Removing bank subsidies leads to full reserve banking.

The major and glaring flaw in fractional reserve banking is that it needs subsidising: it needs taxpayer funded backing. And any subsidy is a misallocation of resources (absent overriding social considerations or market failure).

Frances Coppola accepts that the above subsidy is unwarranted, but supports fractional reserve nevertheless. That on the face of it is an untenable position. I’ve enjoyed thrashing out banking and monetary issues recently with Frances recently here, and I’ve learned plenty in the process.

She says “I can't begin to justify protecting even small amounts of savings by extracting money from people who are too poor to save at all.” And: “I also agree with you that there should be no taxpayer protection for investments, including interest-bearing deposit accounts.” I agree with both statements.

Just to confirm my above claim that removing subsidies leads inexorably to full reserve, I’ll now try to prove the point. Here goes.

ONE WAY of ensuring 100% safety for depositors without any significant taxpayer backing is simply to prevent banks lending on or invest the relevant sums. After all, it’s the fact of those loans or investments going bad that brings banks down.

But of course that means the relevant money is doing nothing. It’s not earning interest, which in turn means the relevant depositors get no interest. And that is a type of account which would certainly suite SOME DEPOSITORS. That is, the deal is: “your money is 100% safe, but there is a penalty to pay, which is you get no interest, and will probably have to pay bank charges”. Indeed, that is hardly a big change from the average current account available at present in the UK. Those accounts normally pay no interest, and in many cases depositors pay bank charges.

But the above is not what every depositor wants, and second, stopping all bank lending would have obvious dire consequences.

Ergo, a depositor must be allowed to let their bank lend on or invest the depositor’s money. But how do we effect that while ruling out taxpayer support? The only way is to have the depositor carry the costs in the event of the underlying loans or investments going bad. And that in effect means the depositor is not so much the holder of a specific sum of money, but is rather the holder of shares in a selection of loans and/or investments.

 
Money creation.
 
Now as regards “safe” accounts (i.e. where money is NOT loaned on) no money creation takes place, and for the following reasons. Where a bank accepts a deposit of £X and lends on the £X, both depositor and borrower then regard themselves as having £X. That is, £X has been turned into £2X. So “no lending on” equals no money creation by banks.

As regards deposit or interest earning accounts, the depositor just doesn’t have quick access to their money. So arguably no money creation takes place their either. That is, the borrower gains £X, while the depositor loses £X (but gains what amounts to a share in the underlying loans or investments). And in fact so called money in deposit accounts (other than very short term deposit accounts) is just not counted as part of the money supply in most countries. 

Provisional conclusion: disposing of taxpayer backing for deposits leads to a regime in which commercial banks do not create money, i.e. where the only money creating entity is the central bank. And that equals full reserve.  

 
Maturity transformation.
 
However, there is a slight flaw in the latter conclusion which is that the EXACT EXTENT TO WHICH money in a deposit account is counted as money is a grey area. To illustrate, if money in a deposit or “investment” account can be accessed within say a week, that is little different to a current account (or to use U.S. parlance, a “checking” account).

Indeed, there are mutual funds in the US which offer cheque books to “depositor / investors”.

But note that where deposit accounts are in effect current accounts, maturity transformation takes place. I.e. “borrow short and lend long” takes place. Plus money creation takes place. That is both borrower and deposit account holder regard themselves as being in possession of that £X. 

Or to be more accurate, assuming no recession, and assuming the relevant bank is run in a competent manner, the value of a bank’s loans and investments should pretty well equate to or even exceed their nominal value, thus where someone has put £X in a deposit account they can be 99% sure of getting £X out fairly quickly.

 
Should we allow maturity transformation?
 
And that leads to the question as to whether we allow maturity transformation (MT) . Well the answer is “absolutely not”, because the basic argument for MT just doesn’t add up, and for the following reasons.

That “basic argument” for MT is that it enables a country to make best possible use of its money supply. That is, under MT, much of the money in current accounts can be invested or loaned on. But the flaw in that argument is that money is simply a book keeping entry: it is “stuff” that is costless to produce. Money is not a REAL ASSET like say the cars owned by a car hire firm or hotel rooms. It makes sense to keep cars and hotel rooms as fully employed as possible.


But that argument does not apply to money. Put another way, if MT is forbidden, that will certainly have a deflationary effect, but the latter effect is easily countered by increasing the money supply (something which, to repeat, can be done at zero real cost).

So there is a choice as follows. Option No 1 is to allow MT. But that involves a risk because MT is inherently risky: borrowing too short and lending too long has brought down hundreds of banks throughout history, Northern Rock being just a recent example. And Option No 2 is to forbid MT. That makes banks safer, which is a REAL BENEFIT. As to the corresponding cost (expanding the money supply) that just ain’t a REAL COST.

Ergo MT should be banned. And if MT is banned, then commercial banks don’t create money. So in that scenario only money creating institution is the central bank. And that equals full reserve banking.

Quad Erat Demonstrandum.