Great Banking Confusion: Is There a Better Way?

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.

Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money.

That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).

To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).

That difference -- that physical paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.

Is There a Better Way?

Consider the banking industry's contribution to society. The banking industry provides three major services to the public:

1. It provides a "safe" place to hold the public's most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.

What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account."

These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to "dip" into the reserves allocated to their 100% reserve accounts. Of course we would make such "dipping" illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.

Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the Fed).

Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion--but would not completely eliminate them.

Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks' credit ratings, quality of management, etc.).

Of course, in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don't. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

If our banking system were set up this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the 100% reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.

Once this choice is given to the public, the banks can then be allowed to fail without severely impacting the payment system which is needed to conduct day-to-day commerce. The only job of the FDIC would then be to insure smooth transfer of 100% reserve accounts to another bank.

I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.

Comments

[elaleph:]

Great post!

Unbundling the transactional services and store of value services from the financial intermediary service would certainly enhance transparency and valuer for customers, i.e. also reduce margins for the banking industry.

In practice the unbundling already happens for large corps,

- who pay for their transactions
- can have their liquid funds hel in risk free securities and
-and get market rates for the funds they put at risk.

I find it unlikely, though, that a major shift would happen towards risk free securities (or 100% reserve deposits), because the cost in lost revenue and added cost would be an incentive against it. However, the very existance of that "virtual cash" would create a more transparent market for both at risk (lendable) funds and transactional services separately.

Jul 02 11:24 AM

[six:]

How dare you! You are suggesting limiting the mechanics that help keep making the rich richer... Imgaine the world where the average person actually considered the risks that banks took with the money they gave them to hold. Putting your money in the bank is no different than buying a bond, the bank loans that money to a business that may or may not pay back the money. So you would think that people would stop and make sure their bank is amking good loans and not doing anything crazy. But the Gov has "insured" their money through the FDIC so they don't care what their banker does with their money. This is the absolute definition of moral hazard.

$50 billion 1/1/2008
$35 billion 1/1/2009
$6.5 billion 7/1/2009

This is what the FDIC has in their reserve fund and it will run out before the end of the year. Not a question of "if" it will run out but only a matter of when. The FDIC has up to 99 years to pay claims back, they will tell you they have never taken very long but it is an option available to them. I have personally known people that waited months to get money after a bank failed. During the S&L crisis- S&Ls were insured by a sister comapany to the FDIC, set up just like the FDIC it took years to pay back claims.
Pull them belts tight one more time boys...

Jul 02 12:22 PM

[Mansoor H. ...:]

Yves Smith of Naked Capitalism has pointed out that Irwing Fisher had proposed something similar in his book, 100% Money (Published in 1935).

Here is how my proposal is different:

Irving Fisher in his book 100% Money (1935) proposed that all banks be required to hold 100% reserves for money deposits payable on demand. In other words the government should outlaw fractional reserve banking. Fisher believed that booms and busts are a result of credit created by fractional reserve banking.

I propose that the government require commercial banks to provide 100% reserve account as one of the options. I do NOT propose that the government should outlaw fractional reserve banking.

Summary:

a) The 100% reserve accounts would just be another option that a public would have. I am in no way saying that banks should be forced to offer 100% reserve deposit accounts only just that they must provide it as one of the choices.

b) I also propose that many institutions absolutely necessary to maintain law and order must not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc). The idea here is that civil law and order should not be disrupted even if several very large financial institutions fail at the same time.

c) I would also remove the protection of FDIC insurance for moral hazard reasons. But I would still have an FDIC like institution to facilitate a quick and smooth transfer of 100% reserve accounts to another bank from the failing bank. The idea here is to keep the payment system running smoothly so day-to-day commerce can continue to function even if a very large deposit taking institution fails.

d) The main objective is to preserve Adam Smith’s invisible hand in disciplining and destroying poorly managed very large financial institutions. I am not proposing that we write a more stringent Glass-Steagall Act or keep anyone from creating complex financials products (securitization, derivatives, etc.) or keep any bank from investing non-100% reserve bank deposits in risky and/or complex financial products. In fact, I would want most banking regulations repealed, as they are unable to protect us from systemic meltdown. Doing this will greatly lower regulatory compliance costs for banks.

e) I strongly believe that if we don’t let very large financial institutions die then they will eventually economically destroy us by mis-allocating huge amounts of capital. There should be no such bank that is too big to fail. But we also don’t want to descend into total chaos after a meltdown and not be able to maintain a basic payment system to conduct day-to-day commerce.

f) In short, our basic electronic ledger based payment system should function even if several very large deposit taking financial institutions fail at the same time without resorting to physical paper cash to conduct day-to-day transactions. Deposits in 100% reserve accounts will provide a basis to build new viable financial institutions if a meltdown occurs.

g) My proposal is a variation on what is sometimes called “Free Banking” with the 100% reserve deposit account as a required option for the public.

Sep 27 04:41 PM