Why the failure of Kaupthing Edge teaches us nothing about full reserve banking (A response to Dow, Johnsen and Montagnoli)

In their paper “A critique of full reserve banking“, Professor Sheila Dow, Alberto Montagnoli and Gudron Johnsen argue that the failure of one of the Icelandic bank’s subsidiaries is evidence that full-reserve banking would not make the financial system safer. Here we explain why the case study is not applicable, and teaches us nothing about the impact of full reserve banking.

Dow et al refer to the experience of KSF, which was a UK-registered subsidiary of Icelandic bank Kaupthing. They argue that the outcome of the imposition of a 95% reserve requirement shows that full reserve banking cannot work:

“To further support our argument that full-reserve banking would not make the financial system less prone to bank runs and financial crises, we look at the case of a British bank, Kaupthing, Singer and Friedlander (KSF), where a 95% liquidity requirements did not prevent the bank collapse, but rather it pulled the trigger on a subsequent failure of its parent company, the Icelandic Bank, Kaupthing.” (p4)

While the case study might say something useful about the narrow banking approach to banking reform (as advocated by John Kay), it is not relevant to the sovereign money approach advocated by Positive Money, for reasons we’ll explain below. We have copied and pasted Dow et al’s description of the sequence of events, and added our commentary in between.

“As a response to a wholesale run on the Icelandic bank in 2006 and 2007, the three Icelandic banks started diversifying their funding base by collecting deposits abroad.”

By this point the Icelandic banks had already expanded their balance sheets by extending large volumes of loans. They were highly leveraged banks with limited liquidity and large amounts of liabilities in foreign currencies. This meant that as wholesale depositors (i.e. large funds and corporates, rather than individual savers) started to withdraw their funds to banks outside of Iceland, the Icelandic banks had to replenish the funding from elsewhere. (In other words, they needed to acquire foreign currencies from new deposits to pay foreign currency to old depositors).

“Kaupthing established an on-line deposit account called Kaupthing Edge, through branches and subsidiaries, including KSF in the UK. After the collapse of Northern Rock, the British regulator, the FSA, stepped up its oversight and imposed a 95% liquidity requirement on the ballooning on-line deposit accounts, demanding that the bank hold 95% of all deposits in the form of liquid and relatively risk free securities on a 24 hour cycle (SIC 2008, Vol. 7: 120). According to the regulator, KSF was to use hardly any of its incoming deposits for regular lending activity, recognising the inherent risk involved in rapid deposit collection.”

In other words, the FSA recognised a bank in trouble, and demanded that it ensures that 95% of its assets were in the form of very safe and liquid assets (such as bonds and reserves held at the Bank of England). This model is similar to the narrow banking model proposed by John Kay, in which deposits (liabilities) must be backed by liquid and “very safe” assets (typically government bonds).

“In March 2008, KSF sought to lower the liquidity requirement. While the FSA reviewed the bank’s request, KSF made a liquidity swap, such that it lent 1.1 billion pounds to its parent company, Kaupthing, on a rolling overnight basis, subsequently categorising the loan as ‘liquid funds’. However, the parent company in turn lent the money back to the subsidiary KSF, on a rolling three month basis. Now, the subsidiary could allocate the money in whichever way it wanted, including lending it back to the parent company, which was in dire straights due to the lack of Forex funding. It was only under severe stress, six months later, when the regulator noticed that these liquid funds were indeed not liquid and KSF had been in breach of liquidity requirement all this time.”

In simple terms, the FSA asked KSF to only hold very liquid safe assets. KSF engaged in some balance sheet wizardry with their parent company to make it look like they were complying with the FSA’s request, even though they weren’t anywhere close.

“As it turned out, the fate of Kaupthing lay in this missing liquidity. A run on Kaupthing Edge escalated after the fall of Lehman Brothers in September 2008 and the FSA started to call for the missing 1.6 billion pounds (additional credit lines of 500 million pounds had been drawn on by the parent company) to have readily available as the depositors asked for their money back. KSF could not meet those requirements, nor even raise the 300 million pound minimum liquidity to cover the bleeding on-line account (SIC 2008, Vol. 7: pp. 160-1). After having waited for KSF management to deliver the missing funds for 10 days, the regulator assessed that KSF was no longer a safe place for depositing the public’s savings.”

Dow et al claim that this episode shows that even 95% liquidity requirements do not create safe banks. But this is not what the case study shows.

• Firstly, the 95% liquidity requirement wasn’t met. As Dow et al explain, the regulators were fooled into thinking it had been met, when in fact KSF and Kaupthing had engaged in something that was either smoke or mirrors, or outright financial fraud (I’m not sure on what the final legal decision was on this point). So the cases study teaches us nothing about the effect of 95% liquidity requirements, because that requirement was never implemented.

• Secondly, the case study does not show that high liquidity requirements can “pull the trigger” on bank failures. Instead, it confirms that low liquidity requirements (along with risky lending) can leave a bank vulnerable to runs and failure.

A 95% liquidity requirement is not a 100% reserve requirement

Even if it had been met, the 95% liquidity requirement placed on KSF is very different from the requirements placed on banks in a Sovereign Money system.

In a Sovereign Money system the requirement is that  any funds that can be withdrawn on demand are stored in full at the central bank. This is similar to having a 100% reserve ratio in which the only assets that could be held to back demand deposits are reserves at the central bank. However, technically, the Sovereign Money system is a no-reserves system, as rather than depositors holding bank-issued demand deposits that are backed in full by central bank money, depositors actually hold and own electronic central bank money through their Transaction Accounts.

Applying this rule in the case study above would have meant saying to KSF, “Every pound that you promise to pay out on demand must be matched by a pound in your account at the Bank of England.” If this had been the case, then the run on KSF would never have happened, as KSF would have been able to repay every depositor in full at all times.

What lessons can we learn from KSF?

So what is the lesson from the case of KSF? Dow et al’s conclusion seems to contradict itself:

“This case clearly shows how easy it is to circumvent financial regulation (by intention or by ignorance), yet how effective quality financial supervision can be in safeguarding the public’s interests.”

In the case of KSF, for 6 months the FSA failed to notice that £1.6 billion of KSF’s assets were not what KSF said they were. It is difficult to see how this can be taken as an example of “how effective quality financial supervision can be in safeguarding the public’s interests.” It was only when a full run on KSF’s parent bank took off that the FSA panicked and froze the KSF/Kaupthing Edge accounts in the UK.

While the case does not reveal anything useful about Positive Money’s proposals, it does show how easy it is to pull the wool over the eyes of even well-resourced regulators. So it’s concerning that so many commentators believe that we should rely simply on better regulation to prevent another financial crisis.

Our view is slightly different. Whilst regulation is still necessary, regulators will never be able to prevent collapses in a banking system as inherently unstable as the current one. Such collapses cause a ripple effect and threaten the stability of the whole financial system, and the real economy.

That is why we take a different approach to banking reform. Our proposals protect the payment system from the risk-taking that is inherent to banking. They remove the responsibility for creating money from banks that are incentivised to take excessive risks. You can read more about the Sovereign Money proposals in our book & free short paper.