The cancers at the heart of the banking system

“The cancers at the heart of the banking system are explicit and implicit deposit insurance, destabilising the system, creating financial crises and creating huge implicit government subsidies to bankers’ salaries, which causes damage to public confidence in the system and encourages harmful regulation and taxes”, according to the Telegraph, 20th Aug 2013

The author of the article, Andrew Lilico, describes how the modern banking was formed in Britain in the early 19th century  in two, quite distinct, forms – retail banks (where depositors lend money to the bank, which the bank then uses to support lending) and “savings banks” (deposits in savings banks were not permitted to be used to support loans). He further explains how these two forms of banking evolved during the next 160 years and how eventually the savings banks as a distinct form of banking disappeared; which, as he says, can in the light of the recent financial crisis be seen as a very bad error:

“When savers had the option of putting money in a completely safe institution that just stored their money for them, monies deposited in a fractional reserve bank, at higher interest rates, could be seen as the risk-taking investments they were. Why should anyone expect to be bailed out when they’d deliberately taken more risk so as to get higher interest?” 

“Nowadays, by contrast, people talk of monies they deposit in fractional reserve banks as their “savings”. Few even comprehend that a deposit is a loan to a fractional reserve bank — in surveys, 92pc of people wrongly believe that they own their bank deposits.” 

“Banking will never be healthy as long as governments feel unable to allow those intrinsically risky loans made to fractional reserve banks that we call “deposits” to be genuinely at risk.” 

“But governments will not feel able to allow depositors to lose money if all citizens feel that those depositors had no choice but to keep their money in the bank — if I was only trying to store my money, why should I lose out if the bank goes bust? ” 

Andrew concludes that the key to enabling governments not to bail out banks and not to insure bank deposits is for ordinary people to have the choice of saving their money elsewhere.

And we at Positive Money agree! 

We propose to ensure this by slightly different approach: by the distinction between two types of accounts that people can choose from:

1. If depositors want their bank to lend on or invest their money, then the taxpayer will not underwrite that money: depositors may not get their money back, or a part of it. We call this type of account “investment accounts” as it better describes what they are about.

2. In contrast, where depositors want their money to be 100% safe,  the money would be lodged in a 100% safe manner – these accounts would be administered by commercial banks, but they would be owned by the customer, with the funds in them held at the Bank of England. We call this type of account “transaction accounts”.

There would be no need to distinguish between different types of banks, instead, people could conveniently bank with just one bank, but choose between these two types of accounts.

The Positive Money system would allow banks to fail:

a) Without large macroeconomic effects, and at no cost to the taxpayer

b) While protecting depositors who had opted to keep their money safe

This model of banking is one part of Positive Money monetary reform proposals. The other crucial part deals with a new way of money creation (since currently the main suppliers of money into the economy are the commercial banks and we don’t think they can be trusted with something as powerful as the ability to create money).

A detailed explanation of the Positive Money reforms is available in the book MODERNISING MONEY.

It also covers the transition process between the current and reformed monetary systems.

A brief plain English description of the proposals is available here and a more technical presentation of our reforms, for economists and those with some background in money and banking here.