Isabella Kaminska opines on full reserve banking – unfortunately.

I dealt with just under fifty (50) criticisms of full reserve banking (FR) here. The criticisms range between the moderately well thought out to the laughably stupid – mainly the latter.

The opponents of FR never seem to give up, and the latest clever clogs to claim they’ve spotted a flaw in FR is Isabella Kaminska in a Financial Times. She clearly knows precisely and exactly nothing about the subject. Her argument runs as follows.

She starts by making the point that central banks do not compete with commercial banks when it comes to granting loans to mortgagors and businesses. (She makes that point in a paragraph copied from a Bank of England publication. That’s the paragraph starting “The 1844 act…”.)

She then says, “This, we suggest, illustrates why Positive Money’s campaign to take the power to create money away from the banks is somewhat naive. Namely, because, a central bank with a clear-cut reputation to protect is never going to be as competitive as the private sector when “money printing” and risk is concerned. Which means, there will always be a market for some sort of entity to come in and undercut it in the private market.”

Now hang on. How is it possible to “undercut” another firm in providing some service or other, when that firm is not (as Kaminska correctly points out) actually providing that service? That is, as she correctly points out, central banks do no provide loans to mortgagors etc, so how can commercial banks “undercut” central banks there? This is nonsense.

Money creation and risk.

Next, note the way Kaminska runs “money printing” and “risk” together. The implication is that some sort of useful service is provided by that activity or combination of activities.

WELL THAT’S THE CENTRAL BONE OF CONTENTION BETWEEN ADVOCATES OF THE EXISTING SYSTEM AND FR!

She’s begging the question!!

To expand on that, under the existing system, commercial banks create money when they lend, but there is no such thing as a totally safe loan or set of loans. So money creation by commercial banks involves risk. Indeed, banks have gone bust regular as clockwork ever since Roman times, a fact which seems to have escaped the notice of half the supporters of the existing banking system. Thus the existing system combines money creation with risk.

Now money is one of the basic and essential bits of plumbing that keeps the economy ticking over, so a system where the economy’s stock of money can disappear into thin air at any time is not too clever. As Irving Fisher put it, “The most outstanding fact of the last depression is the destruction of eight billion dollars-over a third-of our "check-book money"-demand deposits.”  

But there is an alternative! Indeed the alternative is already being implemented on an unprecedented scale: it’s to have CENTRAL BANKS not COMMERCIAL BANKS issue the money supply.

And there’s no risk there at least in that central banks cannot go bust.

Farcical bank regulations.

Regulators have spent millions of hours and dollars recently hunched over their calculators, trying to work out just how far bank capital should be raised so as to improve bank safety, without demanding TOO HIGH a level of capital because that would allegedly raise the cost of funding banks by too much.

There is of course a well-known answer to the latter “cost” point, namely the Modigliani Miller theory (MM). MM basically says that if the amount of capital used to fund a bank is for example doubled, that will halve the risk per share. Ergo doubling bank capital has no effect on the TOTAL CHARGE made by shareholders for funding the bank. Ergo raising bank capital costs nothing.

A large amount of effort has been devoted to working out whether MM is 100% valid, or whether it does not actually work as per theory in the real world. For example David Miles of the Bank of England Monetary Policy Committee claimed that while the MM theory was basically right, that MM “is not likely to hold exactly”.

Why not? He doesn’t say.

But I’ll take a different approach and hopefully show that MM is indeed 100% valid, and hence that having a bank or “lending entity” funded JUST BY CAPITAL (which is what is involved in full reserve banking incidentally) would involve no additional costs at all. The different approach is thus.

Take two hypothetical banks which engage in the same type of lending (risky or safe – whatever you like). One bank is funded almost entirely by capital and the other almost entirely by depositors or other types of debt. Now assuming no taxpayer or government support for banks, what’s the difference between the risks run by those funding those two banks? The answer is “absolutely none”. Ergo there is no difference in the cost of funding the two banks! Simple.

There are of course differences between shareholders and depositors / debt, but the differences are irrelevant. To illustrate, say a bank’s assets decline to 90% of book value, that just means in the case of the shareholder funded bank that the shares would drop to about 90% of initial value. While in the case of the depositor funded bank, and assuming the bank is declared insolvent, depositors would get about 90 cents in the dollar. So shareholders and depositors are in the same position to all intents and purposes.

So where does this idea that bank capital is inherently expensive come from? Well I suspect numerous economists have been misled by various artificial and politically inspired interferences in the free market which have artificially boosted the cost of capital relative to the cost of debt.

For example some countries have deposit insurance funded by taxpayers. Now in that case obviously funding via capital will be more expensive than funding via depositors! The depositors are subsidised. In other words in such a country, to get at REAL COSTS, deposit insurance should be ignored.

Another distortion that artificially boosts the cost of capital comes from the different tax treatment of capital and debt. Indeed that seems to be the most popular criticism of MM. But of course the criticism is complete nonsense because tax is an ENTIRELY ARTIFICIAL imposition. You really have to wonder whether so called professional economists can think their way out of a paper bag. The latter nonsensical tax criticism of MM was made for example by David Elliot, of the Brookings Institution, Lev Ratnovoski, Anil Kashyap, and Urs Birchler.   

