Wednesday, 9 April 2014

Bank balance sheets and full reserve. Part II.

In reaction to my recent post on this topic (Monday, 7th April) it’s been pointed out to me that when loans by private banks (PBs) are handed over to the central bank (CB), it would actually be PBs who continued to collect interest and repayment of capital on those loans, since CBs don’t have the resources to do the job. And that’s a good point. But that point can be taking into account without significantly changing the balance sheets set out in the above post. The changes needed are as follows.
 It would be necessary to debit commercial banks (in the books of the CB) with a sum equal to the capital value of those loans (maybe in a special “capital repayment” ledger). So the only change to the balance sheets is the DESCRIPTION of the £0.6X at the extreme bottom left of the balance sheets. (That’s the asset side of the CB’s balance sheet immediately after conversion to full reserve)
That is, “Loans (formerly owned by commercial banks)” becomes something like “debt owed by PBs to CB and equal to the capital value of loans which former bank depositors do not want to fund” – bit of a mouthful, but hopefully not totally incomprehensible.
The result would be that PBs would collect repayment of capital on those loans and hand the money over to the CB, and the interest on those loans would cover the cost of that collection work.

I glossed over treatment of existing bank shareholders in the above mentioned post. The best way to treat them is perhaps as follows (and I’ll assume Lawrence Kotlikoff’s system rather than Positive Money’s).
First, set up a mutual fund specially for former bank shareholders, where the assets of the fund consists of loans equal in value to the above shares.
To that extent shareholders are treated much the same way as former depositors who want to fund loans (“investment accounts” in the case of Positive Money’s system).
However, the above “special mutual fund” would contain an additional characteristic, namely that those investing in the mutual fund have a right to the profits or losses that arise from the repayment (or non-repayment) of loans mentioned above.
And that would be entirely reasonable because shareholders would have benefited from the latter profit or born the latter loss had PBs never converted to full reserve.
As to how those shareholders are treated in the balance sheets, they’d appear in the “commercial banks after conversion to full reserve” balance sheet (3rd one down). And the way they are treated is so similar to the way depositors who want their money lending on or investing are treated that the only change needed is a few additional words on the liability side. That is “Deposits in PM’s investment accounts or Kotlikoff’s mutual funds” becomes something like “Deposits in PM’s investment accounts or Kotlikoff’s mutual funds plus shareholders’ stakes in the mutual fund specially set up for shareholders”.

Where do PBs get base money?
A possible objection to the above is that CBs deal only in base money. And since PBs in the decade or so immediately after the switch to full reserve are paying the CB fairly large amounts of base money every year (in respect of the repayment of loans where PBs collect those repayments), then the question arises as to where the base money comes from.
Well the answer is that government and CB would be spending base money into the economy to make up for the deflationary effect of the latter repayments. Problem solved!


  1. Your revised/new idea is a £0.6X interest free loan from the CB to the Private Banks.
    This would require further changes to the PBs' balance sheet which would become:
    PB Assets = £X loans + £0.6X reserves
    PB Liabilities = £0.4X investment a/c deposits + £0.6X full reserve deposits + £0.6X interest free loan from CB.

    Question 1. Shouldn't the PBs be charged commercial interest rates on this massive loan? Otherwise there would be a hidden subsidy to the PB's.

    Question 2. In the event of a PB failure, presumably the full reserve deposits would be repaid first (using up the reserve assets). After this, would the CB loan be repaid ahead of the investment deposits?
    If so, the investment deposits would be uncompetitive - in addition to normal investment risks they would also bear the risks of guaranteeing the PB's loan from the CB. So a 100% reserve scheme might work, but a 60:40 scheme would be dubious.
    Alternatively, if the CB loan has lowest priority in the event of a bank failure, the CB/taxpayer would suffer the loss - another hidden subsidy.

    Question 3. You say one of the aims is simplicity. Wouldn't a better and simpler solution be to publicly renounce the "too big to fail" philosophy?
    This would safeguard the taxpayer. No more bail-outs.
    Then the demand for safe banking could be supplied in a free market by enterprising banks eg. by guaranteeing high percentage or even full reserves with only slightly higher bank charges.

    1. Re your question No.1, remember that PBs are debited AND CREDITED in the books of the CB with an approximately equal sum. There’s the reserves credited to PBs, meanwhile they’re debited with an approximately equal sum representing the value of loans in respect of which PBs spend the next ten or so years recouping the capital sum from mortgagors etc. So if we drag interest into it, the interest charges would sort of cancel out I think.

