Bank balance sheet changes on converting to full reserve.

Two IMF authors, Benes and Kumhof, set out their ideas on the changes to the consolidated balance sheet of commercial banks that would take place on converting to full reserve banking.

I expressed reservations about their ideas here. Now for something more positive: some ideas as to what the balance sheet changes WOULD look like.

A brief introduction to full reserve.

Full reserve is a system under which commercial banks do not “lend money into existence” as the saying goes. The only source of money is the central bank. Commercial banks are then free to continue borrowing and lending as under fractional reserve, but they cannot lend money they haven’t got (i.e. they just lend money they’ve obtained from depositors, shareholders or bondholders).

If depositors want their money to be 100% safe, such money cannot be put at risk by being loaned on or invested by a bank. And if such money is not loaned on, no money creation takes place. Also no interest is paid on such money.

In contrast, and where depositors want interest, they are acting in a commercial fashion, and there is no obligation on taxpayers to underwrite that commercial activity. That is, depositors bear any losses due to poor performance by the underlying loans or investments. Thus in effect such depositors become shareholders rather than depositors.

For a more detailed explanation of full reserve, see this work by Richard Werner and co-authors.     

Werner & Co suggest that depositors who want their money invested put their money into “investment accounts” at their bank.

In contrast, Laurence Kotlikoff, another advocate of full reserve advocates that those who want their money investing put their money into unit trusts (“mutual funds” in US parlance).

Effectively there is not much difference between those two above ways of implementing full reserve. Thus I’ll refer to “investment accounts” and “unit trusts” interchangeably.

Also, note that the investment accounts / unit trusts are essentially different entities from safe accounts. To illustrate, if ALL THE MONEY put into investment accounts / unit trusts for a particular bank is lost, that shouldn’t have any effect on “safe” money.

On their page 64, Benes & Kumhoff (B&K) show a consolidated balance sheet which has assets and liabilities equal to 200% of GDP. Let’s stick with that 200% figure. (All numbers henceforth are percentages of GDP).

Next, let’s ignore bank shareholders and bondholders since they form a relatively small part of bank balance sheets (and actually form a small part of the balance sheets shown by B&K.).

So prior to the change, commercial banks’ consolidated balance sheet would be thus.

Assets.                                       Liabilities.

200  loans and investments.      200 Depositors.

On announcement of the change, depositors then have to choose how much of their money they want to have in safe accounts and how much in investment accounts or unit trusts. Let’s say depositors go for a 50:50 split. The new consolidated bank balance sheet for safe accounts would then be thus:

Assets.                     Liabilities.

100 reserves.           100 Deposits.

As to investment accounts / unit trusts, they are essentially separate entities. And their initial balance sheet would be thus:

Assets.                           Liabilities.

100 loans and                 100 Deposits.

       Investments.

The two balance sheets look very similar, there is a fundamental difference. For safe accounts (the first balance sheet) the number next to “deposits” and “reserves” is always exactly equal to the amount lodged by depositors (net of withdrawals). In contrast, for the investment account / unit trust balance sheet, the numbers fluctuate with changes in the value of the underlying loans and investments.

Note that there has been a drastic reduction in the amount lent by and invested by banks, which would have a deflationary effect. That would need to be countered by having the government / central bank machine print and spend monetary base into the economy. Let’s say (to keep things simple) that depositors continue to split their money 50:50 as between safe and investment accounts / unit trusts.

It might seem that government would need to print and spend an extra 200 into the economy so as to return the amount lent and invested by banks to its original figure. However, that would be too much because the NET EFFECT would be to expand private sector net financial assets by 200, and that would have too much of an inflationary effect (assuming the economy was at capacity BEFORE the change to full reserve).

As to EXACTLY HOW MUCH money government would need to print and spend into the economy, that is impossible to know with any accuracy. And for that reason, it would be inadvisable to try to effect the change within just a year or so. That is, it would be better to raise commercial banks reserve requirements by perhaps 20% a year until they had reached 100% after five years.

But let’s assume that at the end of that five year period, the total amount of new money required is 100. In that case, the new balance sheets would be thus.

               Safe accounts:

Assets                        Liabilities

150 reserves            150 deposits

  

  Investment accounts / unit trusts

Assets                                Liabilities

150 Loans and                150 deposits.

        Investments.

The reduced amount of lending by banks (150 instead of 200) would mean, first, an overall reduction in investment, i.e. there’d be more labour intensive economic activity. Second, the proportion of investment funded by equity rather than lending would rise.

No doubt a number of simple folk will react to the latter by claiming that any reduction in investment must be “bad” because investment is “good”, “virtuous” and all the rest.

The answer to that is that it is very naïve to think that a simple increase or decrease in investment (or anything else) is beneficial or harmful. The IMPORTANT QUESTION is: what’s the OPTIMUM amount of investment (or anything else)?

And investment funded by a banking system that needs subsidising (as is the case with fractional reserve) is probably not optimum: on the face of it, the amount of investment brought about that way will be excessive. 

Other changes.

Another overall or “macro” change that takes place on conversion to full reserve is that private sector entities have a bigger stock of cash, and thus do not need to borrow so much.

As to GOVERNMENT DEBT, that is drastically reduced in the B&K scenario, which has got me baffled. Under the scenario set out just above, there is no effect on government debt.