Monday, November 12, 2012

Advocates of fractional reserve won’t explain how they justify bank subsidies.

Fractional reserve banking cannot work without taxpayer backing: i.e. a taxpayer subsidy. I want to know how advocates of fractional reserve justify subsidising what is supposed to be a commercially viable industry.

I’m all ears. But all I hear is silence.

In case you don’t understand why fractional reserve has to be subsidised, here’s why.

Under fractional reserve, people deposit money in banks and banks promise to return sums deposited (possibly plus interest and possibly less bank charges, but let’s ignore that to keep things simple). But as long as the money remains with the bank, the bank lends on or invests the money (or most of it).

But there’s a problem. That system might work 95% of the time, but sooner or later any bank will make a string of bad loans and investments. And when that happens, banks JUST CAN’T repay depositors.

The bank goes bust. It’s happened  OVER AND OVER AGAIN. It happened in the middle ages. In the 1930s, thousands of banks went bust in the U.S. It happened in the recent credit crunch. I’ll put that in extra large red letters below just so as to ram home the message.

Under fractional reserve, banks go bust.

Got it?

That means that EITHER depositors lose their money, or the state rescues them. And a state rescue equals a subsidy of the banking industry.

Of course the safety of fractional reserve banking can always be improved by expanding the amount of loss absorbing creditors on banks’ balance sheets. And Vickers, Basel III and Frank Dodd propose miniscule and near irrelevant improvements of that nature. Basel III currently proposes a leverage ratio of 33: 1, which is truly farcical. Even more farcical is that Basel III needs 30,000 pages to spell out that nonsense.

But even if loss absorbers make up half of a bank’s creditors, that still means that if the bank’s assets decline in value by any more than 50%, the bank is technically insolvent. I.e. there is still a finite taxpayer exposure.

Thus the only way of totally disposing of taxpayer exposure (i.e. subsidy) is to make ALL BANK CREDITORS LOSS ABSORBERS. That’s nice and simple. You don’t need 30,000 pages to explain that. I just did it in a few sentences, didn’t I?

That is, where depositors want the bank to lend on or invest their money, depositors must carry the loss when those loans or investments go bad. In contrast, where depositors want 100% safety, there is no harm in letting them have 100% safety, but their money cannot be loaned on or invested. I.e. they can’t ask for 100% safety while having their money put at risk: that’s just hypocrisy. It’s a self-contradiction.

Now if a bank accepts an £X deposit, lends on the money, while letting the depositor still have access to the £X, then money creation has taken place: both the depositor and the borrower have access to £X. I.e. £X has been turned into £2X. So stopping banks making that promise to return £X and instead making banks promise just to return the value of the relevant depositor’s shareholding in the underlying loans or investments means that commercial banks no longer create money.

As to “safe” deposits, money isn’t created there either.

So there’s no commercial bank created money: the only money created is central bank money. That’s full reserve banking. And full reserve banks cannot fail. Of course those depositors who have chosen to have their money put at risk can see the value of their shares drop. But the bank as such cannot fail, thus no taxpayer subsidy is required.

So fractional reserve advocates: I want to know what the justification for bank subsidies is.

I’m listening.

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