Vague Lending

If I lend you my combiner harvester, you would not record it as an asset on your balance sheet. Yet that it was banks do, when I deposit money with them for safe keeping. This gives them the right to lend the money to someone else. I think the money belongs to me and is ready for me to use whenever I want it. They have given it to someone else. If my friend gave my combine harvester to someone else to use without asking me first, I would be a bit upset. However banks do this all the time.

I would not promise my combine harvester to another person without checking when they planned to do their harvest. I would want to make sure my harvest would be done first, or that they would be completed theirs, before mine was ready. The agree would sort this stuff out, so that I was no left in a situation where I lost my harvest.

Our contracts with banks are too vague. People depositing money in a bank have different intentions.

• Some will be transactions money left in my bank between payday and when my rent is due, or I can get to the supermarket to buy my groceries.
• Some is money that I do not want to use for a while, because I am saving to buy a new computer in about six months time.
• Some will be long-term savings for when I retire.

The bank does not know my intentions. We need deposits with contracts appropriate for the various purposes for which I deposit money in the bank.

Bankers Bonuses

The conventional wisdom is that a major cause of the GFC was the large bonuses paid to bankers that created incentives for short-term profit taking. Many economists and politicians argue that bonuses need to be brought under control to reduce the risks to the banking system.

Jeffery Friedman and Wladimir Kraus argue against this view in their book called Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. They argue that most incentive compensation was paid in equity-based bonuses. These bonuses generally had a vesting period of three to five years, meaning the time horizon of the recipient was constantly moving out as they accumulated equity. By the end of the boom, few individuals had a larger stake in the banks than their own employees. In the aftermath, many bankers lost more than they had earned during the boom. This casts doubt on the idea that bankers knowingly took short-term risk to boost their bonuses.

This confirms the understanding I have gleaned from the biographies of several leading bankers. My impression is that they totally misjudged the risks they were taking on. They did not knowingly take on short-term risk to boost their bonuses. They thought that they had their risks under control. They unwisely went into profit opportunities that they mistakenly assumed were risk free.

The problem was banker foolishness, not deliberate risk taking.

Sound Banking System (5) Stability

This banking system can operate without any need for government regulation or political interference. There is no role for governments in a sound banking system.

Inflation would disappear because political powers would no longer control and manipulate the currency in circulation. Banks would not be able to manipulate their reserves, because people would refuse to deposit money with banks that moved depositors’ money onto their balance sheets. Once this ability is gone, monetary inflation is not possible, so price inflation would disappear. Instead, prices should decline slowly over time, as technological advances make producers more productive. Falling prices make all consumers in the economy better off.

Banks would not able to expand lending to fund asset bubbles. Once investment bubbles are constrained, the bank crashes that usually follow will cease.

This full series can be found at sound banking system.

Sound Banking System (4) Loan Brokerage

2. Loan Brokerage Banks
The second type of bank provides a loan brokerage service. These banks would match the savings of depositors who want to lend with people who want to borrow. Each loan would be matched with a deposit or group of deposits for the same term. Every deposit received and every loan made would have a timestamp. The Loan Brokerage Bank would have to match every loan for a particular term with equivalent deposits for the same term.

Interest rates for the various terms would adjust until the supply of deposits matched the demand for loans for each possible term. The bank would charges either a fee or a margin on the interest rate to cover the cost of providing this service. Sometimes the bank will combine a number of deposits together to make up a large loan. This would be part of the brokerage service.

Loan brokerage banks would usually take responsibility for assessing the credit-worthiness of potential borrowers and the viability of the projects for which they are borrowing. If the bank agrees to take responsibility for any bad debts or fraud that may occur, the cost of this service would be built into the bank's charges. Different banks would offer different options with different levels of service.

Brokerage Banks would provide a re-financing service for people who have placed money in a bank for a fixed term. The bank would have been lent the money out to another person for the same term. If the depositor’s situation changes and they need the money, they may want to withdraw the deposit early. This would be possible, but there may be a cost. The bank would have to be able to replace the money with a deposit for the same term from a new lender, but it would have to charge a fee to cover the work involved in organising a replacement lender. If the market interest rate had fallen, the first lender may have to cover the interest differential for the rest of the term. This cost should be relatively small, as in a sound financial system interest rates would tend to be very stable.

Sound Banking System (3) No Interest

Banks that are operating according to this principle would not be able to lend out money, because they do not own it. This means that they would not be able to pay interest on money deposited with them. To cover the costs of providing their services, transaction banks would need to charge a service fee. Depositors would look for banks that provide the best security and service for the most reasonable fee. Banks that provide better security and a wider range of transactions would be able to charge more. However, bank fees would be quite small. People would be willing to pay the price for a secure and reliable banking system.

