Monday, 11 May 2015

Abolish lender of last resort?


If the above Financial Times story is any guide, the Fed’s lending powers may be REDUCED.

Rather than just “limit” the Fed’s freedom to act as lender of last resort, how about examining the whole question as to whether lender of last resort is justified? After all, lender of last resort normally amounts to a subsidy of banks, and subsidies do not make economic sense.

Of course lender of last resort loans are SUPPOSED to be made at penalty rates and in exchange for first class collateral. But any idea that those conditions were actually imposed during the recent crisis is a joke. In short, lender of last resort as currently constituted is a subsidy of banks.

Contrary to popular perception, Walter Bagehot did not approve of lender of last resort. In the last chapter of his book “Lombard Street” he said he disaproved of it, but thought it was too entrenched a part of the system to dispose of.

But if lender of last resort IS DISPOSED OF, some other way has to found to make banks failure proof. And that’s not difficult: just insist on a HUGE increase in their capital ratios. That way, when a bank does badly, its shareholders take a hit, not the taxpayer.

That “shareholders take the hit” principle applies to every non-bank corporation. Why not to banks?

As to how high capital ratios should go, Martin Wolf (chief economics correspondent at the Financial Times) favors something like 30%. Personally and as an advocate of full reserve banking I favor 100%, one reason being as follows.

Removal of subsidies equals 100% capital ratio.

If all taxpayer subsidies and guarantees for banks are removed, which they  should be, then depositors and bond holders ipso facto pretty much become preference shareholders.

To be more accurate they become shareholders as in “someone who at worse stands to lose everything”. But they don’t become shareholders in that the value of their stake in a bank is not formally reduced to below book value till after insolvency is officially declared.

However, assuming the value of that stake is strictly related to the value of the bank’s assets (which is a slight over-simplification, but not TOO MUCH of an over-simplification) then those depositors and bond-holders won’t lose out by being classified as preference shareholders. That is, if a bank does badly and after ordinary shareholders are wiped out, the value of the bank’s remaining assets are such that after insolvency proceedings are complete, depositors and bond-holders get X% of the book value of their stakes, then in the event of their being classified as preference shareholders, then the value of those shares would ALSO BE X% of book value. But, and it’s a big but: in the preference share scenario the bank is not closed down.

Now what’s the point of closing down a bank when there’s a way of NOT CLOSING IT DOWN that seems to do no harm to ANYONE? Depositors and bond-holders (re-classified as preference shareholders) don’t lose out. There’s no reason for the bank’s assets to be sold off in a hurry, and selling anything QUICKLY may mean that only a fire-sale price is obtained for those assets.

A legitimate question in reaction the latter argument is: "Why not by the same token ban bonds in non-bank corporations". My answer to that is that non-bank corporations are not as critical as banks. That is, if some non-bank corporation wants to lever up too much and it goes bust as a result, that won't result in a credit crunch followed by seven years of excess unemployment. Banks are a very different kettle of fish.


Best option is to abolish all taxpayer funded support for banks and have banks funded just by shareholders, not depositors or bond-holders.

As for accepting and transferring money which depositors want to be 100% safe, that can be done by something like state run savings banks, though numerous variations on that theme have been suggested, none of which I object to in principle. One, which used to be promoted by William Hummel is to let every citizen have an account at the central bank (though Hummel has changed his mind on that far as I can see). The UK’s National Savings and Investments bank actually serves the same purpose.

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