BBC questions fractional reserve banking

nef has been shining the light on monetary reform for some time now (see previous blogs on the topic) so it was gratifying to see Robert Peston opening last night's BBC documentary on the banks examining this bigger picture question. 

Sadly, he did not make it clear that there are two different features of fractional reserve banking that are problematic.

The first, which he highlighted, is the role of banks in lending long-term but borrowing short-term: an important role in the economy referred to as ‘maturity transformation’. This creates a danger of the classic run on the bank. Our money is not in the vault because it has been invested elsewhere. Crucially, we are not allowed to choose how much of our money is kept in the safe, and how much is loaned out. Nor have we really any control over how risky those investments are. Even the money in our current account could be used as gambling chips if the bank so chooses, and as we have seen the banks are quite capable of losing our money on foolish investments. The government gets round this problem by guaranteeing our deposits with taxpayers’ money. The banks keep all the winnings, and the taxpayer picks up the losses.

The second is that the current system effectively allows banks to create new deposits when they make loans. They do not have to wait for a saver to come along and deposit some cash before they make a loan. By making the loan, they credit our current account with what is effectively new money, which then circulates around the banking system as an additional bank deposit. Over 97% of the money supply was created as electronic money in this way, with under 3% issued by the Bank of England as notes and coins. This greatly increasing banks’ scope to expand their balance sheets, profits (and bonuses, of course). If it is not controlled, the banking system’s power to increase the money supply poses a huge risk to the economy in causing inflation and speculative booms.

Some control is supposedly imposed on bank lending by the capital reserves that banks are forced to hold under the international Basel accords. But as Peston made quite clear, banks have proved astonishingly adept at getting much of their lending off the balance sheet (through derivatives  and securitisation) rendering such capital rules ineffective and enabling the massive credit boom that almost sunk us in 2008/9.

Nevertheless, Peston delved in to some serious alternatives when he kicked off by talking to Toby Baxendale, a fishing tycoon, who has been campaigning to end fractional reserve banking for many years.  Baxendale makes a simple argument.  He thinks that when we put our money in the banks, we should retain control over whether it is loaned out or kept 100% safe – in the bank

nef made a similar argument in our recent joint submission to the Independent Commission on Banking (ICB) with Positive Money and Richard Werner.  We argued for full reserve banking, where the transactional function of banking (the payments system) is separated from the lending function.  Our proposal for full-reserve banking ensures that risk-free deposits in the payments system do not coexist with risky assets (the derivatives, securities, bonds and special purpose investment vehicles that dominate modern investment banking). The proposal to achieve this is simple: we simply require that banks keep safe the money which customers wish to keep safe, and invest only the money that customers wish to invest.

An economy running on this kind of foundation should be less prone to pro-cyclical tendencies (boom and bust) and less inflationary (house price inflation in particular) than an economy based on fractional-reserve banking.  And the enormous, tax-payer underwritten banks that currently monopolise credit creation would be bought back down to size, enabling greater competition and diversity in our banking sector.

Britain's Banks: Too Big to Save? is available to watch on BBC iPlayer until 25 January 2011.