How about something truly radical – the complete dismemberment of the banking system as we know it and its replacement with what is known as 100pc reserve banking?
So how about something truly radical – the complete dismemberment of the banking system as we know it and its replacement with what is known as 100pc reserve banking?
This is not as ludicrous a suggestion as is sometimes made out. What’s more, to describe it as radical may be a bit of a misnomer. Actually, 100pc reserve banking is a distinctly “conservative” approach to the problem, for its primary purpose is to make finance as low risk as possible.
Nor is it the completely unrealistic, fringe idea sometimes supposed, having been treated very seriously by President Franklin D Roosevelt during the last great banking crisis in the 1930s, when it was quite widely supported by some of the leading economic thinkers of the time.
In the end, the concept was shelved, but the mere threat of it helped FDR push through a banking crackdown that high finance would otherwise have regarded as completely unacceptable. Given the choice, even Glass-Steagall seemed preferable to the so-called “Chicago Plan”, named after the two Chicago-based economists, Henry Simons and Irving Fisher, who devised and articulated it.
The idea has been given new legs by the outbreak of our own 21st century banking crisis, and it is again fast developing something of a cult following. Research by Jaromir Benes and Michael Kumhof of the International Monetary Fund has found support for all four of the big claims made by Fisher of 100pc reserve banking – better control of the credit cycle, complete elimination of bank runs and a dramatic reduction of both public and private debt.
To understand how such a system would work, you have to go back to first principles. By extending credit, bankers create money. Few of them admit to this dynamic, and certainly, for the individual banker operating at the coal face of credit allocation, it doesn’t look that way. Every time a banker makes a loan, he must fund it with deposits and capital. Where’s the money creation in that?
Well, here’s how it works. Say the banker raises £1m in deposits to make a loan of £1m. The deposits are a liability which the bank is duty bound to honour. Yet the loan is essentially new money which will end up getting deposited somewhere else in the banking system, or sometimes even back with the loan originator, thereby giving the banking system new deposits to make new loans.
The only limits on this process of money creation are the banker’s instinctive fear of making a bad loan that will lead to a loss, and the fraction of deposits held as liquidity against the possibility that depositors suddenly want their money back – hence the term “fractional reserve banking”.
During the credit bubble of the 2000s, liquidity buffers were allowed to fall to dangerously low levels, with the result that when confidence collapsed, many banks had insufficient reserves to meet demand from depositors for their money back. With the panic soon going global, there followed the biggest banking crisis in history.
It is at this stage of the credit cycle that the process of money creation goes violently into reverse. As the bank shrinks its balance sheet by calling in loans, it destroys deposits with the same vigour it created them on the way up. We are still in this stage of the cycle, forcing central banks to compensate for the shrinking money supply by printing their own new money – so-called quantitative easing. Without this offset, the economic textbooks tell us, there would be a depression.
In a system of 100pc reserve banking, none of these problems arises. As the term implies, all deposits are held on reserve, or in cash. The deposit bank is thereby deprived of its money creating privileges, but there is no risk of a run. Credit is instead provided by intermediaries that compete for these deposits and marry them directly with borrowers.
Simple. The credit cycle is abolished, and many of the things that so much concern regulators today – capital and liquidity requirements, risk weighting, how to get rid of the too-big-to-fail problem – would cease to be an issue.
What’s more, there would be no need for deposit insurance or oversight, beyond a framework for simple fraud prevention. Credit banks could be allowed to fail without risk of wider systemic damage.
Under the original Chicago plan, the transition from the current to the new system would also allow the Government to cancel its debts, though obviously at the current level of spending, these debts could quickly re-accumulate.
When something looks too good to be true, it generally is. One of the most obvious drawbacks is that there would plainly be less credit and less leverage in such a system. Indeed, to the extent that credit existed, it would look much more like high-risk equity. For all the social and economic scarring the credit cycle can inflict, it is also a key part of the creative destruction of capitalism.
Without it, you might have a more stable economy, but it is not clear that you would have as much innovation, entrepreneurialism, business creation and long-term economic growth.
The biggest problem of all with 100pc reserve banking is that of transition. Getting from here to there would be a truly revolutionary and potentially highly destabilising process, so much so that it is hard to think of any advanced economy embarking on it.
Then again, we are not through this present banking crisis yet by any means, and already, many things that were once thought fanciful are now part of our every day language. Lord Turner, former chairman of the Financial Services Authority, is devoting a whole chapter in his forthcoming book on the crisis to the idea of 100pc reserve banking.
His own preference is for a kind of halfway house, where required reserves are bigger but there remains the capacity for money creation. This might seem something of a cop-out, but it is certainly roughly where we are in the policy debate.
The only trouble is that it has quite severe pro-cyclical consequences, for a bank required to hold more capital and reserves is even less likely to want to restart credit creation. Hey ho.