Monday, 12 November 2012

Advocates of fractional reserve won’t explain how they justify bank subsidies.

Fractional reserve banking cannot work without taxpayer backing: i.e. a taxpayer subsidy. I want to know how advocates of fractional reserve justify subsidising what is supposed to be a commercially viable industry.

I’m all ears. But all I hear is silence.

In case you don’t understand why fractional reserve has to be subsidised, here’s why.

Under fractional reserve, people deposit money in banks and banks promise to return sums deposited (possibly plus interest and possibly less bank charges, but let’s ignore that to keep things simple). But as long as the money remains with the bank, the bank lends on or invests the money (or most of it).

But there’s a problem. That system might work 95% of the time, but sooner or later any bank will make a string of bad loans and investments. And when that happens, banks JUST CAN’T repay depositors.

The bank goes bust. It’s happened  OVER AND OVER AGAIN. It happened in the middle ages. In the 1930s, thousands of banks went bust in the U.S. It happened in the recent credit crunch. I’ll put that in extra large red letters below just so as to ram home the message.

Under fractional reserve, banks go bust.

Got it?

That means that EITHER depositors lose their money, or the state rescues them. And a state rescue equals a subsidy of the banking industry.

Of course the safety of fractional reserve banking can always be improved by expanding the amount of loss absorbing creditors on banks’ balance sheets. And Vickers, Basel III and Frank Dodd propose miniscule and near irrelevant improvements of that nature. Basel III currently proposes a leverage ratio of 33: 1, which is truly farcical. Even more farcical is that Basel III needs 30,000 pages to spell out that nonsense.

But even if loss absorbers make up half of a bank’s creditors, that still means that if the bank’s assets decline in value by any more than 50%, the bank is technically insolvent. I.e. there is still a finite taxpayer exposure.

Thus the only way of totally disposing of taxpayer exposure (i.e. subsidy) is to make ALL BANK CREDITORS LOSS ABSORBERS. That’s nice and simple. You don’t need 30,000 pages to explain that. I just did it in a few sentences, didn’t I?

That is, where depositors want the bank to lend on or invest their money, depositors must carry the loss when those loans or investments go bad. In contrast, where depositors want 100% safety, there is no harm in letting them have 100% safety, but their money cannot be loaned on or invested. I.e. they can’t ask for 100% safety while having their money put at risk: that’s just hypocrisy. It’s a self-contradiction.

Now if a bank accepts an £X deposit, lends on the money, while letting the depositor still have access to the £X, then money creation has taken place: both the depositor and the borrower have access to £X. I.e. £X has been turned into £2X. So stopping banks making that promise to return £X and instead making banks promise just to return the value of the relevant depositor’s shareholding in the underlying loans or investments means that commercial banks no longer create money.

As to “safe” deposits, money isn’t created there either.

So there’s no commercial bank created money: the only money created is central bank money. That’s full reserve banking. And full reserve banks cannot fail. Of course those depositors who have chosen to have their money put at risk can see the value of their shares drop. But the bank as such cannot fail, thus no taxpayer subsidy is required.

So fractional reserve advocates: I want to know what the justification for bank subsidies is.

I’m listening.


  1. Full reserve can't exist without a £6tn up front subsidy.

    Which is essentially the same as paying out all the deposit insurance in one go.

    It's fairly easy to argue that you can avoid that by paying out the subsidy only when the risk materialises.

    People in the UK are supposed to be good at insurance and understand why it helps make things happen.

    It's a pity its become a religious matter.

  2. Even if one counts the 6tn that government / central bank dishes out to enable full reserve to work as a “subsidy”, it is not a subsidy specifically of banks. Reason is that a money (as opposed to barter) economy can work WITHOUT banks. Indeed some people even today just don’t have bank accounts.

    However, the above is not even a subsidy because a subsidy is the transfer of REAL RESOURCES to the lucky industry or firm involved (usually from taxpayers). In contrast, when government / central bank creates money out of thin air and dishes it out, that is a costless operation (in real terms). As Warren Mosler put it, central bank money is the same as points handed out by the umpire in a tennis match. That is not a “subsidy” of the players by the umpire.

    Or as Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

  3. I realized the importance of full reserve banking upon discovering first F. Soddy 1926 (Virtual Wealth) and then Fisher 1935 (100% Money) in the mid 1990s.

    I have long hoped it would happen, but never blogged on it or wrote about it, although I followed the theory for 15 years. The IMF paper is a major breakthrough I think in getting attention, although I like the Werner/Southampton proposals more perhaps.

    I have mentioned before, politically I do think it is possible to change (in addition to 2008, also a reason) for 2 reasons.
    1) It is actually the best hope for current creditors to not lose out in the current debt situation – if we keep the current situation they are sure to lose under debt repudiation/deflation or inflation. One of the two will happen.
    2) The public is more aware of debt as a problem than they have been in decades because of 2008. But it isn’t just this awareness that makes the public ripe for accepting change – it is that the changes that something like the Chicago Plan would enact would actually make the banking system work much more like the public already thinks it does. Those who want to enact full reserve banking should use this as their number one strategy – sell the public on the fact that the changes will make the system match their intuition and current beliefs about banks more, not less.
    On a related note, I don’t know what you think of but this post of mine might be of interest to some:
    “FT & Investors Chronicle Blogs’ Shameful Attacks on Ben Dyson”
    Kind regards,

  4. Hmm....the post-war Labour government nationalised the Bank of England in 1946. People may have squawked, but I don't think any Conservative government has contemplated reversing this.

    I just wonder why they didn't go the whole hog and nationalise the whole banking system. (Instead of leaving it to their grandchildren to do it piecemeal in the 21st century....).

    Then we wouldn't need to subsidise the banks.

    The banks used to look after people's physical money. They barely do that any more. All they do is move digits around in a computer. Perhaps we should fire all the bankers and just hire some good IT people.


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