Depositing money on call would become less attractive option, because deposits would face bank charges, but no interest. To avoid this problem, people would only deposit money on call, if they expect to use it immediately. If they do not want to use the money immediately, they would be better to deposit it at loan bank for a fixed term (even if only a few days) so it can be lent out and to earn interest.

Sound Banking System (2) Principle

The important principle underlining a sound banking system is that the money in a bank does not belong to the bank. A transaction bank is storing the property of someone else, in the same way as warehouse. A warehouse owner keeps an inventory of everything that is stored in his warehouse. He records the identity and contact details of the owner of each item. He can even transfer the ownership of an item to another person, if instructed to do so by the original owner. However, the recording of assets in his care is kept separate from his own asset register. He can treat the warehouse as his asset, but he must not record the furniture given into his care as his property.

Transaction banks would operate in the same way. They would keep an inventory of all the money being stored and the identity of its owners. These records must be separate from the bank’s own financial accounts. Money stored must not creep onto the bank’s asset register.

The money deposited in a transaction bank is owned by the person who deposited it, not by the bank. This is a biblical principle.

If a man gives his neighbor silver or goods for safekeeping and they are stolen from the neighbor's house, the thief, if he is caught, must pay back double. But if the thief is not found, the owner of the house must appear before the judges to determine whether he has laid his hands on the other man's property…. The one whom the judges declare guilty must pay back double to his neighbor (Ex 22:7-9).

When the goods entrusted to person another for safekeeping go missing, that person is accountable for the loss. If the thief is found, the thief must make restitution, but if not, the person caring for the property must make restitution to the owner. In God’s eyes, neglect of property given for safekeeping is the same as theft.

The Bible describes the valuables presented for safekeeping as the “property” of the depositor, even when they are in the house of the other person. This confirms the principle that the ownership of property does not transfer to person who takes it for safekeeping. The owners of property retain their ownership, until they sell the goods. This biblical principle applies to banking. When a bank treats money deposited with it for safekeeping as its own asset, it has misappropriated something that belongs to another. It has “laid its hands on the other man’s property”.

Sound Banking System (1)

A sound banking system would have two types of bank. Each one would provide a specific type of bank account.

• Transaction Facilitation
• Loan brokerage

I will describe these two types of bank in the next few posts.

1. Transaction Banks
Transactions banks would offer a true warehouse service for people wanting an account to manage their daily financial transactions. These banks would record valid money claims and execute transactions between clients. Some might use paper records while others would use computers. It would not matter how transactions are recorded, as long as all money claims and transactions are recorded accurately.

When a person deposits twenty dollars in a bank, the bank would increase the value of that person’s account by twenty dollars. If the person withdraws five dollars, the bank would reduce that person’s account by five dollars.

If someone instructs the bank to pay ten dollars to another person, the bank would reduce that person’s account by ten dollars, and increase the recipients account by ten dollars.

If the person being paid records his money transactions at another bank, the first bank would instruct that person’s bank to increase the recipient’s account by ten dollars. The second bank would be willing to do this, provided the first bank confirms that it has already reduced the account of the person making the payment by ten dollars.

The banks do not need to exchange anything, as they are simply recording the fact that one person has ten dollars more than they had before, and the other has ten dollars less than they had before. It does not matter which banks record these changes, provided that every time one person’s account is increased, another person’s account is decreased by the same amount.

To sustain their business, transaction banks would have to prove to their customers that their records were accurate. They would do this by opening their records up to anyone who wanted to check. Auditors would be able to look at what the bank is doing and confirm that they are not cheating those who trust them. All banks would watch each other carefully. If one could expose cheating by another, it could eliminate a competitor and increase its market share.

The full series can be found at Sound Banking System.

Community Based Banking (4) Money Records

The task of the record-keeper is to keep a record of who in the community is owed something and who owes something to the community.

In an act of charity, one person gives and another receives. There are no outstanding debts.

In barter, both people give and receive at the same time. The transactions are reciprocal, so there is no outstanding obligation.

In a market transaction, giving and receiving are not reciprocal.

• After a sales transaction, the seller has given, but has not received.
• The buyer has received, but has not given.

