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Economics

Gordon Kerr at the European Parliament

The following is the text of an address by Gordon Kerr, a Cobden Centre Advisory Board Member, to the Brussels Group at the European Parliament on 13th January 2010.

By Invitation of Syed Kamall MEP, Christofer Fjellner MEP and Alexander Graf Lambsdorff MEP. Meeting chaired by Shane Frith.

Syed Kamall, Shane Frith, ladies and gentlemen, thank you for inviting me here to address you today.

1. Introduction

May I provide a few words by way of brief personal background. I have spent the bulk of my 25 year banking career as a structuring engineer.

I played a minor role in wrecking the British banking system by designing and implementing synthetic capital structures – these are mechanisms for banks to produce, as if by magic, additional capital in their accounts which does not in reality exist.

This artificial capital was and remains a product of inconsistent regulatory capital rules that applied to different categories of banking activities.

By way of example: multi billion portfolios of insured loans were flipped from the funded regulatory regime (8% capital ratio) to the derivatives regime (1/16th of this – 0.5%) merely by wrapping them up in credit default swaps.

I will seek to persuade you today of my view that there exists a simple and perhaps Europe-wide cure to the banking crisis. Make a simple legal change.

Simply stipulate that funds deposited under demand deposit contracts with banks belong to the depositor and must be backed by cash or a near cash asset (such as Government bonds).

This proposal would not freeze the banking system. On the contrary, it would revitalise it by ensuring that there could never in future be a run on banks. This proposal would enable free markets to flourish, and would remove the banks from taxpayer dependency.

The European Parliament has this power. Let me invite you to consider using it.

2. Why is this step necessary?

Let me frame the regulatory options very clearly. The number of truly different ways of regulating the banking industry is two. The only alternative to the 100% collateralised demand deposit regulatory structure is the Fractional Reserve system. This is the present system.

Under fractional reserve regulation banks are required to maintain a minimum say 8% “fraction” of their exposures as capital.

Since the bulk of European banks are shareholder owned rather than mutuals or government owned, market forces virtually compel them to push Fractional Reserve regulation to the limit.

No bank CEO could keep his job if he was not fully leveraged in supposedly stable market conditions.

Furthermore, capital is expensive to raise. Under the present system market forces result in the emergence of methods of inflating what I would regard as a fair measure of bank capital such that it appears greater than it actually is.

If the proposal now made is ignored then I fear we will have failed to learn anything from the 2008 collapse.

The alternative is simply to patch the banks back together under a supposedly strengthened Fractional Reserving set of regulations. However, FR in any form is almost certain to lead to another boom bust cycle.

In the initial phase banks will generate large profits as they again inflate the money supply, driving asset prices up which in circular fashion will boost lending once again as the collateral values of the assets justify greater and greater loans. This will give the appearance of economic growth but, like the boom that preceded the present bust, it will merely be storing up more problems for present and future taxpayers.

Contrast the sincere and genuine concern shown here in this Parliament for the interests of future generations in the context of our climate change concerns with the scant regard for their financial interests demonstrated by our continued tolerance of ineffective banking regulation.

3. A few words on the critical importance of demand deposit contracts.

Why has the UK Government, and others, bailed out banks? Of all the stakeholders in banks, which category of stakeholder was deemed so important that such previously unimagined sums needed to be spent to protect its interests?

Borrowers’ interests did not justify the bailout; their loans would be treated as an asset in liquidation and sold to the highest bidder;

Shareholders – surely this is the class of stakeholder least deserving of any taxpayer rescue funds.

Lenders – mainly other banks and institutions. This class does not merit state protection, they knew the risks and took them. Likewise derivative counterparties; this class is in exactly the same category as lenders, the only difference being the technical point that most derivative exposures are unfunded as opposed to funded. The widely quoted credit default swap market illustrates the maturity and professionalism with which both these categories of stakeholder assume credit exposure to banks.

The key stakeholder whose interests could not be sacrificed must be DEPOSITORS. Why are depositors’ interests considered so important and deserving? I think the answer to this question must be that depositors mistakenly believed back in October 2008, and even since then, that funds they deposit in a bank belong to them. That is a serious mistake. In case any of you are in any doubt there is no legal difference in any European jurisdiction of which I am aware between a deposit contract and a loan contract. Both are loans to the bank and a deposit contract is a loan that can be called back by the lender supposedly on demand.

But few UK citizens are aware of this point. A recent UK survey found that 70% of the sample surveyed believe that depositors own the money they put in a bank, just as the client of a law firm owns the funds he leaves in a solicitor’s Client account in the UK. How would you feel if you went to collect your funds from your solicitor and were told “ I’m sorry, I’ve just lost all your money by speculating it without your permission in an attempt to boost my profits? ” Yet this is how we approve of banks treating our demand deposits under fractional-reserve banking rules.

The proposal now submitted would prevent future crashes and would recognize the critical importance of demand depositors by stipulating that ownership of demand deposit funds remained with the depositors, not the banks.

Market forces would ensure that banks worthy of surviving the present crisis would clean up their business models and render their balance sheets transparent. They would seek to grow and profit by persuading depositors to convert some deposits to loans.

4. Replies to Possible Objections

Various objections have been set out:

– Banks would fail to be able to provide loans. Response: Bank lending would only be curtailed to the extent that they could not provide loans not backed by savings willingly lent to banks. Some of the projects presently being financed would not succeed in obtaining credit in such an environment. This is surely no bad thing since it is precisely these marginally viable transactions that form the tipping point of each successive banking crisis. Only 3% of the UK Bank’s liabilities are demand deposits.

– Interest rates would rise and economic development be held back. Response: The absence of bank crises would eliminate the massive squandering of capital goods which accompanies severe recessions, and there is no reason to suppose that the interest rate would be any higher in such a system than the market rate implied in today’s environment. Again, the matching up of saved funds with loaned funds should prevent the inception of non- viable projects saving the system from the crashes which always lead to a freezing up of bank lending.

– A 100% reserve requirement would inhibit the contractual freedom of the parties. Response: On the contrary, the proposal represents the natural application of traditional property law principles to a monetary deposit contract.

– Economic growth is not possible without a certain amount of credit expansion and inflation. Response: May I quote De Soto “ The slight, gradual and continuous deflation (in the sense of a rise in the purchasing power of the monetary unit) would actively foster sustained, harmonious economic development”.

5. Conclusion

At the point of collapse the Royal Bank of Scotland had leveraged itself so severely that it had lent out each pound sterling sitting in so called demand deposit accounts 66 times.

Even the most prominent defenders of fractional-reserve banking recognize that the establishment of a 100% reserve requirement would put an end to banking crises.

Simon Johnson, former Chief Economist of the IMF said in May 09 “The Finance industry has effectively captured our Government…recovery will fail unless we break this financial oligarchy”

You have the power to prevent any recurrence of these banking crises and to free governments and taxpayers from the finance industry. I urge you to use it, change the legal status of demand deposit contracts as proposed – provide that such funds remain 100% cash backed and remain the property of depositors.

Ladies and Gentlemen, thank you.

Gordon Kerr
January 13th 2010

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