Is Vickers' “ring-fence” crumbling?

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The much vaunted ring-fence, nowithstanding the sales talk of the relevant fencing contractor, never was much more than rusty barbed wire full of gaping holes. But now it looks like actually falling down.

It received scathing criticism by Laurence Kotlikoff (professor of economics at Boston in the U.S.). And Paul Volker was not exactly complimentary about the idea. While at the most recent meeting of the Parliamentary Commission on Banking Standards (21st Nov.), they called into question the basic logic of the ring-fence, much to the irritation of George Osborne.

That commission meeting can be read here, or you can watch it here.

Incidentally, many thanks to the authorities for making this material easily available.

Doubts about the ring-fence at that committee meeting were raised by Nigel Lawson (former Chancellor of the Exchequer) who said, “….there is such a huge amount of play in where that boundary is drawn.”

That raised objections from Osborne to the effect that the establishment have now arrived at a consensus about what needs to be done with banks and that “unpicking the consensus” as he put it, would be costly.

To which the chairman of the committee responded, “Nor, I am sure you will appreciate, will we find it very convincing to be told that we should be wary of unpicking a consensus. Just because something has achieved a consensus does not necessarily make it right…..”


What does the balance sheet of a “deposit taking only” bank look like?

There is also an interesting exchange of views starting with Q1117 where the committee get in a muddle over what the balance sheet of a “deposit taking only” institution would look like. That’s an institution which simply accepts deposits and does nothing with those deposits.

The answer to that question for us “full reservers” is easy. I’ll illustrate by assuming a “deposit taking only” bank starts up and accepts cheques drawn on other banks (or cash). The initial effect would be that the new bank’s only assets would be reserves, i.e. Bank of England money lodged at the BoE. Given the gross excess of reserves floating around at the moment, that would probably be the end of the story for our hypothetical new bank.

But in more normal times, there is an inter-bank market for borrowing and lending reserves. So the hypothetical new bank in those circumstances might be tempted to lend reserves to other banks, in which case some or all its assets would consist of loans to other banks.


Complexity proves there is something wrong

Why did everyone jump for joy when Einstein announced that E=MC2? Reason is that if after laborious calculations and complex arguments, and so on you produce an idea or an equation that is beautifully simple, well that equation just has to be one of the basic laws of the universe.

Banking is similar. Walter Bagehot said, “The business of banking should be simple. If it is hard, it is wrong”. And just look at the complexity of Basel III: it consists of a thousand pages at the moment.

But that’s nothing. In the U.S., the Dodd –Frank bank legislation stands at thirty thousand pages! Well that’s just a lawyer’s paradise.

As for Britain, we have had the Vicker’s report and interminable House of Commons committee hearings. And the net result? The consensus, i.e. the “ring-fence” is now being questioned.


The extreme simplicity of full reserve banking

Compare the above complexity to the extreme simplicity of full reserve banking. The basic rule governing full reserve can be written on the back of an envelope. The rule is thus.

Depositors must make a choice as to what is done with their money. They can have  their money lodged in 100% safe manner, in which case no risks whatever are taken with their money. They have instant access to their money, but it earns no interest.

Alternatively, they have their money invested or loaned on. But they cannot have their cake and eat it too: they cannot behave in a commercial fashion (i.e. have a bank invest their money) while being absolved the normal risks involved in commerce. And as is the case with any investment, there is no instant access to the money concerned.

And that’s it.

There are of course a number of subsidiary issues. But they are easily dealt with. For example the INITIAL EFFECT of introducing full reserve is to reduce bank lending, and that could be deflationary: if you like, it might “reduce growth”.

But that is easily dealt with by having the government / central bank machine create and spend money into the economy. As long as the amounts involved are right, employment will be maintained without any excessive inflation.

Moreover, producing that money costs nothing in REAL TERMS. As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

And the net result (amongst many other things) is that households and firms have more cash and thus need to borrow less: their debts decline.

Another result is that (absent blatant and large scale criminality) banks will be very unlikely to fail. And if that would happen, then we could allow them to fail since it wouldn’t have negative effects on the economy.

Of course there is a downside: in effect, some depositors join the ranks of those who invest in the stock exchange (either directly or indirectly via a pension scheme). At least that is certainly the case with full reserve done Kotlikoff style. (The Werner / Positive Money model is slightly different.) So given the failure of a particular investment, or a general stock market crash, those investors lose out. But the FTSE lost a quarter of its value in 2002 and no recession or crisis ensued. Stock market set-backs of themselves do not cause recessions.


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  • Jamie Walton

    Good article Ralph.

    Depositors need not choose to invest in the stock exchange, they could choose much lower-risk investments like public authority bonds, guaranteed for principal and interest. So there need not be any downside effect at all.

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