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A radical proposal for making finance safer resurfaces

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PPP Lusofonia

We can surely find an acceptable alternative between ZERO bank leverage and peak leverage of over 49 times, as recorded by banks which believed in the BASEL illusion of "risk-free OECD sovereign debt".
Have financial regulators never heard of the simple virtues of moderation?
How can capital of 2% of the balance sheet ever meet any reasonable test of "capital adequacy", even ignoring the risks hidden in the other 90% of the off B/S iceberg?
What were the (im)prudent regulators thinking?

More importantly, not all deposits or depositors need or deserve protection. Smaller, local, retail deposits, families and SMEs should be highly protected. Do you want your dentist to be worried about his bank when when he powers up the drill?
And the Eurozone credit crisis highlighted the importance of differentiating the protection between (stable) local deposits (speculative)cross-border funding which zips around the globe faster and faster, at the speed of a click or of acomputerized arbitrage program. A Pigouvian tax would be too good for these "hot-money" tsu-moneys.

Thus,large retail deposits, most corporate deposits and ALL cross-border non-bank and inter-bank funding should be exposed to increasing levels of risk, probably inverse to tenor. The tragic consequences of capital in-flows and sudden stops and reversals should not be underestimated.
That's why we need EUROPEAN deposit insurance for smaller LOCAL retail deposits


In practicality, the "narrow bank" concept would create 1) a bank that serves no purpose then a child's piggy bank and 2) a bank that serves as a financial institution.

The "piggy bank" bank would be a negative return depositary for administrative/operational overhead and safety/insurance costs.

The regular bank would be a regular financial institution subject to fluctuations in deposits/withdrawals from the "piggy bank" with an added lending cost (risk) in the form of a tax.

It is perhaps better to think of a bank/financial institution's relation to the economy to a (non-digital) watch's relation to telling time.

When you open up a (non-digital) watch (bank/financial institution), you will find gears(securities) of varying size and type working together to make the watch(bank/financial institution) function. The watch (bank/financial institution) is built to work triggered by the motion/activity of man and set to operate in its environment.

How well and how precise the watch functions depends on the watchmaker. Sometimes external trauma causes the watch to lose function or precision. But, a well made watch is usually repairable by tuning and/or replacing parts. And, not every watch is well made, some serves a more specific short term purpose.


Question: If banks can't use my deposit to loan then how do I earn interest on it (however small that happens to be)? It seems like the interest would have to go away, which leads me to deposit as little as possible.

8eTnUwXTZ5 in reply to w94pKcNAtm

Under full reserve you'd buy into a unit trust that lends or invests. That way you get interest or a dividend just as you do with existing unit trusts, but you also foot the bill if it goes wrong, rather than the taxpayer footing the bill which is what happens under the existing system.

Christopher D

Thanks for the explanation of narrow banking. Evaluating the macroeconomic consequences is not really my bailiwick but this seems to be a dated approach to keeping the global financial system stable.

The article points to many legitimate hurdles to commissioning and operating a banking system that did not leverage my deposits. Beyond that is the question of whether this would decrease the mandate for the Federal Reserve System, which I presume is the fruit we wish to harvest.

The appeal of getting the Fed out of the underwriting business is luminous. But the reduction to systemic risk from narrow banking is not yet apparent to this novice observer.

I already closed my checking account at Bank Of America after years of mediocre service. I'm at Wells Fargo now, but if that Buffett Buddy were to flail for some reason I would probably get banking services through my brokerage. Bank runs are not, and have never been, on my radar. Banking already seems to offer a good selection of companies for depositors.

Narrow banking seems to address a financial threat from a different era. How would any of this prevented AIG from underwriting too many CDOs and such, or would have provided mega-liquidity when their financial storm hit?

Was that not the precursor to short-term financial markets going dry, forcing action by the Fed in late 2008 just as we were changing Presidents?

8eTnUwXTZ5 in reply to Christopher D

There is a huge reduction in “systemic risk” under full reserve, and for the following simple reasons.

Under FR, the banking industry is split in two. One half is for those who want specific sums of money to be totally safe. That money is lodged in a totally safe manner, i.e. at the central bank. Though some advocates of FR (e.g. Milton Friedman) thought that money could also be invested in short term government debt where it would earn a little interest.

That half of the industry cannot fail because the money is safe.

The second half lends to mortgagors, businesses etc, but that’s done via unit trusts or similar entities where those buying into such entities foot the bill when it goes wrong. I.e. the bank / unit trust as such cannot fail.

In short, bank failures are near impossible under FR.


John Cochrane’s paper has two very important observations, the first one on the lack of regulatory response to run-prone contracts that promise fixed values and first cum first serve payments, is worth a scrutiny.

He states, “When they failed Bear Stearns and Lehman Brothers were financing portfolios of mortgage securities with overnight debt at 30:1 leverage. For every thirty dollar of investment they had to borrow every day a new 29 dollars to pay back yesterday’s lenders”.

