The fatal flaw in maturity transformation and fractional reserve banking. Part III.

Having argued in Part II that there is little difference between full and fractional reserve from what might be called a strictly accounting perspective, there is actually another reason for thinking there is little difference accountancy wise, which is thus.

The risk involved in funding a bank is determined entirely by the nature of the loans and investments a bank makes (absent FDIC type deposit insurance). For example those funding a bank which specialises in NINJA mortgages will want a higher return than those funding a bank that specialises in conventional mortgages.

Thus it doesn’t make any difference whether a bank is funded primarily by equity or by debt: the cost of funding the bank will be the same in both cases. The chance of funders losing 100% of their initial stake in the bank, is the same regardless of whether the bank is funded mainly by shares or mainly by debt.

And that’s probably just a re-statement of the Modigliani Miller theory (an over simplified re-statement I admit, but for the sake of brevity, I’m leaving it at that).

Incidentally the MM theory HAS BEEN criticised, but I examined the criticisms here (p.24) and the criticisms are pretty feeble.


Thus the conclusion so far is that from a strictly accounting perspective or “cost of funding banks perspective” there is little to choose between full and fractional reserve.


Bank vulnerability.

There is however an important difference between the two latter options: fractional reserve banks are VULNERABLE. They are organisations that are constantly skating on thin ice (and constantly falling thru). The reason for that vulnerability is as follows.

Fractional reserve banks have a liability (money) which is fixed in value (inflation apart), while they have assets (loans and investments) which can fall dramatically in value. Think Cyprus or Spanish and Irish property loans or NINJA mortgages. And that is just asking for trouble, witness the fact that banks have gone bust in large numbers and regular as clock-work ever since banks were first set up.

As Douglas Diamond and Raghuram Rajan put it in reference to banks’ liquidity creating activities, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.” And those authors were NOT ARGUING for full reserve: quite the opposite - they argued for FRACTIONAL reserve. So in highlighting a weakness in fractional reserve, they can’t be accused of being biased towards full reserve. (That's in the abstract of their NBER paper No.7430)

The solution normally adopted to that vulnerability problem is to back up fractional reserve banks with deposit insurance and lender of last resort (LLR). Now there’s nothing wrong with those two backups if they’re implemented on a strictly COMMERCIAL BASIS, e.g. if LLR is on the basis of Walter Bagehot’s “penalty rates” and “first class collateral”). However there are four problems there, as follows.


Deposit insurance and lender of last resort.

First, the idea that those two backups ever will be implemented on a commercial basis is laughable. Banksters will always bribe and cajole politicians into implementing the backups on a bank friendly and blatantly UNCOMMERCIAL basis. Witness the THIRTEEN TRILLION DOLLARS loaned by the Fed to banks recently much of it at zero or near zero rates of interest. (That compares to the 10% Warren Buffet charged Goldman Sachs at the height of the crisis). Walter Bagehot will be turning in his grave.

Banksters will always spin sob stories to politicians about economic growth being hit if banks aren’t given favourable treatment. And politicians will believe it every time because about 99% of politicians are economic illiterates.

As for the UK, the authorities quite clearly have no intention of actually charging banks for deposit insurance (unlike FDIC in the US under which banks do actually pay an insurance premium (shock horror)). Granted the so called “Bank Levy” has recently been implemented in the UK, but it comes to a small fraction of 1% of deposits: a near irrelevance.

So a big problem with fractional reserve is that, at the very least, there is a high risk of the two backups amounting to a subsidy of private banks.



Slow versus fast bank failure.

A second problem with fractional reserve protected (allegedly) by the two backups relates to the SPEED at which bank failures take place. As to INDIVIDUAL banks under fractional reserve, failure is quick and sudden (e.g. Northern Rock). As to the banking system as a whole, failure is also quick and sudden, e.g. the sudden freezing of credit markets at the start of the recent crisis.

In contrast, under full reserve, and given poor performance, all that happens is that the bank’s share price falls. And as the former governor of the Bank of England, Mervyn King put it:

“..we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”

To paraphrase Mervyn King, under the existing bank system (aka fractional reserve), bank failures can lead to chaos despite the protection allegedly offered by the two backups.


Cheating the insurer.

A third problem with the two backups is that they amount to a form of insurance for banks, and there is always a temptation to “cheat the insurer”. (10% of car and house insurance claims in the UK involve an element of fraud).

There are of course differences in the EXACT WAY that banks cheat their insurers as compared to house and car owners. In particular, in the case of banks, the cheating takes the form of running excessive risks (if possible, hidden from the insurer) in the knowledge that if it all goes wrong, the insurer will pay.


Bagehot did not approve of lender of last resort.

A fourth and final problem with LLR is that, contrary to common belief, Bagehot did not approve of LLR. In the last chapter of his book “Lombard Street” he expressed the view that LLR was wrong, but thought it was too entrenched to be worth trying to dispose of.