Bankers and their clients are united in one belief. This is that there is not only too much regulation of the banking industry, but that it is excessive, ill thought-out, costly and counterproductive. Yet, lobbying to blunt the allegedly pernicious effects of particular measures apart, they have chosen not to act on that belief. Indeed, the default position of bankers is to implement the new regulations within their own organization and develop services to help their clients implement them as well. This complaisance is the chief expression of the marsupial relationship that exists between legislators (who need banks to scapegoat and to monetize their debts) and bankers (whose profitability depends upon privileges granted by politicians). That at least shows an awareness of self-interest. The position of the independent lawyers and consultants, which never let pass an opportunity to joke about how complicated the regulations are and how much they are looking forward to getting paid by the hour for interpreting them, is merely cynical.
What this unspoken conspiracy of the resigned and the cynical has failed conspicuously to produce is an informed critique of the basis on which regulation is proceeding, or any coherent alternative to the present course. Yet the rationale for the current program of regulation proceeds from a glaring error that is open to an obvious criticism. That error is the belief that the financial crisis is the consequence of the tendency of private finance-capitalism to excess, especially in a deregulated environment of the kind that has prevailed since the 1980s. In truth, the financial system that gave rise to the crisis is the creation not of the markets, but a deliberate creation of law, and one whose excesses are correctly ascribed not to deregulation but to misguided regulation, particularly in terms of capital adequacy. In other words, regulation is proceeding on the basis of a fallacy, which is that the crisis is a case of market failure, which can be corrected only by wise and disinterested regulators and central bankers.
This fallacy has proved astonishingly immune to fact. Consider the unique privileges granted to bankers by the law. Capitalism is founded upon laws of property, whose essence is to grant owners the exclusive use of their property. Yet bankers routinely make use of the property of their customers to fund their own business and to make profits for themselves. The law argues that deposits rank as loans to banks, and permits banks to on-lend those deposits to multiple borrowers, keeping only a fraction of the depositors cash on hand to meet requests for repayment. By this means, the law allows banks to create money ex nihilo. It permits them to create fragile and extended pyramids of credit, in which loans measured in weeks or months or even years are funded by deposits that represent only a fraction of what is being lent, and which can be recalled at any time. Prior to the crisis, it was not uncommon for the leverage of a bank, measured by assets over tangible common equity, to reach 100 times to one, and still meet in full or more the demands of the law and of the regulatory authorities.
The whole panoply of law and of regulation, past and present, is at bottom nothing but the long and often tedious narrative of the persistent refusal of the official mind to accept a patently obvious truth. This is that the extension of credit on the basis of minimal equity, the fractional coverage of callable demand deposits, and the long-term lending of the short-term loans they represent, is intrinsically and ineluctably unstable. Yet the repeated crises in the banking systems of the world are still seen not as the inevitable product of this structural flaw but as a fact of nature. An IMF study of the years between 1970 and 2008 identified 124 systemic banking crisesa definition that did not even include the various currency, balance of payments and debt crises spawned by reckless expansions of creditin that period, or an average of more than three a year for nearly 40 years. The world was only a decade into those 40 years when Charles P. Kindleberger, the great historian of the financial crises of the last two and half centuries, first pointed out that every mania has been associated with the expansion of credit and that in the last hundred or so years the expansion of credit has been almost exclusively through the banks and the financial system.
Of course, the regulators understand this. They just proceed from the fallacy that they can control the expansion of credit. The survival of this belief, despite repeated and often catastrophic defeat over a period stretching back at least 168 years to the passage of the 1844 Banking Act by the British parliament, cannot be explained by the normal processes of ratiocination. The capital and liquidity ratios, single counterparty exposure limits, caps on leverage, singling out of systemically important financial institutions, increased disclosure regimes, greater use of central counterparties and other measures currently proposed by regulators as cures for banking crises would, in other circumstances, be regarded as evidence that the perpetrators were in a pathological state of denial. It would be funny, if it were not tragic, to find adults in positions of responsibility who honestly believe that raising the minimum level of capital to be held against the sum of all risk-weighted assets from 8% (Basel I) to 10.5% (Basel III) over a six-year period between January 2013 and January 2019 will reduce the amplitude of the credit cycle sufficiently to avert the possibility of a severe financial crisis occurring again.
