Vickers Commission needs to get the banking basics right

 By Nick Miller

You won't find too many who will disagree with the regulatory rule of thumb that 'if it isn't going to hurt, its probably not going to work'.  Lets hope the the Independent Commission on Banking is one of the exceptions since shares in the big banks rose between 1% and 3% upon the release of the ICBs interim findings recommendations yesterday.  

We'll get in to the detail of why the banks will be secretly pleased at the outcome of the report in later blogs but I'm going to use this opportunity to raise a more fundamental issue.  That is that the ICB still doesn't appear to understand how modern banks actually operate.  On page 16 of the report there is definition of lending which states the following:

2.8 However, banks do not take deposits simply to provide safety for the savings of the public. They use funds that are deposited with them to provide loans to businesses to allow them to undertake productive economic activities, and also to consumers…

The above statement, sadly, is a working fiction and has been since the birth of modern banking in the UK in the second half of the seventeenth century.  

As nef has pointed out in previous blogs and publications, when a bank makes a loan it does not take other people's deposits and lend them out. This would imply that no new bank deposits are created in the economy when a bank makes a loan.  

The truth is that when a bank makes a 'loan' it simply types in to its account that the borrower owes it a sum of money – this is the bank’s asset. It also types into the customer’s account that he has a bank deposit of the same amount – this is the bank’s liability.  No other customers’ deposits are altered in any way.  

The borrower then spends that loan somewhere else.  The bank has thus created new purchasing power without removing purchasing power from anyone else.  After the loan has been spent, it ends up in another (or even the same) bank as a deposit.  An electronic demand deposit in a bank is money.  It will be accepted by everyone in the UK economy because it carries the same status as sterling paper notes and is accepted to pay tax.  Deregulation and advances in technology (in particular debit and credit cards) mean that 97% of the money in the UK is this 'bank-money'; only 3% is created by the central bank as paper notes.

The implications of this fact are enormous.  Banks create nearly all of the new 'money' in our economy through their loan activity.  They play an absolutely central macroeconomic role.  The tens of thousands of loan officers making decisions everyday about who should receive loans are shaping the outcomes of the economy. The Bank of England is barely able to affect the amount of credit, or money, that the banks create and no authority has any say over how banks allocate this new credit. 

It would be great if the ICB’s suggestion that banks allocate money to 'productive economic activities’ had any basis in empirical reality.  Sadly, the last two decades of actual banking activity in the UK tells us that banks tend to prefer creating credit for either short term speculative returns (financial market trading) or longer term non-productive credit creation (mortgages and commercial property).  

The result has been a massive asset bubble in housing and the 'financialisation' of the UK economy as more and more profits are made through financial speculation as a proportion of GDP.  The ICB’s report (page 22) shows the UK as having the largest banking sector relative to its economy out of 19 leading industrial countries.

Unless the ICB, the Bank of England and the Treasury start to take more seriously the true role of banks as the creators of the overwhelming majority of new purchasing power in the economy, there is little hope for effective reform. Focus instead will remain on propping up a banking model that specialises in speculative credit creation and has become so big that it is underwritten by the taxpayer. 

nef’s joint submission to the ICB on ‘full reserve banking’ would be an effective way of achieving this we believe.  But sadly the ICB appears also have failed to understand this proposal, stating that it would ‘drastically curtail the lending capacity of the UK banking system, reducing the amount of credit available to households and businesses and destroying intermediation synergies.’  (page 98).

It's unclear on what basis the ICB has come to this conclusion.  Full reserve banking would not would stop people putting their savings in an ‘investment account’ which would then be lent out at interest by banks in just the way the ICB describes in the quote on page 16 (at the beginning of this blog).  But if people wanted to keep their money 100% safe, they could also do this by putting it in a custodial account that could not be lent in to the economy.  The need for deposit insurance would then be completely removed and the taxpayer would never again have to bail out the banks and see the enormous cuts to public services that have been the result.  Our proposal does not argue for a ‘shrinkage’ in total credit in the economy – the total money money supply could remain at the same amount as it is today. 

We suggest that instead of private banks making the key macroeconomic decisions about the quantity of credit in the economy, this decision could be taken by an independent group of policy makers, in much the same way as the MPC decides upon changes to interest rates.  This is, perhaps, a role that the new Financial Policy Committee, set up to take a ‘macro-prudential’ (ie broad) overview of the economy as part of the Bank of England, could take on. 

The creation of credit (money) would be separated from its allocation, instead of the current system where both are combined in the hands of private banks.  Credit would be allocated by government departments for larger infrastructure projects and, for less strategic investments, banks would play the intermediary role of recycling savings.  In this way we might move towards an economy where credit is channelled away from 'socially useless' activity and towards productive, job creating areas, whether that be building a low carbon energy and transport future to simply ensuring small businesses get the working capital they need to survive, innovate and create jobs.