Tuesday, 28 May 2013

Making banks work

BANKI think it is probably time to outline how I would reconfigure the banking sector in the UK.

To do that first you have to understand what a bank is and what the point of them are from the perspective of an economic system. For this I refer to Minsky's work on What Banks Should Do.

And that is very simple - promote the capital development of the economy.

About the only reason we should pay bankers to do anything is if they can demonstrate the skill of underwriting capital projects against a prospective income stream.

In simple terms this means somebody going into a bank with a proposal that requires a certain amount of money. The bank staff considers whether the prospective income stream proposed to repay that money is adequate to repay the loan and pay the wages and costs of the bank - including a reasonable return to whatever risk capital underpins the bank.

Note that there is no asset collateral involved in this process.

This underwriting process is of great benefit to all of us as it helps to ensure that we all have jobs and output. And that is why the state stands behind the banking business - helping to make sure that the cost of lending is low - in the hope of promoting that process.

The other reason might be less clear. Banking helps prevent the concentration of equity in society. If I want to start a business and the bank won't lend, then I have to find a rich person and sell them most of my business to get the money necessary to get it going. That turns me from an entrepreneur with ownership into an unpaid lackey dancing to the tune of the Vulture Capitalist class. As Felix Dennis puts it in How To Make Money
All Faustian pacts in the raising of start-up capital should be avoided ... No founder of a business who surrenders control in exchange for capital is ever likely to retrieve control of their business. Their financial destiny is in the hands of others and the entrepreneur has lost their way on the narrow road.
Several of the proposals to narrow banking propose to restrict bank lending far further than is necessary or socially sensible - putting up the cost of lending far too high.


When I was 17 and was looking to start my first business I went to see an old grizzled business advisor. And about the first thing he said was that British Banks don't do their job. That job is the distribution of new state backed money to those who can make use of it to develop the capital of the country. The problem of getting lending to businesses has been around for a very long time.

The lending banks we need are the ones that can lend development capital effectively and stick to doing just that. If we are to have private lending banks, then they need to be able to make a decent profit doing development capital lending.

The way I would narrow banks is to offer them an incentive - an unlimited cost free overdraft at the Bank of England. 0% funding costs. In return they must drop all the side businesses and just do capital development lending on an uncollateralised basis - probably in the form of simple overdrafts. In other words they become an agency businesses delivering state money to those that require it.

I'm not even sure a capital buffer is required here. Losing your lending licence if your underwriting isn't that good should be sufficient incentive to run a tight ship. Backing off the entire thing to the central bank reduces the barriers to entry in lending - making self-employed, highly dispersed and, importantly, locally focussed underwriters a possibility (the 'Provi Model').

Any lending businesses that doesn't want to take the oath, then has to fully fund their lending on a maturity matched basis Zopa style. No deposit insurance, no access to the Bank of England, and losses absorbed by those doing the lending. This then becomes the fate of the shadow banking system - the building societies and money funds.

So that sets state funded lending against fully match-funded lending in competitive tension. State funding will likely be conservative but actually injects extra net financial assets into the non-government sector economy. Fully funded lending is just patient man helping impatient man for a fee in return for the risk.

Now narrowing banking in any way will put the cost of lending up markedly - particularly if you de-collateralise to get away from asset bubble spirals. With the current level of loans that is likely to cause fun and games. So you have to get the total amount of lending down at the same time as the narrowing is put in place.

Probably the quickest way to do that is via a debt jubilee, where everybody gets a set amount of money from the state to set against a loan. That way loan amounts, property values and the level of lending all go down at the same time, and those currently without loans get the cash as compensation for loss of asset value.

So with complete disintermediation by the central bank you can have several models - from a fully nationalised state bank with employed underwriters, through the 'Provi Model' where you have self-employed lenders and collectors, to the normal bank with employed bank managers.

The amount of state money injected is limited by demand - as determined by a highly distributed set of underwriters locally on the ground varying interest rates to suit local conditions and their own profitability vs the competition from fully match funded lenders.

That is a flexible system that can respond rapidly to changes in circumstances and is infinitely superior to a cabal of the elite sat in luxurious surroundings in London trying to work out how much the economy requires by applying the Wisdom of Solomon that they don't really have.

A National Bank Transaction System

The retail bank transaction system is the circulation of our economy - interruptions can prove dangerous and perhaps fatal.  As Cypriots recently found, most of us can only operate for a few days without access to a cash-point or online banking transaction service.  

Transaction banking services are a national dependency, just as our body depends on the circulation system to pump blood around the system.  This dependency is currently held entirely within the hands of privately-owned, dubiously managed, mixed-market banking organisations.  Any threat to their monopolies or their bonuses, and the transaction banking system gets it.  The Government, fearing a Cypriot-style crisis or queues at the Northern Rock, capitulates, and Osborne goes to Brussels to argue for bigger banker bonuses.