The crowning absurdity is that a minimum capital ratio, far from reducing the probability and severity of a financial crisis, played a large part in causing the problems that erupted in 2007-08. Banks were in fact extremely diligent in maintaining the 8% ratio, because they knew the regulators could put them out of business if they breached it. This rendered their Tier 1 capital effectively useless for practical purposes: It could not be used to absorb losses, since that would breach the minimum and see the bank taken over by the regulators. So banks sought instead to minimize its cost, partly by packing their Basel ratios with ersatz forms of capital cheaper than equity, but mainly by purchasing large quantities of assets that the regulators deemed to be safe. In the years before the crisis erupted, banks bought AAA sovereign bonds (zero-weighted under Basel I and II), structured products (weighted at 20-50%, with senior tranches as low as 7%), and overinvested in risky investment banking activities financed by collateralized repos and swaps, because all of these assets attracted more generous capital relief than lending money to a consumer or a company (weighted at 100% under Basel I).
Structured credit, repo, credit derivatives and sovereign bonds are of course precisely the assets (and liabilities) that were and are at the epicenter of the current financial crisis. But the perverse effects of regulation did not stop there. The regulators compounded their first error with two further mistakes. The first was to make the ratings issued by the ratings agencies the primary determinant of the risk-weighted capital consumed by structured credit and sovereign bonds. Although it is now well understood that the ratings agencies were compromised by the fact they were paid by issuers, it is much less well recognized that they were also effectively protected from competition by the regulatory stipulation that they were the only acceptable source of a rating for capital adequacy purposes. The ratings agencies suffered not only from a conflict of interest but from a lack of competition to contest their rating methodologies. It is not surprising that their ratings proved unreliable.
The second regulatory error was to tie the value of capital relief under the Basel regime to the current market price of assets. When the price of structured credit in particular came under pressure in 2007 and 2008, the regulatory insistence on mark-to-market accounting forced banks to subtract a purely notional loss of value from their capital levels dollar for dollar, causing them to shrink their balance sheets much more rapidly than reality dictated. This aggravated the speed and trajectory of the initial phase of the crisis in 2007-08, when the market price of assets that were eventually repaid without incident was severely dislocated. Nothing could illustrate better than this singular blunder the preposterous basis on which the regulation of the banking industry proceeds. Having created a false market in structured credit through differential risk weightings for assets rated by a government-protected oligopoly of ratings agencies, the regulators then insisted that the market prices of those assets should set the pace at which the banking industry shrank its balance sheet.
Given the sequence of errors, it is not immediately obvious to the disinterested observer why so many of their perpetrators are still in positions of authority at all, let alone claiming the right to ensure it never happens again. Of course it is convenient for regulators and central bankers if the public believes that the financial crisis is a case of market failure that they alone are wise and powerful enough to correct. But their convenience is purchased at a high price. So long as the public is not allowed to understand that blaming the crisis on greedy bankers or deregulated finance-capitalism is worse than untrue, workers, savers and consumers are condemned to remain passengers aboard an unending cycle of credit, whose sickening volatility distributes and redistributes the wealth of nations in an entirely arbitrary fashion that punishes the virtuous and rewards the vicious. The credit boom that preceded the current crisis was not the work of private bankers. It was incited by politicians, orchestrated by the central banks and exacerbated by central bankers and regulators whose measures first inflated the credit boom needlessly, then deflated it in the most damaging way possible, and now ends with them trying to inflate it again with all the effect of a piece of earth-moving equipment pushing on a piece of string.
