Sunday, 4 January 2015

Why doesn’t every firm do some banking, asks Richard Werner.

Commercial banks create money when they lend. At least, when making a loan, a commercial bank does not need to get the money from anywhere: it can just credit the borrower’s account with money produced from nowhere. Hyman Minsky made roughly that point when he said: “Anyone can create money. The difficulty is getting it accepted.”
And that money creation seems a good business to get into.
To be more accurate, commercial banks do TWO THINGS: far as I can see, they both re-cycle existing loans / money and create new money.
So why doesn’t every garage and restaurant create some money? Richard Werner (professor of economics at Southampton University in the UK) addresses that question in a very readable paper published recently. It’s about 7,000 words. (Incidentally it was Werner who introduced the term “quantitative easing” to the English language.)

There is of course the obvious point that garages like to concentrate on selling and repairing cars, and indeed  customers pay good money for specialist skills. That helps explain why most garages don’t want to get deeply involved in banking (or running restaurants). But there’s something else going on.
After all, there are bound to be millions of cases where garage owners have a better idea as to the credit worthiness of a customer than the local bank. So why don’t garages create money for those customers?
Prof. Werner’s answer is that (at least in the UK) it’s largely down to an obscure rule enforced by the Financial Conduct Authority. The rule is the so called “client money rule”. (Incidentally, don’t take my summary of Werner’s paper as being totally accurate: if you want complete accuracy, read his actual paper.)
The client money rule stipulates that when any firm without a banking licence holds customers’ money, that money must be kept in a separate bank account (i.e. must be lodged with an institution that DOES HAVE a banking licence).
Obviously non-bank firms (e.g. garages) can hold small amounts of customers’ money for short periods (e.g. pre-payments for car repairs). But it’s the “client money rule” that stymies a garage, should it wish to branch out into banking. So… if a garage DID CREDIT £X produced from thin air to a customer’s account, that money would have to be immediately transferred to an account in a licensed bank.
It’s a bit like forcing anyone trying to get into the furniture storage business to lodge furniture in a rival’s warehouse: rather defeats the whole purpose of getting into the furniture storage business!

Why combine deposit taking with lending?
Another related question which Werner touches on, but doesn’t examine in detail, is the question as to why firms which accept deposits also specialise in making loans. Indeed, he claims that this question has never been satisfactorily answered. James Tobin, an economics Nobel Laureate, made a similar point when he said “The linking of deposit money and commercial banking is an accident of history..”.
My answer to that question is that if a firm made loans but didn’t attract deposits (or didn’t attract money by some other means, e.g. by selling bonds) it would run out of reserves (i.e. run out of base money). To illustrate, if a firm grants a loan using money created out of thin air, that “funny money” will get deposited in a variety of other banks when the money is spent. And those banks will want real central bank money, i.e. base money, when settling up with the firm that granted the loan. So anyone (garage or restaurant) wanting to create and lend out money, has to attract funds and hence base money from somewhere.
Now there is plenty of money sloshing around, and being held in checking / current accounts, and lenders can solve the latter “shortage of reserves” problem if they attract enough deposits. Plus banks don’t need to pay any significant interest on checking / current accounts. So if you’re into the money creation and lending business, there’s much to be said for accepting deposits as well.
Another good reason to attract deposits is that some governments underwrite those deposits (e.g. in the UK). So in effect, banks can attract funds to lend on and have taxpayers carry the risk. Why can’t we all offload our risks onto taxpayers?

So, should the UK dispose of the client money rule? Disposing of the rule would certainly increase competition in banking. On the other hand most countries don’t let any old Tom, Dick or Harry become a bank: you need a banking license in most countries. So to that extent, disposing of the client money rule wouldn’t make much difference.
Second, any firm that wanted to create and lend thin air money to customers has to attract funds to cover most of that money, and accepting deposits is one way of providing that “cover”. So lending and accepting deposits do rather go together (though of course investment banks don’t accept retail deposits). That tends to mean you either get into banking in a big way or not at all.
Third, there is nothing to stop a garage under the existing system acting as guarantor for a loan made by a local bank to one of the garage’s customers. So to that extent, garages can actually get into banking, despite the client money rule.
And fourth, there are big overheads involved in organising check books, debit cards and so on. And that’s plain impossible for a small garage. That point would help prevent garages becoming bankers even if the client money rule was abolished.
So I think Werner over-estimates the importance of the client money rule. Still, his point is interesting.

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