the corporation does guarantee bond holders their money back. And if someone lends to a small business run by a friend, the lender knows perfectly well they may not get their money back.

Another objection which the above criminals, fraudsters and incompetents will raise is that there is no need for 100% of loans and investments made by banks to be covered by loss absorbing creditors (whether those loss absorbers are shareholders, bondholders or interest demanding depositors is pretty immaterial). That is (as Martin Wolf has suggested) a DECENT LEVEL of loss absorbing buffer would do the trick.

The answer to that is, first, that as soon as loss absorbing is at less than the 100% level, the criminals, fraudsters and incompetents will lobby and bribe politicians into having the level progressively reduced till there is practically no loss absorbing capability left – apart from the taxpayer, of course. (Criminals, fraudsters and incompetents in Britain spend £92million a year lobbying politicians). And the criminals, fraudsters and incompetents are ALL FOR taxpayers rescuing them when things go wrong.

I.e. the 100% level is a clear line in the sand.

Second, it is fair enough to criticise a very high level of safety IF THERE ARE SIGNIFICANT COSTS INVOLVED IN ACHIEVING THAT LEVEL OF SAFETY. But Martin Wolf in the above mentioned article failed to specify what those costs were. And if someone of Martin Wolf’s intellectual calibre cannot argue a particular point, the criminals, fraudsters and incompetents certainly won’t be able to do so.

Full reserve banking.

A final twist to this tale is that the system advocated above actually amounts to full reserve banking (that’s a system where just the central bank creates money, not private banks). Reasons are thus.

Under our existing banking set up a bank can accept a deposit of £X and lend it on while still allowing the depositor access to their £X. Thus both the depositor and borrower now have £X in the bank: an extra £X has appeared from nowhere.

In contrast, under the set up advocated above, banks cannot do this. That is “interest demanding” depositors can only get access to their money when a chunk of the underlying assets have been sold. Thus the relevant bank does no create any money out of thin air.

As to depositors who want 100% safety, their money is not invested. Nothing is done with their money, so no “private bank money creation” takes place there either.


  1. Thank you. Well played! I have been wondering this for a while. Instead of have endless regulation unsuccessfully chasing moral hazard, just put the RESPONSIBILITY back into banking. That would be much simpler, much more morally appealing. Have the government spend a given amount each year into the economy. An amount that is widely publicized and goes to widely know use (complete transparency). This would put predictability and commonsense back into the system. Banks would work the way people think they work. I often wonder if the more intense Fractional growth is mainly misallocation and malinvestment... analogous to a man with giantism - growing unsustainably

  2. Lyndon,

    Agreed – more or less. Just a couple of comments though. Re “amount that is widely publicized and goes to widely know use”, I don’t see any need to specify or publicise what the money is used for. The money would simply be added to the total that government spends, which they ought to spend as decided by the electorate.

    We don’t specify what the money from particular taxes like income tax is used for: the argument at election time is essentially over what the TOTAL of public spending as a proportion of GDP should be, and how that total is split between education, defence, etc etc.

    Re fractional reserve, I prefer full reserve (i.e. I think all money should be created by central banks, not private banks) however I don’t think the fractional system involves all that much “malinvestment”. Where private banks can create savings out of thin air to lend out, that will result in an artificially low rate of interest. To that extent there is malinvestment. But apart from that, I don’t think full reserve would allocate investment spending any more efficiently.



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