Under the existing system, if a bank fails due to bad investments, a third party (the taxpayer) will reimburse the savers who have money invested with that bank. This scheme is called deposit insurance, or the ‘Financial Services Compensation Scheme’ in the UK. In the USA a similar scheme is run by the FDIC (Federal Deposit Insurance Corporation).
Deposit insurance removes the incentive for a bank’s creditors (i.e. savers and investors) to monitor the bank’s behaviour. Currently the saver stands to gain if an investment by a bank goes well, but it is the taxpayer that stands to lose.
This means that risk and reward are not aligned. As a result banks are able to borrow from depositors at a much lower rate than they otherwise would do, which is in effect a subsidy that the government provides to banks.
REMOVAL OF INSURANCE/SUBSIDIES
Conversely, in the Positive Money system, a system without deposit insurance, depositors and bank creditors would have a big incentive to monitor their bank’s behaviour, to ensure it does not act in a manner which may endanger its solvency.
While Investment Account holders may benefit from the upside of an investment (by receiving interest on their deposits/lending), they would also suffer the downside if things would go wrong (i.e. they may not receive the full value of their deposit back).
Risk and reward would be aligned, and the subsidy to banks would be removed.
TOO BIG/SYSTEMICALLY IMPORTANT TO FAIL
Currently, many banks are considered too big or too systemically important to fail. This is largely because of the costs to the economy of a large bank failing – in particular, the loss of deposits (i.e. money) – would not only be disastrous for the government that had to reimburse them, but also to the economy as panic spread from one bank to another causing a cascade of bank failures in the process.
Being ‘too big to fail’ means that banks can gamble with their customers’ money in the knowledge that the government will step in to cover any serious losses. This creates ‘moral hazard’ and encourages the banks to take greater risks in their investments: while one group stands to benefit if the bank is successful in its investments, another group (taxpayers) stands to lose if the bank is unsuccessful. As with deposit insurance, being too big to fail means banks can borrow at much lower rates than they would otherwise do (because lenders are not worried that their money won’t be repaid). This constitutes another subsidy.
Conversely, in a reformed banking system taxpayers would never again have to bail out a bank. This would have the effect of removing a subsidy to the banking sector, as well as the added benefit that banks will be far more concerned with the types of loans they are making.
ENDING “TOO BIG TO FAIL”
Because in the Positive Money system a customer making an investment would have explicitly agreed to accept the risks of the investment, there would be no need (nor a justifiable case) for the government to guarantee any investments. If a bank makes bad decisions and loses money, the customers who provided the money for those investments will lose money. In this situation the bank in question would be wound down, broken up and sold off. Borrowers would continue to pay off their loans (at the same rate as before) to whoever bought their loan contracts. This would be far easier and cheaper to do than under the existing system, for the following reasons:
The funds placed in Transaction Accounts would be 100% safe – the bank would not own their customers Transaction Accounts, nor would they appear on its balance sheets, and these would in any case be held separately from the bank’s Investments Accounts.
The taxpayer and government would have no exposure or responsibility whatsoever for the funds owed to holders of Investment Accounts. The Investment Account holders would become creditors of the liquidated bank, and insolvency law would govern whether and by how much they would be repaid their original investment.
That is not to say that all insolvent banks will go bust. In extreme cases the Bank of England could provide a temporary loan to a bank suffering from a short term liquidity issue. However, these loans should not be used to keep insolvent banks alive.
This article is an extract from the document The Positive Money System in Plain English
This proposal for reform of the banking system explains, in plain English, how we can prevent commercial banks from being able to create money, and move this power to create money into the hands of a transparent and accountable body.
A more detailed explanation of the reforms is available in the book Modernising Money (2013) by Andrew Jackson and Ben Dyson, which builds on the work of Irving Fisher in the 1930s, James Robertson and Joseph Huber in Creating New Money (2000), and a submission made to the Independent Commission on Banking by Positive Money, New Economics Foundation and Professor Richard Werner (2010).