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Real Banking Reform - Full-Reserve Banking

|Includes: AIG, BAC, Citigroup Inc. (C), GS, JPM, WFC

We've all heard the calls for full-reserve banking and ending the Fed but how should it be done and what alternative would be put in its place? How on earth does one solve the financial crisis and create a stable financial system?

To fix the problem we must understand the problems inherent within our financial system. It should understood that there is always the risk of a bank going bankrupt under the current financial system. That is simply because banks have more liabilities than assets.

How a bank works is that any deposit made to banks is loaned out. Say you put the money in a checking account that earns 0% interest. They can then loan out 90% of your deposit at any interest above 0% and make money. Shockingly by law, only 10% of the original deposit must be kept on reserve! The banks can do this because most of the time, people do not use all of their money. They have found that they can take the idle cash that you and I put in the bank and invest it elsewhere. In doing so, they take on risk without telling us.

A problem arises when people freak out about the economy and go to the bank to demand their cash. So in our original situation, say the bank invested the depositer's cash in crappy subprime housing loans. So one day, our depositer hears about the crashing housing market. He gets scared and worried because he heard that his bank made a lot of those loans. He goes to the bank to take his money out. However, because his original deposit was loaned out and lost a bunch of value, he can only recover a portion of his money.

Now imagine this on a wider scale with many more depositers and it becomes evident that during a bank run, it is vital to get to a bank first to get your money back. Otherwise, the bank will run out of assets to sell to give money back to depositers.

"But what about the FDIC!?" you ask? The government created the FDIC as a band-aid to fix the problem of bank runs. Unfortunately, it only addresses the symptoms of the problem and not the cause of the problem. But the shiny placard says that all deposits are insured to $250,000! There is no need to worry right!? Wrong.

The FDIC gets its money from an insurance policy the banks pay on all of their deposits. All the premiums go into the "deposit insurance fund" and are supposed to cover all deposits. If you look at the amount of cash in the fund compared to the number of deposits out there, you will see that they simply do not have enough money to pay back everyone. In case of systemic collapse, you might as well kiss your money goodbye.

The problem of bank runs and systemic collapse has been plaguing me until I recently came up with a solution. I've been seeing if anyone else had the same idea and turns out that there is one economist by the name of Laurence Kotlikoff pushing for full-reserve banking. Unfortunately, he does not call it that and I only found out about him by digging through the footnotes of a wikipedia entry on "full-reserve banking." He calls his solution "limited-purpose banking."

Here is what he proposes:

He wants to turn all financial institutions (insurance funds, hedge funds, etc etc.) into banks which would then invest money deposited into mutual funds. One mutual fund that could be invested in would be a cash mutual fund. This fund would effectively just hold cash and return nothing, effectively creating a full-reserve bank.

Unfortunately, banks could not make any money from these deposits and the cash mutual fund will need maintenance fees. A better idea would have the banks simply not lend out any cash deposited in checking accounts and to charge a storage fee on those deposits. Banks would be paid to keep your money safe and secure. They cannot loan or invest this money and these banks would become similar to other storage businesses. Because the money they keep for you is neither loaned nor invested, it is 100% secure. You could take it out of the bank at any time. These banks would not need FDIC insurance.

However, people could still elect to invest their money if they wished. They could put it into a separate financial institution. These "investment bank" would offer various ways to invest. You could put your money in savings funds, stocks, ETFs, mutual funds, or hedge funds. With this, the full risks and familiar concept of "being able to lose everything," like in stock market investments, would be universally understood.

Under such a system, the effects of systemic risk would be limited to the investment banks. Any type of collapse would not matter to the storage banks because customers' funds are immediately available. The FDIC, which is effectively bankrupt anyways, could be eliminated.

Such a system would create a stable and trustworthy banking system that would restore confidence in free markets.

Disclosure: Short S&P index futures