Monday, June 10, 2013

Telegraph's Jeremy Warner: 6 years into financial crisis, time to consider radical reforms

In his Telegraph column, Jeremy Warner looks at the failure of current reforms to satisfactorily address the problems in the financial system and suggests that it is time to consider more radical reform.

He proposes that we consider adopting 100% reserve banking.

Regular readers were first exposed to this idea a couple of years ago with the discussion of Boston University Professor Kotlikoff's call for limited purpose banking.

As your humble blogger noted at the time, we already have 100% reserve banking/limited purpose banking.  It is known as mutual funds.  A mutual fund operates with no leverage.  All gains and losses on its investments are absorbed by its investors.

Mr. Warner described the advantages and disadvantages of such a mutual fund only financial system.
In a system of 100pc reserve banking, none of these problems arises. As the term implies, all deposits are held on reserve, or in cash. The deposit bank is thereby deprived of its money creating privileges, but there is no risk of a run. Credit is instead provided by intermediaries that compete for these deposits and marry them directly with borrowers. 
Simple. The credit cycle is abolished, and many of the things that so much concern regulators today – capital and liquidity requirements, risk weighting, how to get rid of the too-big-to-fail problem – would cease to be an issue. 
What’s more, there would be no need for deposit insurance or oversight, beyond a framework for simple fraud prevention. Credit banks could be allowed to fail without risk of wider systemic damage. 
Under the original Chicago plan, the transition from the current to the new system would also allow the Government to cancel its debts, though obviously at the current level of spending, these debts could quickly re-accumulate. 
When something looks too good to be true, it generally is. 
One of the most obvious drawbacks is that there would plainly be less credit and less leverage in such a system. Indeed, to the extent that credit existed, it would look much more like high-risk equity. For all the social and economic scarring the credit cycle can inflict, it is also a key part of the creative destruction of capitalism. 
Without it, you might have a more stable economy, but it is not clear that you would have as much innovation, entrepreneurialism, business creation and long-term economic growth. 
The biggest problem of all with 100pc reserve banking is that of transition. Getting from here to there would be a truly revolutionary and potentially highly destabilising process, so much so that it is hard to think of any advanced economy embarking on it. 
Then again, we are not through this present banking crisis yet by any means, and already, many things that were once thought fanciful are now part of our every day language.
I happen to agree with Mr. Warner's motivation for reform as returning the banks to where they were pre-August 9, 2007 is of no benefit to society.
The only thing everyone agrees on – from bankers to bank bashers – is that the reform agenda as it stands is far from satisfactory. 
In the sense that the thrust of banking reform to date has been essentially to return the system to the way it was, with a little more discipline and transparency than before...
I disagree with his solution of 100% reserve banking.  Just like the 1930s, where we need to end up is with transparency so that all market participants have access to all the useful, relevant information so they can independently assess this information and make a fully informed decision.

For banks, this level of transparency is ultra transparency.  It existed and was the global standard in the 1930s.  Under ultra transparency, banks disclosed on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The result of ultra transparency would be to radically reform the banking system.  It would subject the banks to market discipline.

With their risk linked to their cost of funds, banks would have an incentive to a) end proprietary trading, b) shrink by eliminating their subsidiaries that engage in regulatory and tax arbitrage, and c) reduction of excess public and private debt in the financial system as banks would absorb their losses on this debt.

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