Thursday, 3 June 2021

Are ordinary depositors smarter than bank regulators?

One of the most common criticisms of full reserve banking is that it would mean higher interest rates. And on the face of it, that would certainly seem to be the case because when switching from fractional to full reserve, a significant proportion of the funding for loans ceases to come from deposits, and instead comes from equity (or what amounts to equity, e.g. stakes in mutual funds held by those who want their money to be loaned out).

Now it might seem that equity holders will charge more for their services than depositors because equity holders carry a risk. But a big flaw in that argument is that risk is far from absent from “deposit funded fractional reserve banks”: it’s just that the risk is carried by the deposit insurance system, which of course charges banks for that insurance, with relevant costs being passed on to borrowers. And assuming that system and the latter equity holders both estimate the risk correctly, then they’ll charge the same! Ergo there should be no difference when it comes to the cost of loans as between full and fractional reserve!

Of course it’s possible banks recoup the latter costs by cutting the interest they pay to depositors, but the effect there is much the same: people will then have a reduced incentive to place deposits at banks with a view to earning interest, ergo loans from banks will be more difficult to obtain or the cost of loans will rise.

The only possible escape from that argument for fractional reserve enthusiasts is to claim that depositors in a full reserve system OVER ESTIMATE the risks, thus (so they might argue) it might make sense for government in its wisdom to step in and set up a system where risks are more accurately gauged.

But there’s a big problem with the latter argument, namely that in 2007/8 we had a major bank crises as a result of which a good ten million people worldwide lost their jobs, tens of thousands were thrown out of their homes, and which was followed by a ten year long recession. Thus the idea that “government in its wisdom” (i.e. bank regulators) are able to estimate risks accurately is obvious nonsense.

And any idea that bank regulators have now got it right is doubtful given that the chairman of the main UK investigation into banking in the wake of the 2007/8 crisis, Sir John Vickers said that bank regulation is still nowhere near good enough. (See his Daily Express article entitled “Storm is Coming”)

The conclusion is that far from bank regulators having a better idea as to what the risks involved in fractional reserve are than depositors, it’s depositors who are the more clued up. Or at the very least, the idea that governments / bank regulator are more clued up than depositors looks doubtful.

And that in turn casts doubt on the idea that depositors overestimate the risks involved in fractional reserve. And that in turn is a big flaw in the idea that interest rates would be higher under full reserve.


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