Scott Sumner  

Will the Swiss adopt 100% reserve banking?

Restricting Speech for Nationa... Politics, complexity, and conf...

The answer is clearly no, because they are not being asked to adopt 100% reserve banking. However there is an upcoming referendum for creating a system of 100% reserve backed demand deposits in Swiss banks. I read the literature in support of this referendum, and I'm having trouble figuring out what problem this is supposed to solve:

3) What are the fundamental advantages of sovereign money? Sovereign money in a bank account is completely safe because it is central bank money. It does not disappear when a bank goes bankrupt. Finance bubbles will be avoided because the banks won't be able to create money any more. The state will be freed from being a hostage, because the banks won't need to be rescued with taxpayers' money to keep the whole money-transaction system afloat i.e. the "too big to fail" problem disappears. The financial industry will go back to serving the real economy and society. The money and banking systems will no longer be shrouded in complexity, but will be transparent and understandable.
Unless I'm mistaken, this is simply false. Even under this proposed regime, the 100% reserve requirement would only apply to demand deposits. Banks could still lend out funds in saving deposits, and hence the same risks to the system would still exist. I don't know about Switzerland, but in America demand deposits are only a small share of bank liabilities. More importantly, if 100% reserve requirements were adopted they would become an even smaller share of liabilities. So no, this doesn't solve the fundamental problem of financial instability, which is mostly caused by government policies that create moral hazard, such as deposit insurance and "Too-Big-To-Fail". It would not prevent another "Lehman moment".

That doesn't mean this is a bad idea, just that some other justification is required. Right now, the US has a weird banking system. It looks private, but it was effectively socialized in 1934. You might think you are lending money to banks when you open a saving account. But what you are actually doing is lending money to the Treasury, which turns around and lends that same money to your bank. If the bank cannot repay the loan to the Treasury, it has no effect on your savings account--which is guaranteed by the Treasury. (FDIC is just a middleman.)

So how could the government's footprint on the financial system be reduced? One option would be for the government to stop re-lending demand deposits to commercial banks. Instead, the Fed would provide checking account services, rather than providing the reserves that back up commercial bank checking accounts. That's equivalent to 100% reserve banking (for demand deposits), except the Fed handles the paperwork instead of commercial banks handling the paperwork.

I have no opinion on which system is best, as I don't know enough about the Fed's ability to provide efficient transactions services to the public. If this form of socialized checking accounts is superior to our current system, then I suspect it's on standard "second best" grounds---it slightly reduces the moral hazard created by other government programs. At the same time, it takes us even further from my ideal, which is a completely unregulated financial system. The first best solution is to reduce moral hazard.

Moral hazard is extremely difficult to address for various political reasons. At a technical level, it's easy to get rid of deposit insurance. There is plenty of public debt around, so even saving accounts up to $250,000 could be made virtually 100% risk free. The real problem is political. Both the banking industry and people who borrow money from banks like the current set-up, where credit is subsidized by the Treasury. Moral hazard would be slightly easier to address under NGDPLT, however, as at least we'd no longer have to worry about bank failures causing nominal spending to decline. Crony capitalism would be the only concern.

PS. Here is the title page of my copy of 100% Money. The frontispiece is actually signed by Irving Fisher. I bought the book in Madison, Wisconsin, for $3.50. :)

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CATEGORIES: Finance , Money

COMMENTS (10 to date)
Jake writes:

I don't know enough about this specific proposal to comment on it in depth, but the problem they are trying to address is worth fixing.

In really simple terms, a dollar bill can't physically be both in your wallet and in mine. Only one of us can use it at any given time.

But our banking system pretends that if I deposit my dollar into my checking account, then the bank can loan that dollar to a dozen other people all at once. And not only that, but whenever I want my dollar back, all I have to do is go ask the bank for it, and it has no bearing on the other people the bank has made loans to on the basis of my dollar.

It just doesn't really make sense in the way that money fundamentally should. And I do think it has played a significant role in the financial system becoming the monster it is today.

Lewis writes:

"I have no opinion on which system is best, as I don't know enough about the Fed's ability to provide efficient transactions services to the public."

Probably worse than the DMV. At least the DMV has had a few decades practice dealing with the public.

Scott Sumner writes:

Jake, You are talking about fractional reserve banking. My point is that this proposal does not address that issue. You may favor a proposal that would address the issue in some way, but this proposal does not do so. That's why I say it's not clear what problem this proposal is trying to solve.

