Thursday, April 11, 2013

Full reserve is to banking as E=MC2 is to physics.


Science attaches importance to simple laws that explain a lot, e.g. E=MC2.

The UK’s Vickers commission, Basel III and Dodd –Frank expended millions of words and failed to solve the main problems that afflict banking. In contrast, the basic rules of full reserve are set out in eighty five words below. And full reserve actually solves those problems.

Certainly the attempts by the above three bodies to solve banking problems have been a failure if the following critics are any guide:
See LaurenceKotlikoff for a scathing indictment of Vickers.
See MervynKing and Ben Bernanke on the fact that “too big to fail” has not yet been solved.
See MervynKing who said “Basel III on its own will not prevent another crisis….”
See MartinWolf who suggests that the 3% capital ratio advocated by Basel III is nonsense and that the ratio should be nearer 25%.
See AndrewHaldane on the complexity of bank regulation.
See also Nigel Lawson and Martin Jacomb and Paul Volker.

The main problems addressed by the above three bodies were:
1. Bank subsidies including the too big to fail (TBTF) subsidy.
2. Reducing the number of banks that go bust.
3. Sorting out the mess when they do go bust (i.e. “living wills”, how best to organist bankruptcy proceedings, etc).
4. Irrational exuberance / asset bubbles of the sort that preceded the recent crisis and largely caused the crisis. This problem was not central to the above three attempted solutions, but full reserve does ameliorate this problem.

The basic rules of full reserve.

The basic rules are thus.
1. Commercial banks cannot create money. Only the government / central bank can.
2. Depositors must choose between:
i) having their money in instant access form and kept 100% safe (e.g. having it lodged at the central bank where it will earn little or no interest), or
ii) letting their bank invest or lend on their money, in which case they do not have instant access, but they do get interest, plus if it all goes wrong, they take a hair cut.

So why does that solve the four banking problems?
Well let’s run thru them in turn.
1. There is no need for any sort of bank subsidy (TBTF or otherwise) because depositors or creditors who have chosen to have their money put at risk carry those risks.
2 & 3. As to banks going bust, they just can’t under full reserve: depositors or other creditors who have chosen to take risks can lose out, but banks as such cannot suddenly go bust, though it’s perfectly possible for them to shrink over a period of time to non-existence.
4. Asset bubbles derive in part from the freedom that commercial banks have to lend money into existence: i.e. create money and lend it out. They were doing that big time  before the recent crisis. If commercial banks cannot do that, then asset bubbles, booms and slumps are ameliorated.

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