Diamond and Dybvig, opponents of full reserve, advocate full reserve.

Douglas Diamond and Philip Dybvig (DD) attack full reserve banking here, but unwittingly support it here.

Their criticisms of full reserve appear in section  III of the above first paper. And their first criticism is the bog standard and not too clever criticism made by others namely that full reserve would constrain bank lending

Now the problem with that criticism is that it is such a blindingly obvious apparent flaw in full reserve that the advocates of full reserve would have to verging on mental deficiency if they hadn’t spotted it and thought of a solution. The UK’s Vickerscommission actually made the same criticism, and I answered it here. But just to repeat, the solution is that government / central bank can perfectly well make up for any deflatonary effect of full reserve by creating and spending new money into the economy.

Indeed, full reserve by its very nature involves replacing commercial bank money with central bank money, thus the above “solution” is pretty much part and parcel of full reserve.

The alleged shadow bank problem.

The second criticism of full reserve made by DD is that if the larger banks are forced to obey the rules of full reserve, that will just result in shadow banks filling the void. That is, shadow banks will up their fractional reserve or money creation activities.

As DD put it, “Furthermore, the proposal is likely to be ineffective in increasing stability since it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity”. (Incidentally, Charles Goodhart also makes much of this problem in the Appendix here.)

Well there are simple flaws in the above DD argument as follows.

First, regulating shadow banks should not be too difficult. One reason for thinking that is the head of the UK’s Financial Services Authority, Adair Turner doesn’t think it would be too difficult. As he put it on the subject of shadow banks, "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."

Next, the larger the bank (a “formal” bank or shadow bank) the more difficult it is for it to avoid being noticed and regulated by the authorities. Indeed, it is not even all that easy for a self-employed plumber or electrician with a turnover of say £100,000 a year to avoid being noticed by the income tax authorities. And £100,000 a year is a minute turnover for a bank (shadow or formal).

So the only shadow banks that MIGHT avoid being noticed by the authorities are very small shadow banks. And small shadow banks have a problem there, alluded to by Minsky when he said “everyone can create money; the problem is to get it accepted”.  

 The problem is that money creation is an activity where size definitely pays. To illustrate (and taking the “very small” end of the scale) any individual person can create money in that they can pay for goods or services with an uncrossed cheque, and the payee can endorse the cheque and pass it to a third party. And the third party can pass it to a fourth, etc. That’s all perfectly legal, and the uncrossed cheque is then in effect a form of money.

But I’ve never in my life tried to pay anyone by endorsing a cheque that someone else gave me, and conversely, no one has ever tried to pay me that way. That method of payment is very cumbersome compared to normal methods.

Same goes for small shadow banks. Those small shadow banks will have no problem doing what shadow banks spend much of their time doing: connecting large borrowers with large lenders. But that process does not create money: it does not equal fractional reserve banking.  In contrast, for a small shadow bank, persuading a significant proportion of actors in the economy to accept its liabilities and pass them from hand to hand  - well that’s much harder, if not plain impossible.

Of course in the world’s financial centres, numerous small shadow banks will be well known to those working in those centres, and that small group of people may well treat a small shadow bank’s liabilities as money. But then all sorts of strange bits of paper get treated as money in the world’s financial centres: government debt is often accepted in lieu of cash in those centres. But there is no country in the world that includes government debt in its money supply.

And remember, government is an entity that is several thousand times the size of the average shadow bank. Given that size pays when it comes to having one’s liabilities accepted and treated as money, small shadow banks have problem competing with government’s liabilities, to put it mildly.

Maturity transformation.

Another form of money creation or another aspect of fractional reserve is maturity transformation (MT), that is “borrow short and lend long”.

Unfortunately for small shadow banks, this is another area where size pays. MT relies on calculating what proportion of depositors are likely to withdraw their deposits in next month or so, and keeping that money available for those depositors, while lending on the rest of the money.

Now a bank with say a quarter of a million depositors can calculate with a very high degree of certainly what proportion of depositors are likely to withdraw in the next month. But same does not apply to a very small bank with say ten depositors. The latter sort of bank would be running an excessive risk if it engaged in any MT at all.

DD’s alleged political problems.

DD’s third criticism of full reserve is that it involves various unstated “political problems”. They say, “Fortunately, the political realities make it unlikely that this radical and imprudent proposal (full reserve) will be adopted.”

Well if DD can’t tell us what these “political problems” are, it’s a bit difficult to answer their point, isn’t it? However it’s not too difficult to guess what these political problems might be, and when time permits, I’ll deal with them.

DD’s advocacy of full reserve.

As pointed out above, in this paper, DD unwittingly advocate full reserve of a sort. That is they advocate a system under which in a crisis, or given a bank run, the rate at which deposits can be withdrawn is limited.

Well now, that is very similar to the systems proposed by two of the leading advocates of full reserve, Kotlikoffand Werner (K & W). That is both K and W advocate systems in which various depositors’ right to withdraw quickly is constrained.
K & W however are more sophisticated than DD (unless I’ve got DD wrong). That is, in the K and W systems, depositors have a right to instant access / current / checking accounts. There are never any restrictions on the rate of withdrawal (up to the amount that depositors have put in such accounts). Moreover, the money is 100% safe and is always there because it is not invested or is only invested in ultra-safe and easily marketable securities like government debt. 

And that is absolutely right: people and firms must have checking or current accounts.

In contrast, under DD the rate of withdrawal from checking accounts might be restricted: totally unacceptable.

As distinct from checking accounts, under K & W there are investment accounts. And there, there is little difference between K, W and DD. Withdrawal is slowed down or banned for a specific period, or (under K) too fast a rate of withdrawal results in “withdrawers” accepting a loss on their investments.