Executive Summary
This submission outlines a proposal for banking reform that addresses most of the concerns of the Commission. The proposal has some similarities with 'narrow banking' and 'Limited Purpose Banking' but avoids some of its main drawbacks such as the need for retail deposits to be backed by government bonds), and offers additional advantages over and above narrow banking.
We believe that the banking sector would be more stable and robust under a
full reserve banking model, where the transactional function of banking the payments system) is separated from the lending function, than under the current business model, which is open labeled 'fractional reserve banking'.
We also believe this reform would create greater competition within the banking sector, by hugely reducing the barriers to entry in the retail sector. In particular, we would hope to see it made much easier for new, 'Transaction Account'-only banks to enter the market to increase competition in the provision of this core payments system service. We also believe this reform would support the development of a more diverse financial services sector, placing institutions such as credit unions and traditional building societies on a level playing field with banks.
The key feature of fractional reserve banking is that the lending activity of banks effectively creates new money, in the form of new bank deposits. As the Bank of England's 2007 Q3 Quarterly Bulletin states: "When banks make loans, they create additional [bank] deposits for those that have borrowed the money". Put another way, the money supply of the real economy depends entirely on the lending decisions of the banking sector. Mervyn King, the Governor of the Bank of England recently identified these changes in the money supply as being central to the financial crisis:
"At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system."
In contrast, in a full reserve banking system, the effective money supply is unaffected by the lending activities of banks. An economy running on a foundation of full reserve banking will be less prone to prof cyclical tendencies and less inflationary than an economy based on fractional reserve banking. The view that separation of the activities of lending money and creating money would lead to better stability in the financial sector is also supported by Governor King:
"Eliminating fractional reserve banking explicitly recognises that the pretence that risk free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets."
Our proposal for full reserve banking ensures that risk-free deposits in the payments system 'do not coexist with risky assets'. The proposal to achieve this is simple: we recommend to require banks to keep safe the money which customers wish to keep safe, and invest only the money that customers wish to be invested.
After a few minor changes to the reserve account systems used by the Bank of England, the economy would have a stable money supply, regardless of the economic climate and the willingness of the banks to lend. These changes would also give customers a truly risk-free method of holding money, regardless of the amount held, and remove the need for taxpayer funded deposit insurance.
Our proposal is similar in spirit to and modernizes those put forward by the leading monetary economists of the twentieth century, namely Irving Fisher (1936), Milton Friedman (1960), and James Tobin (1987). It follows Huber and Robertson (published by nef in 2000) in recognizing the digital nature of modern money, and is designed to cause the minimum amount of disruption to the financial system's computer networks and IT infrastructure in the transition period.
This proposal deserves serious consideration. It is easy and inexpensive to implement – certainly much cheaper than a new bailout, and less disruptive to the City than broader regulation, such as a new 'Glass-Steagal'-type Act. It merely makes banks operate in the way people (including many economists) assume they operate already – as true intermediaries between savers and borrowers. By doing so, it removes one of the primary sources of economic instability.
Towards a Twenty First Century Banking and Monetary System: Submission to the Independent Commission on BankingBen Dyson,Tony Greenham, Josh Ryan Collins and Richard A.Werner
Joint Submission by the Centre for Banking, Finance and Sustainable Development — University of Southampton, School of Management (Professor!Richard A. Werner, nef (the new economics foundation) (Tony Greenham and Josh Ryan Collins) and Positive Money (Ben Dyson)
