Friday, 19 February 2016

Full reserve banking solves every banking problem.

Almost every day I spot a problem which full reserve solves. For example, today I spotted a conversation on Twitter to which Anat Admati contributed. (AA is an economics prof at Stanford who specialists in banking).

Presumably her point is that given that most bank profit and loss accounts and balance sheets are works of fiction, would be shareholders have little idea what they’re investing in, thus they’re reluctant to invest in bank shares. Even if that’s not her point, the latter “work of fiction” problem is still worth addressing. So let’s address it.

Over the last decade or so, banks managed to get away with a number of fraudulent, semi-fraudulent and very risky activities. First there was NINJA mortgages. Second, any bank can in theory crash anytime due to derivatives (despite the recent and alleged improvements to bank regulation). Third there were those CDOs that turned out to be worth a lot less than face value. Now you really can’t blame people for not investing in that nonsense.

In contrast, under full reserve, investors are given a number of clear choices as to what they invest in. In fact the number of possible options is almost limitless. However, one option that all banks must offer under full reserve is to lodge depositors’ money in a totally safe manner. And “totally safe” means the money is simply lodged with the central bank and/or invested in short term government debt.

Apart from that, banks offer what are in effect mutual funds which invest in a variety of more risky stuff. For example a fund could invest just in mortgages where the house owner had a minimum 50% equity stake in the house. That investment would be very near 100% safe.

A second option would be more risky mortgages, even NINJA mortgages. If a number of people want to put their money into that sort of risky investment, why not let them?

 A third option would be just loans to businesses.

A fourth option or variable is the extent to which any of those mutual funds mess with derivatives. A mutual fund might bar derivatives altogether. Or it might not.

To summarise, under the existing system, bank shareholders have little idea what risks they run. In contrast, under FR, those risks are made clear. And if it turns out very few people want to fund risky stuff like NINJA mortgages, than that’s that. Very few people will be able to get NINJA mortgages: arguably a good outcome. 

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