Full reserve banking

for the love of money
Banks make money. That's their business. But should it be allowed? Right libertarians, greens and Islamists join in thinking not.
Sylvia Rowley
30 November 2010

From Irish woes to student protests, the grim fallout of the banking crisis has dominated the news once again this month. But behind the scenes a radical solution has also quietly gained ground, with growing support from some unlikely bedfellows.

Tory MPs, left-leaning and libertarian think tanks and even Muslim shariah bankers have thrown their weight behind a fundamental reform of the banking system. Their idea is simple but radical: banks should only be able to lend out the money in our accounts if we give them explicit permission to do so.

Before the financial crisis most mainstream economists and politicians would have dismissed this idea outright. But this month two Conservative MPs published a Private Members Bill on the topic and, perhaps even more importantly, it’s got the attention of the new Independent Commission on Banking, and the Governor of the Bank of England.

How to make money from nothing


In modern commercial banking, banks keep in reserve only a fraction of the money that we deposit with them, and lend out the rest over and over again. This is called fractional reserve banking. Prior to the crisis, on average, for every £1 of cash minted by the Bank of England, the banking system was able to create around £80 of new bank money (the numbers in your bank account]. As Martin Wolf, chief economics commentator at the FT says “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.”
Under this system, we can access our money whenever we want without having to pay for banking services or take risks. Even though the money we’ve deposited has been invested elsewhere, when we want our money back, we’ll be repaid. Banks benefit from lending most of this money out many times over - essentially creating new money and charging interest on it.
But what if the bank uses our money to invest in risky assets and loses the lot? To deal with this, the British government has a deposit insurance scheme, whereby the state guarantees that anybody who deposits money – up to £50,000 – in any eligible account will get it back even if a bank goes bust, taking away the risk to the customer.  
This is not good news for the taxpayer, because as Mervyn King explained in a recent speech, the use of short-term debt (our bank deposits) to fund long term, risky investments makes banks “inherently fragile”. “Many [people] treat loans to banks as if they were riskless,” he says. “In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer.” In 2008-09 this taxpayer support amounted to £18.9 billion.

Boom and bust

According to monetary reformers this system of “alchemy” is one of the root causes of boom and bust economics, and nothing short of a fundamental overhaul will prevent worse crises from happening in the future.
Ben Curtis from Positive Money, a campaign group coordinating the burgeoning monetary reform movement, says “It's pretty inconvenient to have a financial system that collapses every 7-10 years, but instead of fixing it, we just patch it up and return to business as usual.  We have a banking system that is inherently unstable and triggers these recessions that throw millions out of work and destroy otherwise-sound businesses.” He also argues that the current system “privatises profits and socialises losses”, as banks are able to charge interest on newly created money while taxpayers pick up the tab when it goes wrong.
Steve Baker, one of the two Conservative MPs behind the recent private members bill, goes even further. He argues that current banking practices would “be seen as a disgusting crime” in other industries, and amounts to “collusion between the state and the private sector”.

Possible solutions

In September Conservative MPs Douglas Carswell and Steve Baker introduced a Private Members Bill to Parliament which they said offered a solution to this problem. The bill would “assert sound property rights over money,” Carswell said, allowing us to choose how banks use the cash we deposit. Baker explains how this would work:

“For new accounts people would either have to choose to have a custodial account where the money is theirs and it’s safe and ready for use, or they choose to have that money loaned, [for a set period of time, at their own risk], to someone who wants to borrow it. Those would be the only two types of account.”

This would mean that banks should always have enough money in reserve to pay back their current account customers, and that people with lending accounts could only get their money back at the end of a fixed period, eliminating the risk of a run on the banks

Though the bill would never have been made law (back bench bills like this very rarely are), it was published this month and Baker is setting up a new all-party parliamentary group on money, banking and economics to discuss these kinds of issues, which he will chair. Baker is also promoting the idea with the libertarian think tank the Cobden Centre, where he is an adviser.

For Baker this is a firmly Conservative issue of too much state interference in markets. “The state has ended up underwriting and privileging a particular section of the economy,” he says.  He argues that this not only hurts his constituents, who have to bear the cost of expensive bailouts, but also distorts the lending markets. His belief that the problem is largely one of the state and not markets should help him attract other Tory MPs to the cause.

Fair and sustainable

Over to the left in a completely different area of public life, another group of people have come to a very similar solution, but for different reasons. The think tank nef, (new economics foundation), campaign group Positive Money and Professor Richard Werner from University of Southampton have put forward a proposal for a system of full-reserve banking, which is very similar to Carswell and Baker’s bill. Earlier this month they submitted this idea to Independent Commission on Banking (ICB), which was set up in June 2010 to investigate how the banking system can be made more stable and competitive.

But as well as working for a stable and productive economy, these groups prioritise creating an economy that’s environmentally sustainable and fair; nef exisits to promote economics ‘as if people and planet mattered’ and Werner is a professor of Southampton’s centre for Banking, Finance and Sustainable development

They argue that because banks can charge interest on the money they create through loans, and because most of this interest goes to bankers rather than savers, the system is currently very unfair. Through interest, money flows from the poor to the rich, from the ‘real economy’ to the financial sector, and from the rest of the country to the City of London and the South East, they say.

They argue that a system of 100% reserve banking, where customers have a choice between two accounts as outlined in the Carswell/Baker bill, would be much fairer, more stable, more productive and sustainable.

Full-reserve banking could also put an end to credit-fuelled consumption booms. This would help to curb the over-use of natural resources and the emission of greenhouse gases that cause climate change.

Problems with full-reserve banking

For many economists, however, much of this sounds like heresy. “[Full reserve banking] would be a major change in business models,” says Dr Alistair Milne, of Cass Business School at City University in London. “What the Independent Commission on Banking is more likely to do is to say that deposits should be held in safe banking subsidiaries which have much stricter regulations and can’t engage in certain types of activities. That’s much more achievable practically.”

The move to full-reserve banking would raise a lot of questions. According to Dr Michael McMahon, a research associate at LSE and Assistant Professor at the University of Warwick, the “big unknown” is what proportion of money people would put in these “super-safe accounts”, and what proportion we would choose to lend out, as this affects how much credit would be available and how much the system is affected.

There is also a question, he says, over the knock-on effect on the cost of ordinary banking services to customers. “Banks may decide that providing household accounts was suddenly a very unprofitable activity because of the way they’re allowed to use the money” [i.e. they can’t lend it out], he says. “So they may decide to stop offering consumer accounts altogether… We could move to a system where the cost of having a bank account is very high, where you get charged a transaction fee every time you use your debit card.”

There are also disagreements among supporters of full reserve banking as to exactly how the alternative system would work. While Conservative MPs Baker and Carswell agree with more left-leaning groups such as nef on a surprising number of issues, they disagree on issues such as who should control the money supply if banks don’t – the state (nef) or the free market (Baker and Carswell)?

The future of monetary reform

Ben Curtis from Positive Money says that the campaign he and colleague Ben Dyson started two months ago will step up a gear over the coming year. “We’re trying to take the issue mainstream, to get media coverage, to reach out to the public through organisations such as the Federation of Student Islamic Societies, to work with more MPs, and to bend the ear of the Independent Commission on Banking,” he says.

So for now it looks like the unlikely union of leftwing, rightwing, green and Muslim interests is set to continue. This is vital, argues Curtis, if the banking lobby is to be countered.

“There’s no interest group working on the other side of the banks,” he says. “Banks are obviously going to lobby for whichever system enables them to make the highest amount of profit. There’s nobody representing society’s point of view so that’s what we’re here for, to make the best monetary system for people who use the money.”


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