Tuesday 25 March 2014

The false logic at the heart of fractional reserve banking.

There is a whapping great bit of false logic at the heart of fractional reserve banking, as follows.
Under full reserve, depositors can place their money in a bank which simply warehouses or lodges the money at the central bank. Or they can invest their money elsewhere e.g. on the stock exchange, mutual funds (in the US) or unit trusts (in the UK) and so on.
Unfortunately, as is blindingly obvious from the history of banks ever since Roman times, fractional reserve banks are prone to collapse when they make poor loans or investments. Thus governments (aka taxpayers) underwrite fractional reserve banks, i.e. subsidise those banks. The subsidies take various forms. First, deposits are guaranteed, at least up to some maximum (£85,000 in the UK at the moment.) And second, in the case of large banks, governments are just not prepared to let them fail normally, thus those with more than £85,000 in a large bank in the UK are being subsidised by taxpayers.
And third there are the lender of last resort facilities offered to banks by central banks: not a luxury available to other industries normally.
But subsidising banks does not make sense any more than does subsidising restaurants or garages.
As an alternative, governments can stipulate that fractional reserve banks have enough capital to ensure that they're so called “unlikely” to go bust. What “unlikely” actually means is about a one if fifty or one in a hundred chance of a given bank going bust in a given year. So in that scenario governments still stand behind depositors. So the subsidy is still there.
A solution to that is to make capital requirements so large, e.g. say 50% (which was common in the 19th century), that the chance of a bank going bust is then vanishingly small, and then remove the guarantee that governments give to depositors.
But in that case, depositors then in effect become shareholders, because if their bank DOES GO BUST, they bear some of the loss. After all, a shareholder is one who by definition shares in profits and losses. Thus the bank becomes a sort of mutual fund: one of the alternatives offered to depositors under full reserve.
QED. Fractional reserve is in check mate. It's a glorified piece of false logic.
And that's why Dodd-Frank and others trying to improve bank regulation simply end up producing rules and regulations of byzantine complexity which don't even solve the problem. They're trying to make sense out of something which is fundamentally senseless, which is a glorified bit of false logic. They're on a hiding to nothing. They should pack it it. Give up.


  1. Why not just abolish all the subsidies you mention.
    There would then be a demand by some depositors for greater security.
    This would be a great opportunity for a new enterprising Ralphanomics Bank which would guarantee that all its deposits were backed by CB reserves and/or Treasury Bills.
    There would then be no need for Positive Money or any government intervention.

  2. Hi KingKong,

    That’s an idea worth considering. Let’s say government simply abolished all bank subsidies. Obviously there’d be an outcry from the pampered British public who think they have a right to have everything supplied to them for free or at a subsidised rate. But after a few rioters and protestors had been shot “pour encourager les autres” a proportion of depositors would flee to National Savings and Investments, which is a sort of bank and which more or less fulfils the requirements of the 100% safe accounts or entities that advocates of full reserve want. So there’d be no need for a Ralphonomics full reserve bank.

    And the rest would flee to unit trusts or invest direct in the stock exchange or some other investment. At least the reason I’d personally flee to unit trusts is that rather than have Fred the Shred or the ars*holes who used to be in charge of Northern Rock or the Co-op bank invest my money for me, I’d rather choose the level of risk that suits me personally. And I can do that by investing in a suitable unit trust.

    So you’ve got a point. Simply banning bank subsidies more or less brings about full reserve automatically.

  3. In the absence of subsidies to banks there would probably be demand for a Ralphonomics full reserve bank to provide secure accounts with ATM, debit card and checking facilities. AFAIK these are are not provided by National Savings investments.

  4. You're quite right: NSI doesn't entirely fit the bill, which is why I said above that I "more or less" fits the bill.

    Another point I should have mentioned above is that the mere fact of removing subsidies means that depositors are then risk takers, i.e. in effect shareholders - sort of. I.e. they are then in the position of the hypothetical banks I mentioned in the final paragraphs of the above article which have a capital ratio of 50%.

    To summarise, the mere fact of removing subsidies - regardless of what depositors then choose to do - means one is at least half way to converting from fractional to full reserve.


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