Five years on, with equity markets still crawling sideways and central banks printing enough money for the authorities to pretend that trillions of dollars of assets are worth more than they really are, the same people and the same ideas are still in charge. This is as true of the banks as the central banks and the securities regulators. Since the crisis broke, the banking industry has continued to rely on the advice of the classically trained, output gap monetarist economists that run central banks and finance ministries and which work in their own research departments, their power to bewitch seemingly immune to the many intellectual and practical failings of their discipline. Mystifyingly, bankers defer to regulators anointed to the role of philosopher-kings by politicians in need of a scapegoat for a problem that they created and ought rightly to be blamed. Yet there is already evidence that the latest creation of this clerisy (Basel III) is having predictably perverse effects, as banks scramble to comply with the heavier capital ratios six and half years before they become mandatory. It is exactly the way they behaved under Basel I and Basel II.
In other words, nothing has changed. But something needs to change, and bankers should become the authors of that change. Instead of allowing themselves to be scapegoated as the greedy people who lobbied hard for the deregulation of finance-capitalism and then ran it to excess in markets laced with moral hazard, bankers should try facing up to the truth about what has happened, and what fixing the problem means for the nature of their business. There is no evidence that the compensation practices of the banks played any meaningful part in causing the crisis. As to deregulation, it is obvious that before, during and after the crisis, banking was and is the most highly regulated industry of any. And far from succumbing to moral hazard, even a cursory review of history proves that banks stuck scrupulously to mandatory capital requirements, and invested chiefly in the less-risky assets that regulators specified they should (by making them less capital-intensive). All of the measures taken in Basel III and Dodd-Frank and the Capital Requirements Directive and the European Market Infrastructure Regulation and dozens of other measures, great and small, are nothing but dogmatic applications of failed remedies based on a fallacy that rests on a lie that the only way to prevent the speculative mania of bankers undermining the real economy and imposing massive social costs on taxpayers is to impose mandatory limits on the multiplication of savings through the manufacture of credit.
If the credit cycle could be abolished by changing the ratio between a numerator and a denominator, even the regulators would surely have chanced upon the right number at some point in the sorry history of the last 30 years. The real problem is not the number of times banks can lend their depositors savings but the fact they can do it at all. It is a problem not of hitting on the right amount of regulatory capital, or the most effective regulatory ceiling on leverage. It is a problem of law, and of the expression of that law in the institutional design of the banking system. For more than a century and a half, regulators have sought to cope with the consequences of a legal design flaw. They introduced central banks as lenders of last resort to banks suffering runs on deposits. They insured retail deposits against loss. They replaced private money with legal tender. They replaced the gold standard with pure fiat currencies whose value is established not by its constituents, or by its convertibility into something valuable, or even by a process of exchange, but by government decree. Governments deliberately acquired, in the infamous words of Ben Bernanke a decade ago, a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.
Perhaps not always after all. In the last four and half years, according to a helpful chart published by the Federal Reserve Bank of St. Louis, the monetary base of the United States has increased by twice as much as it did in the preceding 90 years. It is difficult to argue, amid such anemic rates of growth, that this increase in the supply of money corresponds to an increase in the demand for money. If the increased quantity of money is not the outcome of current economic conditions, it is at least worth considering whether current economic conditions are the outcome of the increase in the quantity of money. The men and women currently running central banks and regulatory agencies would doubtless answer this question in the affirmative, arguing with Bernanke that our current predicament would be even worse if economies were not awash with printed money. But there is another way of interpreting what is happening. If it takes years of near-zero interest rates and an inflation of the balance sheets of the Federal Reserve, the European Central Bank and the Bank of England equivalent to $4.1 trillion in just five years to produce the current rates of economic growth, it is abundantly clear that the salvation of the world cannot come from money. Indeed, it is increasingly clear that money does not solve economic problems, but creates them.
