The basic principles that support full reserve banking.

Principle No.1.    Everyone has a right to a totally safe bank account in the same way as everyone has a right to enough food, a roof over their head and so on. Plus many employers find a totally safe bank account useful.

Principle No.2.     The fact that everyone has a right to something is not necessarily an argument for supplying the item to them for free. For example the way food is delivered to everyone is normally to ensure everyone has sufficient cash income; then people are free to choose the food they want and they pay for it, using that cash.

Principle No.3.     Various basic essentials are supplied to everyone for free in many countries, e.g. health care and education for kids. The argument for that, rather than having people to pay cash for those items is that some people would choose not to purchase those items, and instead would spend the relevant cash on luxuries. That would impose costs on the community at large, for example the failure by some to purchase health care could promote the spread of contagious diseases, and the costs of not teaching kids the three Rs are heavy for society at large later in those kids’ lives: they are unlikely to find jobs, which means society as a whole has to support them.

Principle No 4.     There are no particularly heavy costs for society at large that derive from someone NOT HAVING a bank account (i.e. letting them deal just in cash). Therefor there is nothing wrong with requiring people to PAY FOR the privilege of having a bank account.

To that extent, the argument that it is important to let banks lend on depositors’ money so as to earn interest and thus defray the cost of administering bank accounts is not valid. Moreover, cross subsidization (e.g. having money lending subsidise the cost of administering a bank account) is generally frowned on in economics. Indeed, subsidies in general are frowned on unless there is a good social case for subsidies.

Of course the possible withdrawal of physical cash in the next few years might seem to weaken the latter argument. However, even if physical cash is withdrawn, there would still be a few people happy to go without a bank account: for example one member of a husband and wife couple who was happy for their partner to do all the financial transactions for the family. Same applies to children not considered by their parents to be responsible enough to have a bank account.

Principle No.5.     Where anyone wants interest on the money they’ve deposited at a bank, there is only one way the bank can supply that interest, which is to lend on relevant monies. I.e. anyone who wants interest in effect is a lender. That is, they are into commerce, and it is a widely accepted principle that it is not the job of governments or taxpayers to stand behind commercial transactions. Thus there should be no taxpayer deposit insurance where a depositor wants their money loaned on, any more than there is taxpayer backed insurance for people who deposit money at a mutual fund / unit trust, or who deposit money with their stock broker with a view to that money being invested or loaned on.

Principle No.6.     The argument that if deposits ARE INSURED BY TAXPAYERS, that banks will lend more and thus boost GDP does not stand inspection. Clearly if deposits where relevant monies are loaned on ARE INSURED by taxpayers, there would SEEM TO BE a rise in GDP. However, governments (assisted by their central banks) have complete control of aggregate demand, and can thus raise demand and GDP any time they want. To that extent, the additional above mentioned demand stemming from extra private bank lending is irrelevant: i.e. given inadequate demand stemming from deposits no longer being insured by taxpayers, government can easily make good that deficient demand with conventional stimulus, fiscal or monetary.

Thus given that keeping demand at the full employment level is not difficult in principle, the question than arises as to what the GDP maximising banking set up is.

Well it’s widely accepted in economics that GDP is not maximised where anything is subsidised for no good reason. And taxpayer backed insurance for money which is deposited at banks and loaned on is an unjustified subsidy for reasons given above.

Ergo taxpayer backed deposit insurance reduces GDP. Put another way, bank loans should be funded via equity. Or put another way, where X lends to Y and Y does not repay the money, X should foot the bill, not the taxpayer.

A second weakness in the argument that taxpayer backed insurance for lenders increases lending and thus GDP and/or investment is that exactly the same argument applies to lending in the form of the purchase of corporate bonds and even corporate shares. For some strange reason, advocates of the above “taxpayer backing for lenders increases GDP” argument apply that argument to bank deposits, but never to corporate bonds or shares. That is a clear inconsistency.

Principle No.7.     Taxpayer backed insurance is subsidised insurance because everyone knows the “insurance company” cannot possibly fail, unlike private sector insurance companies. Of course taxpayer backed insurance could take account of the artificial privilege that taxpayer backing brings by making an extra charge for its insurance. However the reality is that over the last hundred years or more, bankers have regular as clockwork bribed or persuaded politicians into doing the exact opposite: i.e. bankers have induced politicians to grant private banks special privileges rather than make sure banks and their customers PAY FOR special privileges, like taxpayer backed insurance. Thus the idea that an extra charge for the privilege of taxpayer backing would ever be made, or the idea that if it were made, the extra charge would last any length of time, is a joke.

Principle No.8.      Funding bank loans via equity rather than deposits might seem to raise the cost of loans because equity holders demand a higher return than depositors. That apparent difference is largely or  entirely an illusion: reason is that once the cost of deposit insurance is taken into account, the total cost of funding via deposits is in theory no different to the cost of funding via equity. Reason is that the risks of bank funders losing a given proportion of their money is determined by the nature of the bank’s ASSETS (e.g. NINJA mortgages versus safer mortgages) not by the nature of its funding.

Put another way, the extra return demanded by equity holders as a percentage of their total stake in a bank should be equal to or related to the risk they run. But the risk run by depositors is the same. Ergo the insurance premium, as a percentage of the sum insured for depositors, ought to be the same or at least very close to the latter percentage in the case of equity holders (i.e. the amount equity holders charge for “self-insuring”).

Moreover, the return on bonds (which are similar in nature to deposits) in the US is currently HIGHER than the return on equity!


Conclusion.

The best bank system is one where people can have totally safe accounts if they want, but those accounts are inherently safe because relevant money is not loaned on. Alternatively, if they want interest, they themselves carry the risk of having their money loaned out, not the taxpayer. Under such a system it is plain impossible for banks to fail: to illustrate, if a bank’s assets (i.e. the loans it has made) turn out to be worth only 75% of book value, then the stake in the bank held by those who have chosen to have their money loaned on drops to about 75% of book value. The bank as such does not go bust.

That system is full reserve banking.