Making bank failures impossible is easy. To be exact, making the SUDDEN failures impossible is easy: obviously an inefficient bank should be allowed to fail sooner or later. But it’s the SUDDEN failure that does the damage.
Sudden failure can be ruled out as follows.
Make depositors choose between two types of account. First there are 100% safe accounts where depositors’ money is not loaned on or invested (that’s why it is 100% safe). It could just be lodged at the central bank. Second there are accounts where depositors’ money IS LOANED ON (or invested), but in that case depositors foot the entire bill if the loans go bad. Money in the first type of account would be instant access, but would earn no interest. Money in the second would take longer to withdraw, but WOULD EARN interest (because the money is doing something).
That way the bank as such cannot suddenly fail, though there is nothing to stop it shrinking, or shrinking to nothing over a period of time.
In fact the above system is pretty much the system advocated by Laurence Kotlikoff .
Unit trusts / mutual funds.
One variation on the above theme advocated by Kotlikoff to which I have no objection is that depositors who want their money lending on or investing just put their money into a unit trust of their choice (mutual fund in the US). And those unit trusts could perfectly will include trusts that take over the lending function traditionally done by banks.
Thus the latter trusts would in effect become banks (depending on your definition of the word bank). Or those trusts could be legally separate entities from existing banks while still being run by traditional banks - indeed most large banks already run a range of unit trusts.
In effect, those with a stake in those trusts would become shareholders, and Mervyn King alluded to the advantage of a system of that sort when he said,
“…we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”
Moreover, George Selgin, who is not incidentally an advocate of full reserve banking, suggests a similar “fail safe” system for the banking system he favours. On p.30 of his book “The Theory of Free Banking”, he says, “For a balance sheet without debt liabilities, insolvency is ruled out….”. (His book is available for free online).
Put safe account money into government bonds?
Another variation on the above theme is that “safe” money could be put into short term government debt instead of simply being lodged at the central bank. That way, the money would earn some minimal rate of interest.
Personally I’m not keen on that as government debt can fall in value. As to Greek government debt, well we better not go there.
The variety of unit trusts would be larger.
An advantage of the above system is that depositor/investors would have a better range of choices as to what their money is put into. For example it could be made compulsory for banks to offer a trust where funds are invested just in mortgages where the house owner has a minimum 30% or so equity stake. That sort of investment would be 99.9% safe, though it clearly would not earn a spectacular rate of interest.
In fact under the above Kotlikoff system, British mutual building societies would become “mortgage granting trusts”. And as to the idea that turning building society depositors into shareholders would be a big shock for them, that is questionable. Mervyn King recently pointed out that those building society depositors are already in effect the shareholders. (See question 4510 here.)
As to bank departments that currently specialise in loans to firms and industry, those would become unit trust entities. Thus depositors wanting their money invested for example in small firms would be able to do so.
Adopting the “two account” system does not involve implementing full reserve.
While advocates of full reserve banking tend to advocate the above split between safe accounts and investment accounts / unit trusts, adopting that split does not mean adopting full reserve banking lock stock and barrel (far as I can see).
Would loans become more expensive?
Well loans would become more expensive IN THAT taxpayer subsidies for the banking system are removed. But that’s a move towards a more efficient allocation of resources, isn’t it? That is, it is generally accepted that subsidies misallocate resources. I.e. removing the subsidy makes us all better off.
Another possible reason for supposing that loans would become more expensive is that those funding lending institutions would be, or would in effect be shareholders, and it is commonly thought that shareholders demand a bigger return on capital than depositors. Well that argument was disposed of by Messers Miller and Modigliani.
M&M’s basic argument is that the risks run by a bank are a GIVEN. Thus the charge made for bearing that risk is also a GIVEN. Thus that total charge is not influenced by the number of shareholders amongst whom the risk is split.
There have of course been various attempts to criticise M&M, but I’m not impressed by the criticisms. For example Paul Tucker (who recently nearly became the new head of the Bank of England) trots out a popular and very feeble criticism of M&M. He says:
“As for all firms, interest paid by banks on debt is deductible from corporation tax, which reduces the cost of debt relative to equity. Other things being equal, the average cost of funding can therefore be reduced by issuing debt.”
Well the simple answer to that is that tax is an entirely artificial imposition on businesses: it does not reflect any sort of economic reality. For example if red cars were taxed more heavily than blue cars, that would not be evidence that red cars were inherently uneconomic compared to blue cars.
I’ve actually come across two other papers which trott out that “tax” point recently, and if that’s the best that critics of Miller and Modigliani can do, then it’s game set and match to M&M, far as I can see.
Let’s make sudden bank failures impossible: it can easily be done.