The principal source of monetary expansion is bank deposits. Since every loan creates a deposit, the principal source of an increase in bank deposits is the advance of credit. And the principal source of advances of credit is banks that lend deposits, not once but multiple times. This is the institutionalized, legal design flaw in the system of banking. Correcting it is not a trivial matter, and the short-term effects of doing so would be distinctly uncomfortable, for it entails the abolition of callable deposit banking. In a system in which every monetary liability on the balance sheet of a bank had to be backed 100% by a monetary asset, it would no longer be possible to pay depositors interest. Indeed, depositors would have to pay banks to look after and transfer their money as an administrative service. In a world without fractional coverage of callable deposits, banks would have to become fee-earning fiduciaries that look after money on behalf of depositors in the same way that warehouses accept goods for safekeeping. As custodian banks know better than most, customers paying service fees is scarcely revolutionary. Custodians are paid already for a wide variety of administrative services, in both ad valorem and transaction-based fees.
Nor is there any reason to believe that turning deposits into true deposits (rather than loans) would squeeze the supply of credit, though the transition might well see it become scarcer and more expensive, as banks would be able to lend only genuine savings, and they and their saver-clients would likely exact a higher margin. That is of course precisely the effect intended. Scarcer and more expensive loans will lead to fewer errors of optimism in investment and a less volatile pattern of economic growth as a result. In the longer term, it would also lead to greater stability in the rate of interest. It would eventually reduce it permanently, as borrowers and lenders gradually came to understand that the purchasing power of money would remain relatively static. It is in any event an economic fallacy of the most primitive kind to believe that investment can in the long run exceed saving. All the excessive production of credit under fractional reserve banking can do is arbitrarily redistribute savings between firms, individuals and families, and through time. Most of what currently passes for profit in the banking industry is zero-sum transfers from real resources of exactly this kind, gained through well informed but lavish forms of risk taking whose cost ultimately falls on taxpayers. Even the interest paid to depositors rarely keeps pace with the inflation created by the credit cycle, whereas monetary stability will ensure savers collect a real return.
These benefits nevertheless lie in the future, whereas the cost of the transition to a new system of banking will be incurred in the present. This gives the existing system its inertia. Democratically elected politicians find it hard to solve systemic problems, especially if they incur short-term costs. They are expected to solve socioeconomic problems as they arise, which is why they have charged central bankers and regulators with re-regulating a broken banking system rather than addressing its flaws from first principles. Bankers, however, are bound by no such constraints. Although it would be impossible for a single bank to embark on a solo transition to a fully reserved system, since it would face ruinous competition from fractionally covered deposit-taking banks, there is no reason why a group of banks in one country should not attempt it together. They could compete directly with fractional reserve banks once all banks are no longer backed by central banks and underwritten by taxpayers, which must be the overriding objective of any sensible reform. The goal of that reform is simply stated: to remove demand deposits from the collective balance sheet. The net result will be banks funded not from callable deposits at all, but from a mixture of equity and interest-bearing debt capital such as money market instruments and longer-dated bonds. Excising such a large proportion of the liability side of the balance sheet obviously entails either shrinking the asset side commensurately or replacing deposit funding with something else. The best answer is to shrink both sides of the balance sheet.
This can be done by netting down interbank loans to zero. The reserves the banks hold with the central banks can be transferred to the balance sheets of the central banks and used eventually to redeem government debts. Depositors would be given government-backed digital certificates, or specie, or digital certificates convertible into specie, equivalent to the value of their individual deposits. Demand deposits would then disappear from the collective balance sheet. The net result would be a surplus on the asset side of the balance sheet equivalent in size to the deposits plus reserves placed at the central banks. This would translate into a dowry for the banks, which they could realize for profit. If this was an unwelcome ideaand it almost certainly would be, in the current climate of opinionit can be solved by issuing shares to the government, which could be sold, and the proceeds used to redeem the surplus assets or pay off outstanding government debt, thereby relieving the aggrieved taxpayers of an interest bill. True, granting shares to the government would massively dilute existing shareholders, but they could scarcely complain, given the level of public support their companies have received in recent years. Indeed, the right and inevitable downward revaluation of the remaining assets of the banking system, as the artificial inflation of values under the current system comes to an end, would oblige the shareholders to take a further haircut on the value of the assets represented by their shareholdings.
