Letting a bank go bust when all its creditors are shareholders or loss absorbers is pointless.

I support Positive Money, while not agreeing with every single one of their policies. One of their policies that doesn’t stand inspection is the idea that depositors should take a hair-cut when a bank fails. (Section 6.9 of their book “Modernising Money”).

They advocate that shareholder should be first in line for haircuts in the event of failure, and no one can quarrel with that: that’s common practice with a corporation that fails – bank or any other corporation.

Next in line are bond holders, and finally depositors. And that all sounds reasonable, doesn’t it?

However, there’s a kind of self-contradiction there, and as follows.

Suppose that in the event of insolvency it turns out that depositors’ stake in a bank turns out to be worth 80p in the £. Instead of closing down the bank, which causes a lot of disruption, why not just say to depositors “sorry, but your stake is now worth 80p in the pound. You can cash that in now, or keep hold of your stake in the hopes that things improve.”
Depositors would be no worse off: either way they get 80p, or thereabouts.

Now that’s exactly what happens in the case of a shareholding in any firm or indeed a stake in a unit trust (“mutual fund” in the US). That is you buy your stake for £X a unit on 1^stJan, knowing full well that next day, or at any point in the future, the stake may be worth more than or less than £X.

And indeed the latter sort of model is the one advocated by Laurence Kotlikoff for banking: that is, anyone who wants their bank to lend on their money so that interest is earned has to face the value of their stake varying in line with the value of those loans. In effect, under Kotlikoff’s system, depositing a FIXED SUM of money in a bank and getting interest on it comes to an end. That is no longer allowed. Instead, and to repeat, those who want interest have to take a stake in the underlying loans or investments.

It could be argued that the Positive Money system, depositors have the advantage of being able to get £Y back for every £Y they deposit at a bank, unless the bank goes bust. But that’s a bit of a self-contradiction: it’s a bit like saying that a boat floats unless it sinks. I.e. under the PM system, depositors just DON’T HAVE 100% security.

Moreover, a system in which a bank claims that depositors have Z million worth of deposits when the assets to back that Z million are worth less than Z million is a bank that creates money out of thin air. And that’s exactly what PM opposes.

And finally, when a bank DOES FAIL under PM’s system, the failure is SUDDEN. In contrast, under Kotlikoff, when a bank performs badly, all that happens is that the value of the stakes held by all creditors (shareholders, bondholders, and depositors) drifts downwards. (Actually in the case of Kotlikoff’s system there aren’t any shareholders or bondholders, as I understand it.).

Former governor of the Bank of England, Mervyn Kingreferred to the advantages of that GRADUAL collapse. He said:

“And 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..”