In a series of articles brought to my attention today, Matthew C Klein has been building the case for separating lending institutions from depository institutions. In Klein’s estimation, the function of banks — to fund long-term liabilities with short term assets — makes banking inherently unstable. Due to this fact, it is important to separate popular myth of what most people think of as banking — warehousing deposits — from lending.
What banks do — sell short-term debt (like deposits) to fund long-term loans — is inherently risky. In theory, shareholders bear this risk. In practice, much of it is dumped on citizens, even though they’ve no claim on the returns associated with the risk-taking.
The problem is that banks have too little capital to absorb losses without going bust. Even the new, stronger Basel III rules mandate a bare minimum ratio of bank equity to bank assets of just 3 percent. This means that a bank that loses more than 3 percent of its portfolio becomes insolvent.
The rub is that the equity side of a bank’s balance sheet is funded mostly by insured deposits. That exposes the public (at large) to various types of risk incurred by banks. This risk is magnified by the fact that banks have a tendency to load up their balance sheets with serially correlated liabilities. As I have mentioned before, this sort of homogeneity reduces the ability of a system to deal with shocks by reducing a systems’ reserve capacity.
So the first line of disagreement that I have with Klein is whether we can consider bank instability truly endemic, or the emergent result of incentive structure. I would say that the problem is incentive-driven. Far from being inevitable that a bank is going to blow up, as a society we have subsidized and encouraged the actions banks take on that path. In the absence of explicit and implicit public subsidy (through deposit insurance, the GSA’s, HHS, TB2F, etc), the vast majority of the market for securitization would probably whither and die.
Moving forward to the solution. Klein intimates in the second post in his series that we create “public utility banking”:
A genuinely radical approach would be to kill banking as we know it. Rip all banks, large or small, in two — separate deposit-taking from credit-creation. Back the deposits one-for-one with reserves at the central bank. Then fund loans not with deposits or other money-like liabilities but by tapping investors who understand they’ve put their savings at risk.
The real motivating idea here is to run “the” payments system as a low-margin public utility. I had mentioned on Twitter that I was skeptical of this idea, as it would make deposits more expensive, and the expense not absorbed by what amounts to demurrage on cash balances* would have to be subsumed by either public subsidy or fees for using the payment network. But then again, we have an entire new subsection of law on the books of the United States Federal register that attempts to move financial institutions to more explicit revenue-generating schemes, and away from swipe fees…although it is likely that the spread between deposits and IOR/IOER and deposits would mitigate fees from getting too wild. It may work, but I think we’re assuming extreme risk aversion/liquidity preference. Indeed, the idea of this proposal is to legislate away credit risk.
Furthermore, under this model of banking, depository institutions would immediately want to reflux creditor institutions’ liabilities back to them for monetary base (in the form of vault cash and reserves at the Fed). Otherwise, these institutions would be taking on too much risk. This implies an extreme outsized role for the monetary base, as something like M2 would end up likely consuming every other money aggregate. That would put the government at the forefront of consumer banking and the money system. You’ll, of course, notice where this is going.
*A tangent: I support the idea of taxing deposits. I’ve always had a strong aversion to the “store of value” role that was grafted onto money. Taxing deposits would force everyone to hold just the amount of money (cash and deposits) they need for transactions purposes, and then invest the balance in the continuum other assets. These would range from assets with a high level of liquidity (moneyness)/high risk — like stocks — to extremely low liquidity/safe assets, like houses or planting trees (or ski jumps!).