Once demand deposit banking is abolished, it can be replaced by a banking system that is no longer a creature of law and a plaything of politicians. Instead, consumers could benefit from a genuinely competitive market in banking services, because there is no risk of bank runs when every bank is subject to the constraint that every deposit is matched with money. The savings deposited with banks would be a genuine surplus derived from increases in productivitymaking or doing more with less through better technology or techniquesand not the fictitious savings manufactured by the combination of money-producing central banks and credit-manufacturing private banks. The central banks themselves could be abolished. They are equally unnecessary in a system where banks cannot fail, at least as far as depositors are concerned (they could still make fatal mistakes in lending, but there could never be a run on a bank in which depositors would lose money without a bailout by the taxpayer). The abolition of the central banks would as a matter of course eliminate them as monopoly issuers of money. This would remove the risk of politically inspired monetary incontinence designed to provide cheap finance for pet projects, or to monetize debts, or to drag more taxpayers into the higher tax brackets. Instead, private banks would be free to issue their own currenciessubject always to full reserving of callable demand depositsand consumers would be free to choose between them.
Despite a century of attempt to dismiss it as fantasy of so-called gold bugs, it is highly probable that the successful currencies would be either gold or warehouse certificates convertible into gold. Gold was the most widely accepted medium of exchange from ancient times, chosen by the markets, and meaningful substitutes have yet to be invented (despite various proposals for commodity-backed currencies). The currencies would have to be gold, not in the sense of the jerry-built gold standard of the 1920s but one in which gold is literally money and money literally gold, or at least pieces of paper whose value was equivalent to a sum of gold. The adoption of a gold-backed currency would of course lead to windfall profits for holders of gold, but that is scarcely a reason to refuse it, when the costs of the existing system are so high and the benefits of a more stable system so tempting. Over time, gold-backed currencies would bring into being a de facto world currency, akin to that which prevailed before the First World War. It would also tie the rate of growth of the supply of money to the rate of growth of the worldwide stock of gold, which in turn depends upon the profitability of gold production. Prices (in terms of the purchasing power of gold) would inflate to the extent that productivity increased by less than the output of gold, and deflate to the extent that productivity increased more than the output of gold.
This might sound primitive by comparison with the digital printing press of Ben Bernanke, but the true superstition is to believe that the quantity of money can have any long-run effect on the performance of the economy. An increase in the standard of living depends on an increase in productivity, not an increase in the production of money. All a fixed quantity of money can do is measure the rise in the standard of living caused by the downward pressure on prices of higher productivity (a rise in the purchasing power of money) or track a fall in the standard of living as prices rise because of the lack of productivity (a fall in the purchasing power of money). It is often forgotten, especially by the inflationists who run economic policy today, that the standard of living can be improved by a fall in the price level as surely as it can be eroded by a rise in the price level. In the final quarter of the 19th century, for example, the American economy continued to grow rapidly despite the price level falling by half, precisely because its productivity was rising so rapidly. One of the many mysteries of output gap monetarist economics is why price deflation and economic growth are thought to be incompatible.
The eventual structure of the banking system that would emerge from such a reform is as hard to predict as that of any other market process. However, it is likely that some banks would take the form of mutual funds, which would invest in loans to companies and individuals, and whose shares would trade in the secondary market at a premium to net asset value when loan books were prospering, and at discounts when they turned sour. In other words, investors could suffer losses when in possession of claims on mutualized private banks. But that will be an important discipline, whose adverse effects will be felt by investors only, and not by every taxpayer, deterring irrationally exuberant lending of the kind that takes place under the present system. Importantly, it is a discipline that those would-be competitors to the deposit-taking banks, the money market mutual funds, never had to live with. Obliged to compete with interest-bearing, fractionally covered, insured bank deposits backed by a lender of last resort and the full faith and credit of the taxpayers, they had to commit themselves to an ultimately impossible pledge never to break the buck. With no central bank, and no promise of rescue by the taxpayer, they will compete in the first truly open market for banking services for at least two centuries. The bankers who complain about the burden of regulation today should consider that prospect and ask themselves if it is not a more pleasing one than continuing as catamites to the self-congratulatory prisoners of their own mistakes.