Admati and Hellwig’s flawed criticisms of full reserve banking.

My so far fruitless search for flaws in full reserve banking (FR) continues. Anat Admati and Martin Hellwig make some criticisms in their work “The Parade of the Bankers’ New Clothes….”. 

Basically their work attacks the dishonest arguments put by banks and other defenders of the banking status quo. So obviously I agree with much of what A&H say. Also they advocate a big rise in bank capital ratios, to about 30%, whereas FR involves a 100% ratio. So there again, A&H and FR have something in common. Though against that, A&H are skating on thin ice by criticising the 100% ratio, while backing the 30% ratio: defects in one are almost bound to occur at least to some extent with the other, as will become apparent below.

FR in brief.

First, though a brief introduction to FR (skip if you like).

Four of the main proponents of FR are as follows.

1. Irving Fisher I his book ‘100% Money and the Public Debt.’ (1936)

2. Milton Friedman in Ch3 of his book ‘A Program for Monetary Stability’ (1960), under the heading “How 100% Reserves Would Work”.

3. Laurence Kotlikoff.  

4. Richard Werner.

100% reserve banking / FR consists of the following. The banking industry is split in two. One half caters for those who want total safety. Their money is backed by base money and/or government debt. Plus that half pays little or no interest, but it offers money transfer services (cheque books, debit cards, etc).

The second half invests savers’ money in mortgages, loans to businesses, etc, but savers themselves (not taxpayers) carry the risks. I.e. loans are funded by shares, not deposits. Thus no sort of taxpayer funded subsidy for the banking industry is needed. Trillion dollar bail-outs are never needed.

Admati and Hellwig’s criticisms of FR.

Their criticisms come under two headings: “Flawed Claim 23” and “Flawed Claim 24”. I’ve put their criticisms in green italics.

“Flawed Claim 23: The best way to make banking safer is to require banks to put funds from deposits into reserves of central bank money or Treasury Bills (so-called narrow banking or the Chicago Plan for 100% reserve banking). Narrow banking will give us a stable financial system, and there would be less need to impose equity requirements. What’s wrong with this claim? Requiring banks to put all funds into cash or Treasury Bills will make these banks safer but the financial system as a whole may become less efficient an d/or less safe.”

Why “less safe or efficient”? No reasons given. If A&H’s reasons are one or more of the reasons set out below, then they need to specify WHICH REASONS.

“If final investors maintain current funding patterns, banks will provide a lot of funding to the government; which may well come at the expense of funding of nonfinancial firms. The experience of southern European countries in the decades before 1990 shows such crowding out of private borrowing by government borrowing can have substantial negative effects on economic growth.”

The first weakness in the above point results from the similarity between A&H’s 30% capital ratio and FR’s 100% ratio. That is, while the introduction of the 100% ratio WOULD CAUSE some depositors to flee to safety, by the same token, a 50% or 30% ratio will also cause a finite amount of flight to safety.

Next , A&H’s above point portrays the state as an entity that is similar to microeconomic entities: i.e. the suggestion is that the state can run short of money. In fact the state (or more accurately the Fed in the case of the US) can create a trillion, trillion, trillion dollars in the next sixty seconds if it wants.

Put another way, the fact that the state warehouses money for those who want their money warehoused should not have ANY EFFECT on what proportion of GDP is allocated to public spending (investment or current spending). The latter is a PURELY POLITICAL decision.

To illustrate, if politicians want to leave the proportion of GDP allocated to public spending unchanged on introducing FR, then the Fed / state would not spend extra monies lodged with it as a result of introducing FR.

Shadow banks.

“More likely, narrow banking would lead investors to put substantially more of their money in other institutions, for example money market funds which are “bank-like” without being subjected to the same regulation as banks. As we have seen in the weeks after the Lehman bankruptcy, such institutions can also be subject to runs and can be a major source of systemic risk. Financial instability would merely shift from banks to those “bank-like” institutions. In this context, it is useful to recall that Lehman Brothers was an investment bank, AIG was and is an insurance company and, in Europe, Dexia and Hypo Real Estate were in the covered-bond business; none of the institutions had any deposits.”