This is perhaps the best example of a run-prone contract that no regulatory overhaul has been able to tackle. On the contrary John’s suggestion of the Pigouvian tax of 5% where for each dollar of short term debt issued, the bank or other intermediary must pay say 5 cents, thus by taxing run-prone liabilities we could make them exist where there was economic sense in it (this is an action against financial pollution similar to industrial pollution). This could be more effective than the capital ratio stipulations by the new Basel norms.


You consider John Ochrane’s “21st century” version of the Chicago plan, which involves levying a tax on bank debt to counter the negative externalities of leverage. However, you fail to put his proposals in the context of recent regulatory changes à la Basel III (or its risk-weighted shortcomings) - even though this is likely to be the biggest “implementation” problem with Mr Cochrane’s idea.

Why? As Basel III capital requirements push banks into holding more of their assets in the (perceived) safety of sovereign-debt (itself an implicit asset tax); the Pigouvian tax on debt-liabilities would add to the burden on bank profitability, and undermine their efforts to build capital. Furthermore, even if it successful in herding banks towards more equity capital, this would undoubtedly raise funding costs. Banks might compensate for this by increased risk-taking elsewhere to remain attractive to shareholders.

A truly “radical proposal” would be to reconsider the bias in Basel capital regulations for banks’ investment in sovereign debt through zero capital charges. History, and more recently Greece’s debt restructuring, has shown that such securities are far from risk-free. Such a re-think would force banks to actually raise capital – rather than simply adjust balance sheets to exploit this (flawed) regulatory loophole. Meanwhile, additional interventions that skew an already biased regulatory framework are unlikely to make the financial system safer.

8eTnUwXTZ5 in reply to bilal.khan

What makes you think there’d be any significant increase in bank funding costs if capital requirements are raised?

According to Anat Admati (economics prof at Stanford) it was common for banks in the 1800s to have 50% capital ratios. That’s way way above anything suggested by any of today’s regulators. But that doesn’t seem to have done much harm: the 1800s was a period of economic growth unprecedented in human history.

Second, the Modigliani Miller theory greatly weakens the “higher funding costs” argument. As MM correctly pointed out, if the number of people carrying the risk involved in running a particular bank is doubled, then the risk PER PERSON OR PER SHAREHOLDER is halved. I.e. the total charge for carrying the risk remains the same.

Third, to the extent that funding costs DO RISE, that simply reflects the removal a bank subsidies, e.g. the TBTF subsidy.

By the way, I’ve no idea why my name appears as 8eTnUwXTZ5 above. My real name is Ralph Musgrave, if anyone is interested.

I agree with Professor Cochrane's underlying proposition, but I think the two ideas, elimination of run prone liabilities and the provision of money-like assets, could be merged into a single and easier change.

He suggests that banks should be funded by equity or by some long-term debt. This certainly eliminates run prone liabilities. Equity is simple solution, but long-term debt can be made to work too and provide a new and more soundly based form of money.

If each bank issued a single tranche of perpetual floating rate debt and the interest rate on that were set by an online auction, its value would remain at par. The rate would immediately reflect the credit of each bank. It would not be run prone as it would have no redemption after a long notice period if at all. Under Basel III pressure, these types of bank deposits are already becoming popular as evergreens or notice period deposits. The rate would be truly continuously floating rate unlike current periodic reset floating rates. The interest rate or margin would be capped so that, in a crisis, the liquidity risk would be widely dispersed among holders until that bank’s position was resolved.

This has the advantage of:

• There is no double taxation of the income as there is with equity funding.

• Being at always par, it would fit the payments system easily in a similar way that demand deposits are settled, or it could be sold on the online trading system, for a demand deposit for a few seconds to allow the current payment system to operate. If however, other variable price securities (e.g. Apple stock) are used by the payer, they will need access to an always open and fast market maker to trade the Apple stock for the security that the payee wants (say Brazilian bonds). The market maker would need to provide both spot and future prices for future payment obligations (which are very common in trade) and then, problematically, the parties would both to need to have credit limits with that market maker.

• The rate could replace LIBOR (already compromised) as the basis for floating rate term bank loans

• This deposit is a senior long-term claim on a bank, which has senior claim on a higher amount of long-term loans, which has a senior claim on an even higher amount of long-term real assets. It is closely matched (after all the junior capital buffers) to the value of the long-term real assets. Long-term real assets are the largest and most diverse pool of assets globally (all businesses, housing, real estate, land, infrastructure, intellectual property). Short-term real assets (trade credit and inventory) are a much smaller pool and are the only sound basis for short-term debt.

• Banks then become managers and aggregators of loans made against real assets. Credit is their main risk, against which their equity is a sound hedge. They no longer need to engage in MT (as Maturity Transformers). That said, since central banks granted Lender of Last Resort backing, they have actually been MT (Maturity Transferors). The shadow banks just engaged in MT (Maturity Take no notice of it). As Prefessor Cochrane rightly says, notwithstanding how many times, like an article of faith, the ability to transform maturity has been claimed, maturity risk cannot be transformed it can only be sliced and diced pooled and tranched. As physicists will attest, time (maturity) is a rather immutable property of the universe and all the accountants and regulators, much as they might pretend otherwise, cannot change that.

