Dr Lilico of Policy Exchange Gives Serious Consideration to Banking Reform

It is a great pleasure to see a respected and mainstream economist jump into the debate about our banking system. Although Dr Lilico does not go far enough as far as I am concerned, he has made a great and courageous leap in the right direction when proposing the straightening-out of the law in relation to the regular deposit contract. In short, Dr Lilico would like to see 100% safe storage deposits for people who want to store their money and still own it, and investment deposits which would not be insured and would have the same characteristics as the current fractional reserve demand deposit.

A 100% cash reserved safe deposit does not need any government gilts or insurance behind it as Dr Lilico suggests, just the cash itself, but this is a minor point. I disagree that factional reserve accounts should exist — they rely on a legal privilege to not keep creditors whole, and they mislead depositors by calling money “yours” when it is really theirs — but this report is a strong move in the right direction.

Here is a collection of news articles that this policy proposal has attracted to date. I have added my comments to some of them:

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2 replies on “Dr Lilico of Policy Exchange Gives Serious Consideration to Banking Reform”
  1. says: Traktion

    I just got around to reading this interesting paper. I agree that it is good to see others considering the root cause of the problems we have today, but the impression I received from this paper is one of saving the current system, rather than creating a better system.

    My criticisms are:

    1. It wouldn’t stop bank runs on fractional reserve parts of banks; it seems to fall foul of the same criticism cited over having both types (full and fractional reserve) of banks earlier in the document.

    2. In relation to the above, storage accounts likely be less often used, except for times when there was a crisis. While it would provide a safer, and more convenient, haven than a safe at home, it would have a similar effect on the credit supply – it would be choked off, triggering 1 above.

    3. The system would still rely on central banks setting interest rates, which seems a rather blunt tool, open to causing large scale malinvestment. There is nothing free market about a centrally set base rate.

    4. It doesn’t address any of the problems in the insurance industry, particularly of financial products. As AIG failing could have triggered financial meltdown, failing to examine the insurance on risky financial products, is probably missing a major flaw in our system.

    5. In relation to 1 and 2, I find it hard to believe that deposit insurance wouldn’t be implied. I’m afraid my faith in politicians and their friends, the bankers, is too shaken for me to accept this. If FRB is given a government sanctioned gloss, is regulated by the government etc, then people will expect help.

    6. It provides no counter cyclical remedy, despite this being listed as a failure of LPB (which I disagree with – see 6a. below).

    7. FRB requires either steady growth or at least stasis to function without assistance. FRB is essentially leverage, which is great in the good times, but can be very destructive in the bad times; FRB has no useful reverse gear. We may be entering a prolonged period of low growth, punctuated with stasis or negative growth (peak oil or high competition for resources may be upon us). I do not think that FRB, with its high leverage, will be suitable for such an environment, which may mean we need a phase change in the way our economy functions. Continued exponential growth is a mathematical impracticality and one we should face up to.

    While arguments have been made for negative interest rates, these appear not only dangerous for currency stability (would anyone hold rotting currency?), but also seem grossly unfair; making an investment and losing is one thing, but being forced to lose wealth, just to save the system, is another.

    To address the above with solutions, I turn to Limited Purpose Banking, which seems to have been dismissed too easily in this paper. It is good to see it being mentioned, but the arguments against it seem to be weaker than the author merits. Addressing the above:

    1a. As mutual funds can always be traded on an open market, there would be no bank runs. There is no first come, first serve, until the money runs out, as all funds have a market value. Even in a deteriorating market, people could still sell their shares. In fact it could dampen swings (see 6a).

    As the mutual fund industry is a growing one, even when competing against high leverage FRB, it is clearly worth considering. With modern technology now available (particularly, the Internet), trading mutual fund shares should now be very simple. Exchanges could be set up to allow easy bidding and auctioning (perhaps even eBay and other auction sites would be used at times) in a way which could not previously be possible. With this in mind, is the traditional banking model not a little out dated anyway?

    2a. While there could still be swings from riskier to safer mutual funds, with the risk of a bank run removed, the rush for the exits would likely be less pronounced. This would address the problem cited in point 1 to a reasonable degree, providing a better solution than the one outlined in the paper.

    3a. Moral hazard aside, with LPB there is the choice for a central bank to directly purchase shares in struggling mutual funds, to ease both the credit provided by borrowers and also support the liquidation price for investors. As irrational exuberance tends to target certain asset classes, creating asset bubbles, this monetary tool could *directly* target key areas of the economy if needed – this is far more accurate than the setting of a base rate or the ad hoc purchasing of bank assets (which may be hard to price).

    At all other times, mutual fund shares could trade in an open market, with price dictated by supply and demand. In isolation of the point above, this is worthy of discussion in itself – it would crack open the banking/investment market, making it far more open and transparent, with individuals able to participate on a level footing with bankers. Not only does this give more personal responsibility for those who want it, but it also paves the way to more competition and choice.

    4a. LPB addresses the insurance problem of ‘insuring the uninsurable’, thus preventing AIG type situations. As insurance has many parallels with fractional reserve banking, it shouldn’t be ignored. – this was one of the root causes/danger of the crisis in 2008.

    5a. Changing the way the system works, would also redefine how people think about banking. By just sharpening the edges, people will be less likely to see/understand the differences in the proposed system. Drawing now, strong, lines in the financial industry may cause disruption and confusion in the short term, but it would also confront people to make them understand how the new system works. Once understood, there would be no implicit guarantees – the mutual fund market mechanism illustrates this.

    6a. As there would be no rush for the limited, first come, first serve pool of money, people may choose to *hold* onto their investments. As soon as the danger of losing all (or even a high percentage, or fast access) has been removed, the incentive to liquidate investments is reduced. This would likely dampen the swings of irrational exuberance (which will always exist, of course) as much of the danger of holding is removed.

    7. Periods of negative growth would be handled with aplomb. Those who made unwise investments would get a negative return, while those who invested wisely (or safely) would lose nothing. Malinvestment should be avoided and forcing everyone to pay for it is morally wrong. Surely, our financial system should not require growth in order to avoid collapse – it is an accident waiting to happen, especially in light of ongoing events.

    I could go on about the advantages of LPB. Online (or offline) fund managers could spring up, allowing people to choose their portfolio split percentages, or simply defining how much “risk free” money to hold (with the fund manager doing the rest). People could take a very hands on approach instead – they could even trade mutual fund shares *as money*, paving the way for simpler international trade.

    IMO, we need to start from the viewpoint of what is the *best* system we can think of, rather than one which fits around what we have no; we should target the former and plan how to get there. LPB has a clear transitional route, which would cause short term change/disruption, but would have long term benefits. With a sovereign crisis looming, it may be the wake up call needed, for more radical changes to the financial system.

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