Removing bank subsidies leads inexorably to full reserve banking.

The above is the title of a paper I just put online (10k words and 34 references). The argument is basically as the title implies. Here is a 700 word summary.

The existing, i.e. fractional reserve banking system cannot do without state backing, i.e. a subsidy. Reason is that banks’ liabilities (mainly deposits) are fixed in money unit terms (i.e. in terms of pounds or dollars), while banks’ liabilities occasionally fall drastically in value: when they make a string of bad loans or investments – a mistake which any bank is bound to make sooner or later.

And when that happens, taxpayers do a rescue, which equals a subsidy of banking. Plus the lender of last resort facility is also a subsidy of banking. But it is widely accepted that subsidies result in a misallocation of resources, or put another way, they reduce GDP (absent any good social justification for the subsidy).

The solution is to give depositors a choice. First they can have their money 100% safe and instant access. But if their money is 100% safe, it cannot be put into anything remotely risky: indeed it’s best if the money is just not loaned on or invested at all. Second, depositors who want a dividend or interest on their money can let their bank invest or lend on the money. But in that case depositors bear the cost when the underlying investments or loans go bad.

That all means that it is near impossible for a bank as such to fail, which in turn means no subsidy for banks is needed.

However, the latter “two choices for depositors” means that private banks cannot create money. Banks create money when they lend, and in the case of the first or safe option, no lending takes place. As to the second option, when investors place their money with a bank, they lose access to it for as long as the borrower or investee has such money. So there again, no money creation takes place.

Net result: commercial banks do not create money. Ergo only central banks create money. And that equals full reserve banking.

The latter inability of commercial banks to create money might seem too restrictive: that is, why not impose much better capital ratios, which is what Basle III or Frank-Dodd is SUPPOSED TO DO (but arguably fail to do). Those better ratios could make banks 99.9% safe, which in turn would also mean a near absence of bank subsidies.

The answer is that there are no circumstances in which it makes sense for commercial banks to effect significant increases in the money supply which are out of line with decisions by central banks and governments to do likewise. Indeed, money creation by commercial banks shot ahead of money creation by the central bank (in the UK least) just prior to the crunch, and we are still paying a heavy price for that folly. I.e. giving the commercial banking system the freedom to create money is not just pointless: it can be disastrous.

In contrast to restricting the ability of the commercial bank SYSTEM to create money, restricting the ability of INDIVIDUAL banks to create money or lend money into existence is equally harmless, and for the following reasons.

1. If a bank or other lending entity spots a larger number of viable lending opportunities than normal, an inability to lend money into existence is not a big problem. The bank can always borrow from other such entities (e.g. inter-bank lending). Alternatively it can do a joint venture with other lending entities to fund larger than normal borrowers. Both activities already take place.

2. Even if inter-bank lending or inter-bank joint ventures were prohibited, a bank that spotted more than the normal number of lending opportunities would limit lending to the MOST VIABLE projects. I.e. it’s the projects of marginal viability that would not go ahead, and little harm comes from that.

To summarise, we have a choice as follows.  One option is to arrange for 100% of loans or investments made by banks to be covered by loss absorbing bank creditors, as is the case with full reserve. The second is to make the figure more like 10-20% which is what Basel III, Frank-Dodd, etc are supposed to do. The advantages of the former are thus.

1. It is easy for banks to gradually lobby a 10-20% figure down to impotence (if they haven’t done so already). In contrast, 100% is a clear line in the sand.

2. There are no big advantages to be had from letting the private bank system create money, and there can be horrendous costs: the recent crunch. Or more generally, where private banks have the freedom to create money they tend to exploit that freedom PRECISELY when stimulus or money creation is NOT NEEDED.

3. 10-20% still means a finite taxpayer exposure, i.e. a finite subsidy.