Mervyn King, governor of the Bank of England said, “If there is a need for genuinely safe deposits the only way they can be provided while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.” Quite right.
He also said, “Of all the many ways of organising banking the worst is the one we have today”. Right again.
The big problem in using deposits (made safe thanks to the taxpayer) to fund risky investments is that this is a subsidy of commerce. And it is a HUGE subsidy.
That can be put another way. If you invest directly in shares in corporation X and it goes bust, you lose some or all your money. But if you put money into a bank account, and the bank uses your money to buy shares in corporation X, or makes a loan to the corporation and it goes bust plus the bank goes bust, you are safe. You keep your money.
It’s a free lunch! And of course the taxpayer pays for the meal.
Two types of bank account.
My favourite solution to this problem is to require depositors to come clean: make them choose between two alternatives. First they can have 100% safe accounts, or second, they can have what might be called “investment accounts” (for want of a better phrase).
Money put into safe accounts would NOT be invested in anything remotely risky: perhaps it could be deposited at the central bank. Those accounts would have a government guarantee, but they’d earn little or no interest.
In contrast, money in investment accounts WOULD BE invested in commerce, mortgages, etc. A decent rate of interest would probably be earned, but there would be no taxpayer funded rescue if the bank went belly up.
Regulation is simplified.
The beauty of the above system is that bank regulation is simplified. As regards investment accounts, there’d be no more need for more regulation than applies to the stock exchange. If you buy shares it’s largely a case of “buyer beware”: same principle would apply to those wanting investment accounts.
As to safe accounts, the money has to be lodged at the central bank, or perhaps invested in government stock. That is dead simple. It is easy to check up on and audit.
Would lending would be constrained?
An apparent problem with the above system is that if a significant proportion of depositors opt for safe accounts, then funds available for banks to lend might seem to be reduced, which might seem to constrain economic growth. And banks can be relied on to shout this argument from the rooftops. (You can tell how concerned banks are about economic growth from the wonders they’ve done for economic growth over the last four years – ho ho.)
Anyway, the answer to the above economic growth argument is that if you implement a taxpayer funded subsidy for any activity (bank lending to business, or anything else), that activity will expand. And conversely, if the subsidy is withdraw, then the activity will become less popular.
However to argue that constraining loans by banks constrains economic activity is nonsense in that there are alternative ways of funding businesses: shares, bonds, etc. Thus to the extent that the latter funding methods made up for reduced bank lending, there would be no reduced funding for businesses.
But even if total funding for businesses did decline, that in no way stops government boosting aggregate demand when appropriate and maintaining full employment (in as far as governments have the competence to do this - and clearly they are not 100% competent in this regard.)
Moreover, where total funding for business DID DECLINE, it is false logic to argue that GDP declines. That reduction in total funding for business, if it occurred, would simply result from the withdrawal of an unjustified subsidy.
And subsidies DISTORT ECONOMIES and lead to a GDP REDUCTIONS. So unless someone can prove that there is market failure which leads to a sub-optimum amount of funding for business, then any reduction in such funding as a result of withdrawing the above subsidy will lead to AN INCREASE IN GDP, not a DECREASE.
Put another way, there is an OPTIMUM amount to be invested in any business or in a nation’s entire business sector. The amount invested can be too much as well as too little. Untill someone shows that the above subsidy is justified because of market failure, the assumption must be that removing the subsidy will result in us moving from excess investment to something nearer the OPTIMUM.
Now bankers: get out of that one.