Following the financial crisis, the banking model was criticized for being inherently unstable. There were two key reasons for this instability: first, the fractional reserve model in which banks keep a percentage of their deposits within the coffers and lend or invest the rest was thought to encourage irresponsible decision-making. With deposits being insured by the central bank up to a certain limit, moral hazard is a cause for concern. Secondly, the money creation process allows the central bank to create money through the act of lending, or more generally, the utilization of debt finance. Since money is no longer tied to anything tangible, the central bank effectively has a carte blanche to print as much money as it chooses. What limits its’ discretion is inflation and the fact that the money goes to commercial banks. Banks in turn will have to lend out, but will have to ensure they lend to people who can pay it back. This means that it is incumbent on the borrower to make a sufficient amount of profit from the sales of goods and services. If there is inflation, the value of money will decrease, making goods more expensive. Central banks and commercial banks need to ensure a balance the amount of money in the system with the amount of goods and services.
Nevertheless, commercial banks are the thoroughfare by which which money is distributed. They have the power and authority. Now in attempting to mitigate the financial crisis, central banks embarked on a course of pumping more money into commercial banks (quantitative easing) to make them solvent with enough reserves both in terms of capital and liquidity. It was hoped that the commercial banks would then loan to borrowers thereby propping up the economy. This did not happen as readily as hoped, as banks held onto their largesse to protect themselves. Neither did investment banks undertake risky transactions. There was uncertainty and a fear of ending up like Lehman Brothers.
With central banks pumping money into the system, commercial banks could protect their depositors in that maturity transformation – in which short-term deposits (the bank’s liabilities) would be transformed into long-term loans (the bank’s assets) – could be undertaken without using deposits. But quantitative easing was terminable. Eventually, commercial banks would have to resort to deposits and the fractional reserve system to make loans reviving the first instability mentioned above. Even if banks create money by loaning that which they don’t have, deposits still act as an anchor to how much the bank can loan. There are limits.
However, the potential to make profits is seen to be more necessary than to mitigate risk. Regulation, such as the Basel rules, is issued to ensure banks undertake their financial intermediary role of making their liabilities into assets responsibly. Yet why should banks be allowed to take the money a person earns and convert into a source of capital through which they can generate profits? Very few people understand how commercial banks work, but when they deposit their income, they are certainly not thinking that this money should be considered an investment. Neither do they consider their deposits as loans to the banks (which legally speaking they are) by which they earn interest. Interest on current accounts is simply a nice benefit in their eyes.
Instead, most depositors need to secure and protect their money. They cannot put thousands under their bed when banks offer greater safety. Moreover, now that many transactions are undertaken without the need for cash, banks offer an invaluable service. But instead of a person’s income being used as a bank’s capital on which it makes profit, it would be riskless if a person’s income remains in the bank, only touched by the person himself. Commercial banks would not be allowed to use it to loan, and neither could they create new money though the act of loaning. Risk of bad debts for the bank would be reduced to 0.
At this point, the capitalist would chime in to argue that by doing this banks would be arresting economic growth. In the end, Savings equals Investment according to the circular flow of income which contributes to GDP. Investment is then used to develop or sustain businesses leading to employment and capital growth. This is true, and regardless whether there are occasional financial crises, GDP growth continues to surge. But there is a growing feeling that the economic growth many pine for is having irrevocable consequences on the planet itself. Over-consumption, over-usage of land, environmental degeneration and degradation, wastage of food and material resources, climate change, etc, have become real talking points. The cause for this is the constant act of production which is possible though equity finance, and more prominently, debt finance vis a vis bank loans.
The naysayers’ warning can be mocked, considered the ramblings of treehuggers! But their pleas are the canary in the mine. One can see the devastation wrought on land, and the slow depletion of resources. Oil, that precious black gold, will one day run out. It is an inevitability. Food security and producing clean water is a growing concern for many countries particularly in hotter regions. In addition, the growing inequality and the automation of labour are leading towards poverty for great swathes of people.
There has to be a balance between production and consumption. It is argued that demand creates supply, but supply has become so abundant that waste is secondary effect. There has to be a limit to demand and a limit to supply.
Ensuring that deposit income is not used as capital for loans means that other forms have investment has to be sought. Equity finance through venture capital or share investment is an alternative. In respect to the former, established companies and the wealthy can pool their profits and income to invest in start-ups. In the latter, people can invest in companies according to their choice. Companies will then have less money to play with forcing them to be more efficient and limit their production. This could mean less variety in terms of good choice, but really, how many types of cereal do you really want?
For commercial banks, the government should be the owners. Individuals placing their money in their bank should pay a percentage of their income and the government should increase taxes by a little to ensure that the deposits are considered as public goods. This reduces the moral hazard risk, and makes commercial banks an awfully dull institution to work. However, it protects depositors fully, and ensures that only productive income leads to productive solutions. If that means a reduction of investment and consumption, then this might not necessarily be a bad thing. A move efficient configuration can lead to a reduction in overproduction and over consumption. This only leads to better outcomes for the world at large.