Saturday, 27 September 2014

Musgrave’s law of banking.

It goes like this.
1. Neither of the two main activities of banks, accepting deposits or making loans should be subsidised.
2. Therefor all subsidies should be removed.
3. Removing subsidies by definition means that all bank creditors become shareholders, even where they are CALLED “depositors” or “bondholders”.
4. However, there is a legitimate demand for a totally safe way of lodging money, thus government should provide that service and on a non-subsidised basis: something that governments already do in various countries, e.g. National Savings and Investments in the UK.
5. And that all amounts to full reserve banking.


  1. 3. Happily there are alternatives to the government provision of full reserve banking:

    a). End government provided deposit insurance and other subsidies. Existing bank deposits would then become less safe, which is likely to lead to the introduction of safe full reserve accounts by competitive private sector banks.
    But this option would not work if people continue to believe that the government would still intervene to help depositors and banks during the next financial crisis.

    b). Introduce laws/regulations to compel banks to have full (or larger) reserves backing deposits. This is the proposal of most full reserve advocates. But there could be transition problems.

    c). Charge banks for government provided insurance for all deposits which are not fully backed by safe assets. The charge would be largely passed on to depositors in such.accounts.
    It would then become profitable for competitive private sector banks to offer full reserve accounts which would not bear these costs and would therefore be relatively attractive.

    d). Similar to option c) would be a tax on deposits other than those in full reserve accounts. The rationale for the tax would be the high external costs of financial panics, which are far greater than just the costs of deposit insurance, lender of last resort and to-big-to-fail interventions.

    1. Hi KK,

      Re your first point - “a” – there isn't much difference between what you suggest and what advocates of full reserve (FR) suggest. I.e. once subsidies are removed, a proportion of former depositors would flee to safety, thus it would pay commercial banks to offer totally safe accounts, as you rightly say. The only possible disagreement arises from whether commercial banks should be FORCED to offer that service, or whether commercial banks can be left to offer that service only if they want to.

      However, those safe accounts WOULD BE government provided in the sense that money in those safe accounts would be lodged at the central bank, with commercial banks acting as “go between” between bank customers and the central bank.

      Re your “b”, I don’t agree that forcing banks to have more reserves ameliorates the basic problem in the existing or “fractional reserve” banking system. Reason is thus.

      All bank reserves are SOMEONE’S property: most likely the property of depositors (e.g. someone or some entity that has sold government debt as part of QE and got a cheque from the central bank in payment for that debt). And commercial banks cannot nick that property and use it to make good silly loans. The only alternative is that reserves are the property of the commercial bank itself, which amounts to saying the reserves are the property of bank shareholders. Now I don’t see the point in bank shareholders having to deposit £X of base money (i.e. reserves) at a commercial bank for every £Y of shareholders’ money that is loaned on by the bank: under FR, lending entities / banks are funded just by shares, so they cannot go insolvent. That solves the problem. So forcing those lending entities to hold more reserves than they would otherwise want to achieves nothing, far as I can see.

      Re your “c”, I deal with the question as to whether deposit insurance makes sense in section 1.4 of the book featured at the top of the left hand column. I agree the cost of that insurance gets passed on to depositors, and in 1.4 I argue that that is a fatal flaw in deposit insurance. The reason, briefly, is that the “passing on” of that cost results in depositors making no better return on their money than if they “self insured”, i.e. bought shares in the relevant bank (and that’s one of the options for bank customers under full reserve). Plus the cost of deposit insurance is a cost that is ultimately passed on to banks, and hence results in banks being funded at the same cost as were they to be funded just by “self-insurers”, i.e. shareholders.

      There is therefore no more of an argument for the state getting involved in deposit insurance than in pet or jewellery insurance.

      Re your “d”, that comes to the same as your “c”, as you rather imply.

      Hope some of that makes sense??!!??

  2. Ralph, thanks for the reply.
    I am struggling to follow your points on b) and c).

    Full reserve option b). [Banks compelled to have full reserves backing for deposits.]
    Bank reserves would NOT be owned by depositors!
    On the contrary, just like today, bank reserves at the cb would continue to be assets owned by banks. And, just like today, depositors would voluntarily exchange cash for obligations to repay from the banks.
    With 100% reserves the banks would always be able to repay depositors. Doesn't this "ameliorate the basic problem in the existing or “fractional reserve” banking system"?

    Full reserve options c) and d). [Charges or taxes on deposits which are NOT fully backed by safe bank assets.]
    We agree that these costs would largely be passed on to depositors. But I completely disagree that this "a fatal flaw".
    On the contrary, the higher costs/charges are the essential merit of the proposal. They would induce full reserve banking through competition and market adjustments rather than by regulation.
    Enterprising banks would find it profitable introduce new safe full reserve accounts which would be exempt from the proposed charges/tax. These new accounts would attract depositors from conventional accounts because the latter would have higher charges/ lower interest that hitherto.
    A guess is that a charge or tax of 2% p.a. on conventional NON-full reserve deposits would be sufficient to induce the majority of deposits to be switched to new full reserve accounts (or NS&I). If 2% p.a. is not enough, raise it to 3%. Surely 5% would work !!

    1. Hi KK,

      Re “b”, the question as to whether bank reserves are the property of commercial banks or of depositors is a bit semantic. It wouldn’t be untrue to say that they are the property of commercial banks while matching every £ of reserves is a £ of debt owed by commercial banks to depositors. But it is equally true to say that those depositors own the reserves and that commercial banks just act as go between between depositors and the central bank. After all, each depositor is entitled to demand to be given their “reserves” in the form of real central bank money (e.g. £10 notes) whenever they want.

      Re “c” what I meant by “fatal flaw” is a flaw in the idea that there is something to be gained by going for say a 25% capital ratio with the remainder (75%) of bank funding coming from depositors who self insure, rather than for a full reserve style 100% capital ratio. The big problem or “flaw” there is that “self insuring depositors” will get the same return as shareholders, far as I can see. Reason is thus.

      A return on money invested or loaned out is obtainable for two reasons. First there the fact that the lender abstains from consuming a chunk of wealth and lends it to be borrower. Second, there is the risk involved in losing some or all of that wealth. But to insure against that risk the premium must equal the reward obtained for accepting the risk. Ergo self-insuring depositors are pointless: they don’t result in banks being funded any more cheaply.

      So the above 25% / 75% arrangement is pointless. I.e. one might as well go for full reserve, that is, have banks funded just by shareholders.

      Re your point that the transition would take place via “market adjustments” rather than via detailed legislation, I don’t flatly disagree with that. I.e. all that’s required is a firm and binding announcement by government that it will never rescue a bank in trouble, plus government will provide totally safe accounts for those that want same (which the UK government already does via National Savings and Investments) and pretty much everything then falls into place. But possibly there might be a case of “detailed legislation” in the form of forcing every commercial bank to specifically offer totally safe accounts – I’m not sure about that.


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