Well, yes and no Mr. Reece

The solution is about changing the shape of banking, not maintaining it and asking us to insure it.

The Bank of England should be lender of last resort to a bank\’s retail deposit base – but only that. That business needs to be stand-alone, or ring-fenced internally in banks integrated with wholesale functions, and policed by the regulator.

The risks associated with other activities, and sources of funding, should be borne by creditors and shareholders and absolutely not, as is the case today, by taxpayers.

But this still doesn\’t solve the problem. We know that banking systems without deposit insurance are subject to runs.

We also know that the modern banking system operates more on wholesale deposits than retail. Without some form of insurance available for those wholesale deposits then the system will be subject to runs.

So, we need to do one of three things. Either stop the use of wholesale funding altogether, insure such deposits or accept that there will be runs.

The effects of the first would be horrendous, a massive reduction in lending capability right across the economy. The second is, of course, subject to the usual moral hazard problems. The third, well, no one really seems to like the third as current complaints show.

But just because there are no particularly attractive options in our possible solutions set does not mean that there are others more appealing. As far as I can tell those are our options (there are many other more minor ones but at the heart of the matter those are the three) and we\’ve got to pick one of them.

3 thoughts on “Well, yes and no Mr. Reece”

  1. Well, you could tell banks that the safest way to operate is not to engage in maturity transformation. If banks and lenders have a contract which specifies that the principal will not be repaid until the end of the term, then the bank cannot be run. It can still go bust if it cannot meet its obligations.

    Tim adds: Quite true. But one of the functions of a banking system is maturity transformation. It’s what they’re for.

  2. “We know that banking systems without deposit insurance are subject to runs.”

    Really? From history it looks like regulatory restrictions on capital and diversification seem to be the major factors.

  3. There’s no such thing as “other” activities. Banks both borrow and lend. You can’t do one without the other and be a bank, or make any money, or pay interest. You can’t “ring-fence” deposit taking as a stand-alone activity. You could ring-fence retail banking, so the deposits are being used for such safe outlets as (do I say er here, Tim, in the blog-world?) as mortgages and credit cards. Banks look at each lending business first from the lending opportunity and then check what source of funds are available, retail or wholesale, with what risks. when they get it wrong, that’s CIT and Fortis or Bear Sterns (jury’s out on Lehmann). You can absolutely run an “it’s a wonderful life” bank, but that’s still not without risk, and it’s probably by definition tiny, because all the really short-term lending outlets are wholesale, and the whole thing is seriously exposed to short term risk.

    So I think this is a silly misunderstanding of what the business is like.

    Not sure about your three alternatives, though Tim – I’d say to the man that if he means it, he should just abolish banks.

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