• The funds raised do not go to the Treasury who would use it to fund more government spending. To make a globally applicable solution, the solution needs to be unreliant of huge government debt - not all counties have that and of those that do, not all of their debt is reliable

• It avoids the full nationalisation of today’s “money” which is largely bank deposits (notes are small by comparison and with electronic cash, will go the way of coin soon). In fact, this effectively denationalizes money as advocated by Hayek.

• If inflation increases, real long depositors will raise the rates on these deposits immediately without central bank action. The rate on bank loans will then automatically rise. Less loans will be made and some repaid. Less of these deposits will be required and the bank will repurchase them reducing the rate and reducing this form of “money” supply. When inflation is low, the reverse will occur creating new money.

• The supply of Treasury issued floating rate notes would be far less likely to affect the creation rate of real public sector assets in a rational way.

• It is not fiat money as it can be exchanged (and eliminated) for the extinguishment of loans against a senior claim to real assets – much larger, and more diverse, asset base than say gold.


Re the claim in the above article that there are difficulties in “implementation” when it comes to narrow banking, Milton Friedman, a supporter of narrow banking saw no difficulties in “implementation”. He said “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.” That’s from his book “A Program for Monetary Stability”.

Second, the article claims “…there would be formidable opposition from vested interests”. No doubt, but what of it?

Put another way, the professional liars, fraudsters and criminals at the top of the banking industry would object. Does the Economist seriously attach any importance to views of those worthless individuals?

Third, the article claims “…the transition would require banks to dispose of a vast stock of loans, or raise an equivalent amount of long-term debt and equity.” So? You don’t say what the problem is there.

Narrow banking requires that those to want their money loaned out so that they can earn interest have to accept the risks involved in doing that. If you object to that, do we take it The Economists also thinks there should be taxpayer funded insurance for anyone investing on the stock exchange?

Fourth, you claim that runs would not be eliminated because “other institutions replace banks in making loans”. Well clearly if narrow bank legislation applies only to large official banks then there’d be a shift to the shadow lending sector. But as Adair Turner said, the rules should apply to ALL LENDERS (though obviously those with a turnover below some level can be ignored). As he put it, “If it looks like bank and quacks like a bank, it has got to be subject to bank-like safeguards”.

Fifth, I do like this sentence in the above article: “One study found that mutual funds holding illiquid assets were more likely to suffer investor redemptions because of bad performance than were funds holding liquid assets.” I’m baffled.

And that’s enough for now. I’ll continue my demolition of the article later in the day.


The above article is totally incompetent. I don't have time to demolish it right now, but will do so in a day or two.

As for Shaun39's claim that privately created money which is what I assume he means by "credit money" leads to "stability over time" that is laughable. If he looks at the money supply figures for the UK just prior to the crunch he'll see that privately created money was racing ahead of central bank money, as it always does in a boom. Then come the crunch, and private banks exacerbated the process by bringing the credit creation process to a grinding halt.

"Stability"? Don't make me laugh.

Next, Shaun asks "what kind of assets are banks supposed to hold against the money they issue?". Well half the point of narrow or full reserve banking is that private banks DON'T ISSUE MONEY!!! Since Shaun doesn't get that basic point, he really shouldn't be commenting on this issue.


Crudely spoken, this is the dumbest proposal for banking reform out there. Hell, reintroducing the gold standard would be less destructive.

Modern currencies are credit currencies. Price stability is a consequence of that: the close coupling of money supply (bank account credit) and money demand (debt issuance) is the reason that prices are well anchored. Both supply and demand for money grow in step with one another when both come with expanding bank balance sheets, and the intertemporal nature of debt ensures stability over time.

The legal obligation on millions of businesses and households to generate cashflow for servicing debt is at once the underlying source for money demand and the anchor of prices over time.

If banks are to avoid lending or holding risky assets (against demand deposit liabilities), then what kind of assets are banks supposed to hold against the money they issue? Government IOUs with value proclaimed by fiat?

Under this madness, these independent money lenders allegedly would raise their finance in equity and longer term bonds (less of a maturity transformation than in the banking system). Not only would this market be smaller than the present banking system; but this crazy proposal would be poisoned as price instability (how much money is going to be issued over the next year?) undermines the confidence among both potential debtors and potential creditors.

neil21 in reply to shaun39

Why not tie money creation to velocity? Take a nightly snapshot of money turnover: if it fell, deposit a few pence to everyone's account. If it didn't, don't.

Design the precise amounts (% fall in turnover; $ deposited; rate of increase if turnover falls persistently) to target 2% NGDP growth. Or maybe even 0% since we're not worrying about the lower bound any more.

The nightly snapshot might be difficult before emoney, but that has so many benefits we're clearly headed there shortly.

8eTnUwXTZ5 in reply to neil21

That's a smart idea. Of course the fuddy-duddy conservatives (with a small C) who can't get their heads round full reserve banking won't understand the merits of your idea. But your idea is certainly worth thinking about.



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