The above claim that savers would switch to money market funds (MMFs) is out by 180 degrees in that MMFs are actually being forced at the time of writing to abide by the rules of FR!! See Forbes article by K.Weiner entitled ‘Will New Money Market Rules Break Money Markets?'

Moreover, it is nonsense to regulate entities that declare themselves to be banks while other entities (shadow banks) which actually are banks but claim not to be, remain unregulated. That’s a bit like allowing fraudsters to continue with their activities if they deny being fraudsters. As the former head of the UK’s Financial Services Authority, Adair Turner, put it, “If it looks like bank and quacks like a bank, we will regulate it like a bank”.

Funding via debt rather than shares is beneficial?

“Flawed Claim 24: The financial system would be safe if banks are subject to a 100% reserve requirement so they can take no risk with depositors' money, while non-bank financial institutions are entirely prohibited from borrowing.

What is wrong with this claim? This ignores the benefits of using some debt to fund difficult to value investments such as loans. (What benefits?) Moreover, having no debt in financial intermediation would not necessarily eliminate fragility and possible harm to small investors. Investors want much of their money to earn some interest and yet to be liquid so they can get it fairly reliably when they need it.

What exactly is the merit in having debt fund loans? On the contrary, there is a HUGE PROBLEM in doing that, namely that when it is discovered that the loans are worth much less than was thought, the relevant lending entity is liable to then be insolvent. In contrast, when “difficult to value” stuff is funded by shares, insolvency is impossible.

“having no debt in financial intermediation would not necessarily eliminate fragility and possible harm to small investors.”  Er… if a lending entity can go insolvent, that equals a fair amount of “harm” for the relevant “small investors” doesn’t it? But I’m not suggesting that where loans are funded by shares that harm to investors is totally ruled out. Indeed, the amount of harm is about the same in each case. But certainly it  is not true to suggest that there is significantly LESS HARM in the “fund via debt” case.

Cash shortages.

If banks must operate as open-end mutual funds with no debt, investors who need cash would return (or sell) their shares and get whatever the shares were worth.

The answer to that is as follows. Anyone who runs so short of cash (under the existing system or under FR) that they have to sell assets every time they want cash needs to take a course in common sense. That is, everyone should make sure they have available to them a sufficient stock of cash (or ready access to a lender) enough to ensure they can do day to day transactions. Thus frequent “sale of assets” shouldn’t be necessary.

In contrast, everyone (and every firm) at some time or other has an exceptionally large need for cash. In that case they either borrow or sell assets. If the latter, then there will inevitably be the problem (under FR or the existing system) that they won’t be able to predict with any great precision what those assets will fetch.

Determining share values would be easy if the assets held by a fund (of the fund itself) were traded daily on a public exchange, but otherwise would be problematic, and the mutual fund could suffer something similar to runs if shareholders fear significant asset price declines returned their shares and the fund had to sell assets in a hurry.

The answer to that is that the above alleged “valuation” problem does not seem to be a problem with EXISTING mutual funds.

Trading in stock markets exposes individuals who need to trade for liquidity reasons to losses from better-informed investors.

The possibility of being ripped off by “better informed investors” when selling an asset applies just as much under the existing system as it would under FR. E.g. when selling a house or a car it is possible to get ripped off.

The opacity of assets consisting of many mortgages and other loans would give rise incentives to those with access to better information to engage in such trading if the shares of banks with 100% equity were traded on stock exchanges. The information-insensitivity of banks' debt is valuable for liquidity provision and the idea of requiring significant equity (such as 30% or even more) but not as much as 100% is intended to preserve this function and strike a balance between liquidity provision and the stability of the banking system.” 

Exactly that problem, at least in theory, exists with the hundreds of mutual funds that already exist. But for some reason, no one regards it as a big problem.

And finally, as regards the "liquidity provision" mentioned just above, that is wholly irrelevant because under FR the central bank / government can provide the economy with whatever amount of liquidity / money it needs in order to keep the economy operating at full employment.