Economics blogger Frances Coppola writes that “Martin Wolf proposes the death of banking”, in response to his article last Friday advocating the Positive Money proposals for reform of the banking system.
“The third proposal, from Positive Money UK, is actually the closest to Wolf’s ideas. Though there are differences. Rather than backing deposits with central bank reserves as Wolf suggests, Positive Money UK simply cut out the middleman. They propose that transaction accounts should be on the books of the central bank. Commercial banks would only hold risk-bearing investment accounts, from which they could lend. It’s a neat idea, and unlike the other two proposals – both of which completely ignore the crucial role of banks in facilitating payments – it does recognise that transaction accounts and interest-bearing time or sight deposits serve very different purposes. Both Wolf and Positive Money UK envisage banks charging customers fees for payments and account management. This does, of course, mean the end of “free while in credit” banking.”
It’s correct that this reform would mean the end of “free while in credit” banking, although there are already moves towards ending this style of banking, which is an anomaly unique to the UK. In most other countries there are already per-transaction fees on current accounts. The ‘free’ is also a misnomer: it really means “paid for by people who use unauthorised overdrafts, and cross-subsidised with the profits from lending”.
“But once again, there is a problem. Banks are not fund managers. People who want to put money at risk for a return don’t generally put it in banks: they invest it in funds or manage their own portfolio. People put money in banks for two reasons:
· because they want safety AND a return
· because they need liquidity (including access to payments systems)”
Banks can only provide safety AND a return as a result of the guarantees provided by the state. Without taxpayer-funded bailouts, all the customers of HBOS and RBS would have found that the idea that banks can provide “safety AND return” is an illusion. In fact, Mervyn King, former governor of the Bank of England has described this perception as akin to a belief in alchemy:
“It is [the current banking] structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer. “
Coppola argues that ending this taxpayer-funded safety net which underwrites banks would lead to the death of banking:
“Wolf recognizes the second of these, but not the first. I fear that the “investment accounts” he and Positive Money UK envisage would disappear like the morning mist once the deposit insurance that time and sight deposit accounts currently enjoy is removed.”
Note that in our reform, ‘sight deposits’ would be replaced by completely-risk free Transaction Accounts, where the money in them is stored at the central bank and never placed at risk. So it is only time deposits – money that savers have agreed to lock away for a set period of time – which are affected by the removal of the government guarantee on bank accounts.
But why will those “investment accounts” disappear? Are banks incapable of competing with the rest of the financial sector for people’s savings? Our proposals simply force banks to work like any other financial sector business, raising funds from savers and lending them to borrowers but without the unique ability to fund their loans by creating new money. The fact that banks already have relationships with nearly every citizen through providing current accounts (Transaction Accounts in our reform) means that they are far better placed to attract funds than any other type of financial market company.
In addition, there are currently over £1 trillion of time-deposits in UK bank accounts; this is money that customers have actively chosen to set aside for a certain period of time, and therefore money that they have actively chosen to save. In order for these accounts to “disappear like the morning mist”, that £1 trillion has to be invested elsewhere. Which investment market exactly can absorb an additional £1 trillion without it turning into either a bubble, or yields falling significantly?
“Positive Money UK’s proposal therefore probably means the end of commercial banking, unless they could find other sources of funding. In Wolf’s world, commercial banks could survive for a while as pure deposit-takers, but as mobile money platforms reduced their fees to undercut the banks now forced to charge transaction fees, and quasi-banks offered supposedly safe liquid depositary services for a better return than the banks now unable to pay interest on safe deposits, they would eventually wither and die.”
A few points:
1. If banks find their transaction fees are undercut by new entrants, that’s a prime example of market innovation and new technologies rendering old, inefficient businesses obsolete. This might happen even with the current system. It certainly can’t be said to be a disadvantage of our reforms. To flip the argument around, should we retain the current banking system to protect banks from competition?
2. The only risk-free method of holding electronic money (excluding investing in government bonds or government savings products) would be the transaction accounts in which money is stored at the central bank. So there would be no ‘quasi-banks’ that can offer safer financial products than the banks.
3. If the current business model of banking only persists as a result of government subsidies and taxpayer guarantees, is that something that we should preserve?
Coppolla then argues that the inability of banks to attract funders from savers mean they’ll turn to securitised assets. But as we’ve explained, there seems to be little reason why banks would be unable to raise their funding from savers, so this risk doesn’t apply.
A more fundamental question is this:
“This brings me to the heart of Wolf’s proposal. Wolf thinks banks should only be able to lend money they already have, not money they hope to receive: in the absence of loanable deposits, this tends to force banks down the equity funding route because of the inherent illiquidity of other forms of stable funding. But as I explained in my critique of the IMF paper, money creation through bank lending is an inevitable consequence of double entry accounting, and preventing it is by no means as simple as Wolf suggests. Completely eliminating fractional reserve lending means removing banks’ responsibility for lending decisions. Yet again, we face the death of commercial banking.”
Banks can create money for the simple reason that they issue demand liabilities (the numbers in a bank account) when they make loans, and then provide a payment system that allows members of the public to use those liabilities to pay each other. This is not an inevitable function of lending; but it is a design feature of the current banking system. Remove their ability to create demand deposits which can be used as a means of payment, and you remove their ability to create money.
“But my bigger concern is this. Wolf’s idea amounts to replacing a demand-driven money supply creation mechanism with central planning of the money supply by a committee. Central banks’ record on producing accurate forecasts of the economy is dismal, and their response to economic indicators is at times highly questionable. Put bluntly, they get it wrong – very wrong, at times: consider the ECB raising interest rates into an oil price shock in 2011. Is the entire lifeblood of the economy to be dependent on the whims of such as these?”
It would be fairer to say that we’re suggesting that the Bank of England would create money directly, rather than using interest rates to indirectly influence how much money banks create. Today, they already make a decision on whether to move interest rates down (or up) in order to encourage people to borrow more (or less) and banks to create more (or less) money. Our proposals would simply allow them to do the money creation directly.
True, central banks have made poor forecasts and bad decisions in the past. But they have also had to manage a system that is ultimately unmanageable.
Simply look at recent history to see what happens when banks create money. It hasn’t exactly been good for the economy.
“Personally I would prefer the money supply to respond to demand rather than be decided by a committee, or an algorithm for that matter. I don’t in theory have a problem with removing the link between bank lending and money creation: bank lending is by nature pro-cyclical, so the money supply does tend to expand when it really should contract and vice versa. But until someone can identify a better indicator of demand for money, bank lending – or perhaps better, lending activity in the financial system as a whole, including non-bank lending – is the best we have and certainly a lot better than the MPC. The system we have is undoubtedly flawed, but Wolf’s alternative is a whole lot worse. “
However, it’s wrong to view the current money-creating banking system as something which just responds to people’s demand for borrowing. By inflating house price bubbles, it actually creates the necessity for ever greater levels of borrowing. And by being the sole supplier of money to the economy, the banking sector benefits from a system that the entire money supply is on loan from them.