Lewis, That's also my concern.

Mark writes:

Why not just eliminate federal deposit insurance and leave deposit insurance to the private sector, then provide a subsidy to all account owners that can be used toward purchasing private deposit insurance? Then you can have a free fully insured account with $x at a low risk bank offering an interest rate equal to inflation, or you can deposit $x at a riskier bank and either pay extra out of your pocket for the more expensive insurance or just purchase partial insurance. You could even deposit money at a bank offering interest

In any case, wouldn’t this solve the problem of moral hazard while allowing the state to provide a measure of security to depositors?

Jacob Egner writes:

Scott Sumner:

Thanks again for the earlier link to the gentle introduction to the case for NGDPLT; it was a great read.

When you say, "it takes us even further from my ideal, which is a completely unregulated financial system", does this ideal world still contain government-issued fiat currencies?

John writes:

Jake: the 100% reserves policy would only apply to checking accounts. If you deposited $100 into a checking account then the bank would basically have to store it in a vault. However, if you bought a CD then it would be a risky investment, in the sense that if the bank makes poor investments then they could default on the CD.

However, in Switzerland, like most western countries there is some sort of deposit insurance. If I save up to $X (which is $250k in the USA) then the government will "guarantee" that investment, even if the bank cannot meet its liabilities. Scott is pointing out that as long as deposit insurance exists, then full-reserve checking accounts won't solve the problem of banking crises, since government backed savings accounts will cause all sorts of moral hazard.

Scott Sumner writes:

Mark, I suppose some would worry that the private insurance company would be TBTF. But yes, that would probably be better than the current system.

Jacob, I'd guess that it would. Thus if Canada went to a laissez-faire regime, I suspect the Canadian people would choose to use the US dollar for transactions.

Matthew Waters writes:

Limiting the issue to demand deposit banking is too limiting. The real issue is maturity transformation.

The financial crisis was really the ultimate asset owner pulling on the end of string of many short-term liabilities backed by long-term assets. The ideal system would be:

2. Maturity transformations, or financial intermediation in general, having sophisticated ultimate asset owners who suffer losses.

Commercial paper was essentially a vehicle for maturity transformation. Main Street Firms which used CP for payroll basically became banks themselves.

This article from 2002 described how ABCP was lending long and borrowing short.

"Some companies instead are selling more asset-backed commercial paper. Investors in such securities get paid from cash flows generated by underlying assets, such as credit card or auto loan payments. Since these are held in a bankruptcy-remote special entity, they garner higher credit ratings. That allows the securities to be sold at a lower cost.

"Asset-backed commercial paper seems to be where alternative commercial paper funding is going," said Louise Purtle, head of U.S. credit strategy at CreditSights. According to CreditSights, asset-backed commercial paper outstanding totaled $727.3 billion, while there was $675.6 billion in unsecured commercial paper outstanding."

The Reserve Primary Fund broke the buck due to Lehman commercial paper. Most Money Market fund investors were sophisticated, but Main Street investors could invest in them as well. I know of one person who had a debit card from his broker. He literally was afraid the ATM would no longer spit out money.

The stock holder-CFO relationship was a basic principal-agent problem. Shareholders did get fearful of *unsecured* CP. Maturity mismatches were rightly feared by shareholders. Shareholders were assured by asset-backed commercial paper, which allowed the CFO to continue leveraging difference in rates. However, most collateral was vulnerable to a systemic run for liquidity.

Now the CFO was a technically sophisticated actor. But the ultimate principals were not sophisticated. In some cases, such as Pension funds and Main Street banks, the principals explicitly included taxpayers.

So 100% reserve banking should be used for short-term liquidity needs when the true assetholders are taxpayers. Deposits under FDIC limits, pensions and insurance companies all have such explicit taxpayer backing.

Richard writes:

"Even under this proposed regime, the 100% reserve requirement would only apply to demand deposits. Banks could still lend out funds in saving deposits, and hence the same risks to the system would still exist."

My savings account, at Chase, is a demand deposit. I can withdraw my funds whenever I want.

Are savings accounts in foreign banks different?

Lorenzo from Oz writes:

Scott, what do you make of this effort? A claim to have empirically supported the credit creation theory of banking against the fractional reserve and financial intermediary theories of banking.

Claiming that Japan is an example of a successful banking system seems nuts to me, but the "regulatory implications" bit seems somewhat orthogonal to the empirical evidence claims.


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