Conclusion.

The bank regulators mentioned at the outset above,  hunched over their calculators have been wasting their time. They might just as well have implemented the VERY LARGE increase in bank capital advocated by for example Martin Wolf, chief economics commentator at the Financial Times, and by Anat Admati. To repeat, that would not have raised bank funding costs.

Indeed, the process can be taken much further: have lending entities funded JUST BY SHARES, which is what is involved in full reserve banking (FR), or at least some versions of FR. That of course raises an obvious question: how about depositors? Well the answer is that under FR, depositors (i.e. people who want to be guaranteed to get $X back for every $X they deposit) simply have their money lodged at the central bank and/or put into short term government debt. No risks are taken with their money.

The net result is that banks are failure proof. The lending half of the banking industry cannot go insolvent because by definition, an entity funded just by capital cannot go insolvent. And as to depositors, their money is totally safe (or at least as safe as is possible in this imperfect world).

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P.S. (24^th Nov 2014). To add to the muddle, there is this less than inspiring Bank of England paper (“The Financial Policy Committee’s review of the leverage ratio”) which has a lot to say about the leverage ratio, but doesn’t actually explain why a low ratio will costs us more than a high ratio . . . except for a reference (p.24) to a NIESER computer model which apparently contains estimates of those costs. Unfortunately I’ve found that model impossible to access.

Anyone writing a paper which claims that X=Y should spell out in very clear language exactly why they think X=Y, strikes me.

 

Mankiw and Krugman and on full reserve banking.

Mankiw expresses sympathy with full reserve banking. He says, “Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.” (Narrow banking is just another name for full reserve banking, btw.)

Krugman answers that by saying “Where Greg goes astray here, I think, is by trying to apply Modigliani-Miller, which says that capital structure doesn’t matter. If you look at the assumptions behind that argument, you realize that it requires that all assets be perfectly liquid.”

 “I think of the whole bank regulation issue in terms of Diamond-Dybvig which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”

Well the answer that is that you don’t need conventional banks, or indeed any sort of bank, to obtain a good degree of liquidity. Your car and house are moderately liquid in that cars can be turned into cash within 24 hours and houses normally in a month or so. Plus the stock exchange funds investments in ILLIQUID assets while ensuring that those who fund those investments enjoy a high degree of liquidity: you can turn your stake in General Motors into cash within 24 hours, though the actual number of dollars you’ll get is not totally predictable.

As to liquidity in the sense of a fixed number dollars, or a liquid asset which is guaranteed to hold its value (inflation apart), traditional commercial banks are just not needed for that purpose. That is, government and central bank can provide an economy with whatever amount of money the economy needs. Indeed, central banks are doing just at the time of writing on an unprecedented scale in that there is a record amount of base money sloshing around thanks to QE.  

Or that “central bank money administering” job can be partially farmed out to commercial banks: that is what Mankiw meant by “Suppose we were to require banks to hold 100 percent reserves against demand deposits.” I.e. the safe half of the banking industry under full reserve deals just in base money or money which is backed 100% by reserves.

Moreover, if a private bank is going to provide customers with what might be called “extreme liquidity”, i.e. a fixed number of actual dollars, that NECESSARILY makes banks’ balance sheets fragile, as indeed Douglas Diamond himself eloquently pointed out.

As he and his co-author put it, in reference to the liquidity / money creation that private banks offer: “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”

That is, if a banks’ liabilities consist of dollars / money, then those liabilities are FIXED in value (inflation apart). In contrast, its assets (the loans it makes) can fall in value. That equals fragility. It’s asking for trouble.

Conclusion.

Traditonal commercial banks with their money creation activities are a complete pain in the whatsit and for the following reasons.

The stock exchange, or more generally shares, provide a degree of liquidity. Of course banks provide a better way of transferring and storing money that dealing just in physical cash kept under the mattress. But so far as the provision of liquidity goes, commercial banks add nothing. They cannot give us liquidity without at the same time giving us fragility, and possible bank runs, credit crunches, etc.

Daniel Aronoff versus Positive Money.

It’s game set and match to PM, if you want to know the final score. But details are as follows.

Fran Boait of PM in the letters section of the Financial Times cited a Bank of England publication which pointed out that commercial banks create deposits when they lend.

Daniel Aronoff responded (his 2^nd paragraph) by saying that when the DO LEND, that changes the ratio of deposits to bank reserves (which is obviously true, given more or less constant bank reserves).

But he then jumps to the conclusion that that shows that the cause effect relationship can run the other way, i.e. that expanding reserves enables banks to lend more. Unfortunately it is widely accepted by economists that there is only one significant determinant of bank loans: the availability of credit worthy borrowers. I.e. reserves are well nigh irrelevant.

Certainly a large increase or decrease in reserves from their present level is irrelevant so far as bank loans go. In contrast, given the sort of level of reserves that existed prior to the crisis (i.e. about one tenth their present level), banks are then near the minimum stock of reserves that they need for settling up with each other, so the volume of reserves might be argued to be relevant there.

However, even that argument has been widely criticised. Just one example: as Bill Mitchell puts it, “As we have discussed many times banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit…..These loans are made independent of the banks’ reserve positions.”