Even the wildest free-marketeers would hesitate to place our entire road network in private hands, so banking transactions should be protected in the same way.

There is no such thing as 'cash in the bank' if you're beyond the central bank's deposit insurance limit (note I didn't say "state's insurance limit" - only the central bank can provide reliable deposit insurance). At that point you're a risk investor in the bank as many in Cyprus have recently found out.

The transaction system is clearly being used as a hostage by the banks to get whatever they want out of the government and the central bank. Do as we say or we shoot the transaction system!

The transaction system has to continue to function in the event of a bank failure.  Funds held in transactional accounts should be unaffected by that bank failure. The bank illusion of money in the vault has to be replaced with the reality of money in the vault. It can never be allowed to be shattered otherwise you get a sudden shift in expectations at best and cascade failure of businesses at worst.

But that can't be done by simply propping up banks no matter how ridiculous they behave. Capitalism without losses is like Catholicism without hell-fire. It no longer works as a concept. Bad lenders have to be allowed to fail.

Additionally the transaction system is a massive cost overhead to banks and they hate it. Every bank has a unique system, they are fundamental incompatible and that means the duplication between banks is colossal. I've done quite a bit of work on bank transaction systems over the years and the scale dis-economies are quite spectacular. And so they follow management fads - like outsourcing and offshoring - that do little more that shuffle the costs around the business. The recent failure of the RBS transaction system is a case in point.

The banks can do things together. APACS (now UKPA) and LINK show what can be done with mutual co-operation. That needs to be taken one step further, with the transaction system incorporated into a similar body.

There are lots of ways of designing a mutual transaction system. But at its core is one concept - that transactions operate on the balance sheet of the central bank, not the individual banks. So you would have a Transaction Department at the Bank of England (alongside the Issue and Banking Departments) and current and savings account ultimately represent liabilities on that balance sheet.

The functional aspects are less important - existing bank accounts could be held in trust by the current banks, run as separate subsidiaries companies and a myriad of different other options. But the key point is that the operational entity is acting as agent and the legal ownership and responsibility is always at the central bank. That makes anything recorded in the transaction system exactly the same as holding cash. You have a receipt for liabilities at the central bank.

However that makes the individual banks short of deposits and balancing liabilites. The replacement on the individual bank's balance sheets is of course an overdraft from the central bank - as mentioned in the section on lending. Existing banks would then have to get the match funding to free themselves from the central bank lending restrictions, conform to requirements or just enter run-off.

The transaction system is like the road or rail infrastructure and is a common good required by all. Inevitably the state will have to fund its existence - because there is no money in running it. I see the state providing a 'white box' system that anybody authorised can put a marketing veneer on. Done correctly it would mean that you can literally operate your bank accounts through any of the competing front ends. Account numbers would stay the same whoever you are notionally with.

Shadow banks would just have an account on the transaction system like everybody else and would lend by advance - paying money from their account into somebody else's. Overdrafts would be authorised by the underwriters for state funds. All that does is lower the limit at which transactions are refused to somewhere below zero. You could have a combined savings/transaction account by allowing the customer to increase the limit at which transactions are refused above zero.

This design maintains the mutual elements of the UK banking system - our common cash machine system and payments infrastructure as well as the 'free banking' transaction system, it frees the lenders from a crippling cost obligation and it ensures that everybody can rely on 'cash in the bank' being there - regardless of the turmoil in the lending institutions.

The one casualty is interest on deposits. To have interest on deposits in a private system there has to be income from somewhere else to pay that interest. Therefore in this system it becomes a line item of government spending - likely via interest bearing accounts for individuals at National Savings. Paying interest on deposits in this way is then really just the same as paying coupons on Gilts. Gilts, of course, would cease to be issued under any rational government.


Much of this is an amalgam of ideas from all over the place. There's nothing new as such - perhaps just a slightly different arrangement.

There are some key points though:

  • People who put money in the banks believe they are storing an asset safely. It's important that the reality reflects that belief. The bank illusion must be maintained at all times - whether individual institutions fail or not.
  • We can keep the free banking and mutual nature of our cash machines and payments system. It's a good thing to have a freely available rapid transaction system just like it is a good thing to have freely available banknotes and coins.
  • Lenders have to be allowed to go bust. Constant forbearance is a bad thing in a capitalist system. Failures must fail and the costs borne by those funding those operations. The state's job is to mitigate the effects of failures in the private capitalist system.
  • Lending of state money is a valuable way of dynamically increasing and shrinking the money supply. It's automatic and distributed. It helps the capital development of the economy and helps to dilute the ownership of equity. But the nature of that lending has to be tightly controlled.
  • Getting the state to lend directly via agents in the field would lower the barrier to entry in lending.