Former FDIC chairman wants loss absorbers to make up 20% of bank creditors.

See this Financial Times article by William Isaac and Cornelius Hurley.

So why not just go the whole hog and make it 100%? The latter would not increase bank funding costs for reasons given by the Modigliani-Miller theory. The latter “theory” is actually very simple. All it consists of the idea that part of the cost of funding a bank comes from the total risk incurred by the bank. Thus whether that risk is carried by 10%, 20% or 40% of the bank’s creditors has no effect on total risk. Ergo increasing the proportion of bank creditors who are loss absorbers (like shareholders) has no effect on the total cost of funding the bank.

So the “funding cost” argument does not stand up.

And a further advantage of 100% is that there is still a finite risk at 20% or 40% . . . etc. At 100% there is no conceivable taxpayer exposure, i.e. no form of taxpayer subsidy for banks.

Money creation.

100% does mean that private banks can no longer create money. Reasons are thus.

If every dollar loaned out or invested by a bank has to be backed by a depositor / bond holder / shareholder who is going to take a 100% hair cut in the event of the bank’s loans / investments becoming totally worthless (unlikely, of course) then those bank creditors cannot have access to their money as long as it is loaned out or invested.

That incidentally does not stop an individual creditor withdrawing their money fairly quickly as long as some other creditor takes their place.

But what it does mean is that the private bank cannot create money. Reason is that private banks create money when they lend. As Mervyn King put it, “When banks extend loans to their customers, they create money by crediting their customers’ accounts.” 

To be more exact, the money creation process is thus. I deposit $X in a bank instant access or checking account. The bank lends it on. So the borrower has $X and so do I. Magic: $X has been turned into $2X. However IF I LOSE ACCESS to my money as long as it’s loaned on, then no money creation takes place.

Now if a private bank system lends money into existence in the above 100% scenario, it’s a certainty that that no all the increased deposits resulting from the money creation will come from those who want to take a hair cut when a bank gets into trouble. That is, a proportion will want to plonk their money in an instant access account, and that’s money that cannot be loaned on in a 100% regime.

Ergo, extra money must be created by the central bank.

Does 100% impair private banks’ flexibility? Nope.

And that raises a possible objection to the above “100% loss absorber” idea, namely that the private bank system’s flexibility is impaired. In particular, when the system sees a larger than normal number of viable lending opportunities, it won’t be able to expand lending.

Well now, what examples have their been over the last few decades of the private bank system spotting a larger the normal number of “viable” lending opportunities. Ah yes  - I know: those property speculating “viable lending opportunities” prior to the crunch. And those gave rise to the worst recession since the 1930s. Now that’s a brilliant argument for letting the private bank system go on a lending spree, I don’t think. In fact STOPPING the system going on a lending spree would bring HUGE BENEFITS!!!!!!

SamuelBrittan actually touched on this point in the FT on the same day, when considering whether an increase in demand should come from investment or from consumers. He said:

“So far the government has focused mainly on stimulating business investment, equivalent to trying to drive from the rear locomotive. There have been bouts of investment led growth – such as the US and UK 19th century railway booms. But the normal process is for consumption to lead.”

Too right. If demand is inadequate, then boost demand. Employers can decide for themselves how much of that additional demand to channel to investment. They don’t need economically illiterate politicians dreaming up schemes to encourage investment.

So what are the arguments for letting the private bank system do stimulus? There aren’t any, are there?

Moreover, when stimulus is needed, everyone looks to the central bank or the fiscal authorities to do something, don’t they? Why do we need duplication of effort in the form of the private bank system doing stimulus?

In fact it’s worse than that – far worse. The private bank system WONT DO STIMULUS when it’s most needed!!!! It does exactly the opposite: it goes on a lending spree in a boom – exactly when stimulus is not needed!!!!!!

So the former FDIC chairman’s argument for making 20% of bank creditors loss absorbers does not stand up. The figure should be 100%.