Tuesday, 4 November 2014

Sir John Vickers Backs Maturity Transformation and Opposes Full Reserve Banking.

Sir John Vickers (chairman of the Independent Commission on Banking) published a discussion paper in 2012 (well after the commission’s final report). The above MPRA paper is my contribution to the “discussion”. It’s about 7,000 words. The paragraphs below are 750 word summary.
I make two basic criticisms of Vickers’s paper. First he backs “borrow short and lend long”, i.e. maturity transformation (MT). I point out some serious weaknesses in MT. Second, he criticises full reserve banking (FR). I point to some flaws in those criticisms.

Maturity transformation.
Vickers’s puts the standard claim for MT, namely that it enables depositors to share in the relatively high interest that is earned from long term loans and investments, while keeping quick access to their money. That is, an alleged merit of MT is that it promotes liquidity or creates a form of money
However, the first weakness in MT is that commercial banks can only produce liquidity / money by making themselves fragile, i.e. vulnerable to bank runs, credit crunches, etc. As Douglas Diamond says in his abstract and in reference to the liquidity / money creation that private banks offer: “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”
The reason for the fragility is simple: when someone deposits £X in a bank and the bank lends the money on or invests it, the bank creates money, but it then has a LIABILITY which is fixed in value (inflation apart), and assets (the loans it makes) which can fall dramatically in value (e.g. when it is discovered that incompetent loans have been made). That is asking for trouble.
An alternative arrangement is to have loans funded just by shares. That way, the bank’s liabilities (if you can call shares a liability) have no fixed value, thus the bank or lending entity cannot go insolvent.
As to liquidity / money, that can be produced by the central bank: a function that central banks already perform on a large scale, and without giving us fragility at the same time.
And the latter arrangement is what full reserve banking (FR) consists of, or at least it’s what Laurence Kotlikoff’s version of FR consists of.

Vickers’s criticisms of FR.
However, Vickers makes four criticisms of FR. First, he claims that under FR, money which depositors want to be totally safe is backed by government debt and that government bonds are not entirely safe.
The answer to that is that the Vickers commission assumed that the UK government would behave RESPONSIBLY. Thus it is not consistent to assume that government might be IRRESPONSIBLE when it comes to FR.
Second, Vickers claims there might not be enough government debt / bonds.
The answer to that is that most advocates of FR actually argue that “safe money” should be backed by base money, not debt. However, Milton Friedman (who backed FR) argued that debt should be used to some extent. But if there is not enough of such debt, no problem: just use base money.
Third, Vickers claims that those who need government bonds (e.g. pension funds) might find them in short supply.
One answer to that is (again) use base money instead. Second, pension funds do not need to invest at all: they can always switch to some extent to a “pay as you go” system. Third, because one set of people want an interest yielding investment, there is no obligation whatever on any other set of people to provide same. If the first set are really keen on making a profitable or interest yielding investment, they can always make their own investments: perhaps build houses to let.
Vickers’s fourth criticism is that the economy needs a continuous provision of credit (i.e. loans), and FR might not succeed in providing that, particularly in a crisis.
The first answer to that is that the existing banking system only managed “continuous credit provision” during the recent crisis because it was the lucky recipient of several trillion dollars of public money: not a brilliant advertisement for the existing system. In contrast, under FR, when it is discovered that incompetent loans have been made and lenders’ assets fall in value by say Y%, all that happens is that the relevant shares fall in value by about Y%. There is no threat of insolvency, therefor no bank bail-outs are needed.
Of course in the latter FR scenario lending would DECLINE. But then it declined under the exisiting system in the recent crisis.

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