Separating Money, Credit Equals Safety

Over the past few years, banks in the United Kingdom and elsewhere have amassed a mountain of credit. This giant pile of bank money has fueled economic booms and upticks in inflation. It has also resulted in bank runs and the bankruptcy and the nationalization this week of Northern Rock, one of the U.K.’s five largest mortgage lenders.

Is there a better way to organize banking, so that it would be safer, sounder and more stable? That is, so that it wouldn’t require backbreaking taxpayer bailouts?

[C]redit booms and busts would become things of the past.

Today, banks that accept deposits are not required to hold 100 percent liquid reserves against those deposits. Accordingly, banks operate under a fractional-reserve system that allows them to create liabilities: bank money. To eliminate this element of discretion in the money circuit, fractional-reserve banking could be replaced by 100 percent-reserve banking. In short, banks would be required to cover all deposits they accept with 100 percent liquid reserves, which would restrict investments of depositors’ money into “safe” and liquid securities such as government bonds or bonds guaranteed by the government.

Under 100 percent-reserve banking, banks that accepted deposits would essentially be transformed into money-market mutual funds – “narrow banks” – which could not create credit. Accordingly, credit booms and busts would become things of the past. Depositors would also no longer have to live in fear of being unable to withdraw their deposits because banks would have the liquid reserves to cover any withdrawals. Banking panics, systemwide banking crises, and taxpayer bailouts would all be relegated to history.

Another important advantage of 100 percent-reserve banking is that banks would need very little equity capital to cover the small risks associated with the matching of their assets and deposit liabilities. This makes the 100 percent-reserve system particularly well-suited for emerging economies, where banks are notoriously undercapitalized.

How would credit be supplied in such a money and banking system? Merchant (or investment) banks that do not accept deposits would assume that function. They would intermediate savings and generate credit (not money) by issuing shares and subordinated debt instruments (unsecured bonds that have low-ranking claims on a company’s earnings and assets).

This approach facilitates credit flows while separating money from credit. By doing so, it injects safety, soundness and stability into the credit circuit. Indeed, shareholders would provide an important source of market discipline to the merchant banks because the banks’ owners would risk losing their investments in case of merchant bank failures.

The other element in the merchant banks’ capital structure would be provided by subordinated debt. This debt also provides an attractive source of market discipline because, as distinct from depositors, the holders of subordinated debt cannot withdraw their funds on demand when bad news surfaces. The holders of subordinated debt would, therefore, have an incentive to monitor the merchant bankers carefully.

Would speculative entrepreneurial ventures never get loans because merchant banks would be too conservative? Not at all. Banks that specialized in riskier loans would simply issue subordinated debt at significantly higher interest rates. Investors would purchase these instruments, just as they purchase high-yield junk bonds.

If banks that accept deposits were prohibited from creating bank money and were transformed into money-market mutual funds, bank runs – like those that toppled Northern Rock – would come to a halt. And more importantly, taxpayers would be off the hook, too.

Author Steve H. Hanke