Thursday, June 27, 2013

Martin Wolf queries 1:1 bank leverage.

In this Financial Times article, Martin Wolf describes bank leverage of 33:1 which existed prior to the crunch as “frighteningly high”. But then says “I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”

The answer to Wolf’s question is as follows.
Reducing the 33:1 to for example the 4:1 suggested by Wolf in a later FT article would certainly reduce the chance of bank failure to a very low level. And if all we were concerned with was bank safety, then 4:1 would probably suffice. But there is another point to consider, which Wolf spelled out in very eloquent form here.

Money creation.
In answer to the question as to how the credit crunch possible, Wolf says “The answer is that we have entrusted a private industry with the provision of ….the supply of money..” To be exact, when a commercial bank lends, it creates money.
Or in the words of Mervyn King, “When banks extend loans to their customers, they create money by crediting their customers’ accounts.”

In other words there are good arguments for a system under which only the government / central bank machine creates money – sometimes known as “full reserve banking”.

And full reserve is a system that necessarily involves 1:1 leverage. Reasons are thus.
If £X of money freshly created by government is deposited at a commercial bank, and the bank lends it on, then the commercial bank is creating money, for reasons spelled out by Mervyn King above. To be exact, once the loan has been made, both the depositor and borrower consider themselves to be in possession of £X. So £X has been turned into £2X.

In contrast (and taking Laurence Kotlikoff’s full reserve system), if the depositor wants their bank to lend on or invest their money, then under LK’s system, the money is put into a mutual fund (unit trust in the UK) of the depositor’s choosing. The depositor then no long holds money: they hold a stake in a mutual fund. And the value of that fund rises or falls in line with the performance of the underlying loans or investments.

And those depositor / mutual fund stake holders are effectively shareholders. Thus the bank’s leverage is effectively 1:1.

As distinct from money that depositors want to have loaned on, there is money to which depositors want instant access, and which they want to be near 100% safe and backed by taxpayers. If that money is simply lodged at the central bank (as it would be under the full reserve system advocated by for example Positive Money), then no money creation takes place, plus there is very little risk involved.

Another problem with private money creation is that it is pro-cyclical: exactly what we don’t want. 

All in all, there are good arguments for banning private money creation.

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