      Of course the reserves stay there for ever, so you could argue that interest be charged on that. But PBs themselves can’t do anything with those reserves: that money is essentially the property of sundry non-bank private entities (i.e. households and firms). I.e. the latter in effect have an account at the CB with PBs acting as go-between or agent. William Hummel thinks households and firms should have ACTUAL ACCOUNTS at the CB. He has a brilliant website on money and banking, but I think he’s wrong on the latter point: CBs just don’t have the infrastructure for administering tens of millions of individual accounts.

      Milton Friedman, an advocate of full reserve, thought that interest should actually flow the other way: that is that the central bank / government should pay the private sector for holding reserves. Personally I think “no interest either way” is the best and simplest option.

      Re question 2 and PB failure, half the beauty of full reserve is that banks just can’t fail (though they can slowly decline). As safe accounts, that money is safe, so there’s no possible failure from that source. As to the half of the industry that lends, if it makes really stupid loans and investments, the all that happens is that “depositors” or those with a stake in said loans and investments see the value of their stake decline. The bank (or mutual fund in the case of Kotlikoff’s system) as such doesn’t fail.

      Re question No.3, I think we’d have riots if government suddenly announced they no longer stood behind bank accounts. I.e. it would be better to FIRST set up easily available safe accounts, and then tell the public “You now have a choice. If you want 100% safety, you can have it, but you’ll get little or no interest. Alternatively, if you want to have your money invested, then you run a risk in exactly the same way as if you invest your money on the stock exchange.”

  2. Regarding Q2: You say "half the beauty of full reserve is that banks just can’t fail (though they can slowly decline)". Wrong. They can fail if liabilities exceed assets.
    Indeed, this would be a distinct possibility if the infusion of £0.6X reserves into PB's is accompanied by what you say, "debt owed by PBs to CB".
    If the value of a PB's loan assets falls below its debt to the CB (£0.6X in your numerical illustration) then the bank's net value would become negative. It could not repay the CB even if the investment a/c holders get nothing.
    Would the CB/taxpayer close this failed bank down to get whatever it could from selling the loan assets of the bank?
    If not, your new proposal is that the PB's get £0.6X reserves is more like a GIFT than a loan.
    Surely "we’d have riots if government suddenly announced" a GIFT £trillions reserves to the banks.

    A related possibility is that the CB gets shares in PBs in return for reserves, i.e. the PBs are nationalised. In practice this would be similar to your idea of an interest free loan with no binding repayment obligation.
    This could be much better for taxpayer who would enjoy dividends from their massive investment in banks, instead of the proposed zero interest "loan" investment.


    1. “They can fail if liabilities exceed assets.” True in theory, but I’ve looked at the asset to liability ratio of the hundred or so small banks that have failed in the US over the last five years or so and that has never happened. The worst case was a bank where assets had declined to 10% of liabilities. As to Lehmans, it now looks like their assets comfortably exceeded liabilities: their mistake was that the assets were not liquid enough.

      But that’s a GENERAL point about lending entities or “banks” under full reserve. Your point about my proposed balance sheets is slightly different. You say “If the value of a PB's loan assets falls below its debt to the CB (£0.6X in your numerical illustration) then the bank's net value would become negative.”

      My answer to that is, “not quite”. Remember that the special mutual fund set up for those who were shareholders before the switch, consists (on the asset side) of some loans taken over from the pre-switch bank. Plus (as I said above) stakeholders in that mutual fund also have a right to the profit or loss resulting from payback (or failure to pay back) other loans.

      Now stakeholders in that mutual fund carry a fairly large risk. But it’s similar to the risk that bank shareholders carry anyway under the existing system. E.g. if a bank under the existing system is funded say 5% by shares and 95% by deposits, then loans made by the bank only have to drop 5% in value, and shareholders are wiped out.

      But the reality of course is that when a large bank fails under the existing system, the state comes to the rescue. I.e. taxpayers bear some of the risk.

      So the above special mutual fund for former bank shareholders kind of represents the dying embers of the old system and it retains the big flaw in the existing system, namely that the taxpayer is on the hook for potential losses. But the size of those potential losses gradually declines as mortgagors repay capital sums.

      Hope that makes sense!?!?

      Re your final two paragraphs, you seem to be reverting to my original proposal: i.e. that complete ownership of loans be handed to the CB. As was pointed out to me (see start of the above article) the problem with that is that CBs just don’t have the staff and resources to collect capital repayments and interest on mortgages etc.


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