Thursday, 20 March 2014

Adair Turner criticises full reserve banking.

Full reserve is a system which splits the banking industry into two halves. First there is a 100% safe half which just lodges depositors’ money at the central bank (or possibly invests the money in government debt.)

As to commercial or private sector loans, those are made by the second half. That half is funded by “depositors” who accept the inescapable truth, namely that there is no such thing as a loan or investment that is risk-free. Those depositor / investors are essentially no different to those who buy into unit trusts (“mutual funds” in the US). And as with standard unit trusts, investors can choose what to invest in: safe mortgages, NINJA mortgages, platinum mines, etc.

That split system is fail-safe. As to the first half, money lodged at the central bank is entirely safe. As to the second half, if the relevant “bank” makes silly loans, all that happens is that the value of depositor / investors’ stake in the bank / unit trust falls. The “bank” cannot suddenly fail.

Adair Turner in this work, (bottom of p.44 onwards) makes various criticism of full reserve. Let’s run thru them. I’ve put Turner’s words in green.

Limiting the involvement of commercial lending banks in risky proprietary trading is undoubtedly also desirable. Losses incurred in trading activities can generate confidence collapses,

And in similar vein, he claims:

Investors would be likely in the upswing to consider their investments as safe as bank deposits. Investments in loan funds would therefore be likely to grow in a pro-cyclical fashion when valuations were on an upswing and then to run when valuations and confidence fell, creating credit booms and busts potentially as severe as in past bank - based crises.  

Answer. There is no need for detailed legislation to determine what “lending banks” do (as Turner seems to imply in the first above sentence in green) under the above very simple basic rules of full reserve. The proportion of depositors who would choose to let their bank invest their money in high risk stuff will probably be small. That’s in stark contrast to the existing system where banks can use grandma’s savings to bet on dodgy derivatives, with the taxpayer picking up the pieces if it all goes wrong. To that extent, Turner’s claim that full reserve brings no improved stability is plain untrue.

Moreover, EVEN IF THERE IS A “confidence collapse”, as Mervyn King pointed out, the effect of stock market set backs are mild compared to the effect of banks collapsing. As 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. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond.

But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.” (That’s from his “Bagehot to Basel” speech.)

The underlying assumption is that the existing system is unstable only because   explicit deposit insurance and implicit promises of future rescue undermine the market discipline which would otherwise produce efficient and stable results.      

Not true.  Advocates of full reserve, e.g. Positive Money, are perfectly clear that even if full reserve is implemented, the economy will still be subject to swings of confidence and outbreaks of irrational exuberance, etc. Plus they are clear that that unstable characteristic of the free market would need to be countered by stimulus (or “anti-stimulus”) implemented by the government and central bank.

Maturity transformation.

The  essential  challenge  indeed  is  that  the  tranching  and  maturity  transformation  functions  which  banks  perform  do  deliver  economic  benefit,  and  that  if  they  are  not  delivered  by  banks,  customer  demand  for  these  functions  will  seek  fulfilment  in  other  forms. 

 Answer: the idea that maturity transformation brings benefits is a popular myth, which I debunked here. But briefly, the flaw in MT is thus.

The argument for MT is superficially very attractive. It’s that depositors short term deposits can be “transformed” to some extent into long term loans because banks know that only a limited number of depositors are likely to withdraw all their money at once.

Thus, so it seems, depositors making short term loans can share in the rewards of making long term loans.

Well now, suppose the economy is at capacity, i.e. full employment. And suppose MT were suddenly banned. There’d be an obvious initial deflationary effect. So government and central bank would have to implement stimulus, monetary and/or fiscal. Let’s say they do both in equal measure, which essentially comes to printing new money and spending it into the economy, and/or cutting taxes.

Now assuming that stimulus is of just the right amount, then lo and behold, the economy is back to capacity or full employment. But what’s the REAL COST of doing that? I.e. what’s the real cost of printing money and spending it? Well the cost is absolutely nothing. It costs nothing (to put it figuratively) to print hundred dollar bills.

Ergo MT achieves nothing.

Turner’s system fails to dispose of bank subsidies.

As soon as government (i.e. taxpayers) guarantee deposits, they are subsidising banks. And subsidies do not make economic sense (unless some very good social reasons can be found for a subsidy).

And the beauty of full reserve is NO GUARANTEE OR SUBSIDY is needed. You could argue, I suppose, that government is guaranteeing those safe accounts, but the risk there is negligible, thus there is a negligible subsidy. The same cannot be said for the banking set up advocated by Turner, far as I can see.


Adair Turner needs to think again. But the above article of his was published in 2010, so perhaps he already has “thought again”. He is certainly a bright spark, and said recently that he’s been on a steep learning curve over the last four years or so.

So have I  :-)

(P.S. I am indebted to Vincent Richardson, who runs a business in the North East of England, and who is a Positive Money supporter for drawing my attention to Turner's article.)

1 comment:

  1. Thanks for the analysis Ralph.It is as I suspected a rather naive stance to take.The sheer volume of loans made by the banks during the pre-crunch period was unprecendented and multiplied many times over by the power of leverage.
    If Turner seriuosly believes that 100% reserve system would create anywhere near the same scale of catastophe then he is not and never was fit for his role at the FSA.

    However as you say he may have changed his stance since 2010,but the very fact that such an experienced head is saying such things as late as that this,is a indication of the mind set we have to overcome with the types we cross at the Treasury and Bank of England.


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