The record-keepers will record that the buyer has received, but not yet given. The buyer has taken on an obligation to give something to someone in the community. More likely, they will have had a previous obligation from the community wiped out. The seller has given, but has not yet received. The community now has an obligation to give something to them. More likely, he will have had a previous obligation to give someone to the community wiped out.
If someone has a positive record, they have given things to other people in their community without receiving anything equivalent in return. They are not someone wanting something for nothing, so people in the community should be willing to supply them.

The person who has given but not received will be recorded as plus x. The community has an obligation to that person. The person who has received, but not given will be recorded as negative x. They will have the agreed to the price of the purchase that they have deducted from their account. They have an obligation to the community that can only be settled by giving something of similar value to someone else in their community.

The unit that debts are recorded in does not matter, provided everyone understands it and uses it. It can relate to a particular commodity or to a currency that has existed in the past. People can look around and see goods and services priced in the units adopted, so they can see what the unit is worth.

Historians record that pounds, shillings and pence were used as units of account in Western Europe hundreds of years after these coins had stopped circulating. Coins in these denominations did not exist, but people still used these units for recording debts and other market valuations. When I was growing up, guineas were used at stock auctions even though these coins have not existed here for more than a hundred years.

Community Based Banking (2) Multiple Recorders

In some communities, several people will operate this transaction recording service. The next step in the development of community banking would be the cancelling out of countervailing debts and credits between different recorders. If a person had a credit with one record-keeper, that person could get them to another pass the credit to another record-keeper to assign to another person that has supplied the first person with for goods or services.

The record-keeper would be happy to pass a positive balance to another recorder, because it does not belong to them, but to the person they recorded it for. They would not mind if the person who was previously positive went negative in the records, because it is not a debt owed to the record-keeper, but to the rest of the community. The debt would only fall to the record-keeper, if the person owing it cheated by keeping on taking, but refusing to give anything to anyone else. This would be a risky course to take, because once the record-keeper alerted the rest of the community to what is going on, that cheat would either be ostracised or intimidated into settling their debt.

A wise record-keeper would stop recording their own debts and credits and get another trusted recorder to do it. That would reduce the temptation to cheat and add extra transparency to their operation.

Once several people have entered the record-keeping business, the negative and positive balances recorded by particular record keepers would no longer balance. One might have negative exceeding positives. Another might have positives exceeding negatives. However, the negatives and balances would balance out across the entire community. For everyone in the community who is owed something, there would be another person in the community who owned the same amount. If all the records were put together, the balances should net to zero.

Community Based Banking (1) Recording Transactions

Most modern people assume that a money system has to be established and regulated by the government. Those who reject this view tend to assume that money must be based on a precious metal like gold. Both these views are wrong.

A money system can emerge in any community where people trust each other. All that is needed is a few people that are trusted by everyone in the community. Christians need to understand this. The money systems of the world are shaking and may eventually collapse. Christian communities should be strong on trust, so they will be well placed to develop to stable money systems to replace the ones that have failed. In this series of posts I will describe how a community-based money and banking process could emerge and grow.

Recording Transactions
A community-based banking service would most likely start when a trustworthy person starts supplying goods and services to other people in exchange for things that they need. The trustworthy person might begin recording their economic transactions. The process would not need to be sophisticated. A slate or exercise book would suffice. If the trustworthy person trusts some of the people being supplied, they might be given them credit by allowing to buy goods without paying for them straight away. The trustworthy person would keep a slate recording the amounts that various people owe. Keeping records in this way would enable the trustworthy person to become an active trader in the community.

Provided they trust the person keeping it, a person clearing their slate might provide more goods and services than they owe. Their record on the slate would be changed from a negative to positive. By recording negative and positive values, the slate would develop into a record of debits and credits. The trustworthy trader would owe things to some people and be owed something by others. These economic transactions would be recorded on the slate or exercise book.

The next step in the development would be for person who has received something from another to settle their debt by asking the trustworthy person to reflect this transaction on the slate by changing their balance to negative and changing the record for the person supplying the goods to a positive value. The trustworthy person would facilitate trade within the community by recording debits and credits and shifting them between people as they exchange goods and services.

The trustworthy trader could extend their business by providing the same recording service for other producers and traders. Many of these would not have sufficient trust in the community to be able to do this for themselves. People could then start bringing their surplus goods to the market and sell them to any other trader in return for a credit with the record-keeping trader. They could then use the credit to purchase goods from the traders who had what they wanted.

Once their service is widely accepted, the record-keeping trader might start recording the purchases and sales for everyone living within the community. Some might leave some of their credit with the record-keeper until they needed fresh goods later in the week. More people would use this record-keeping service when they see that many people trust the record-keeper trader and this way of doing business offer greater flexibility than barter.

If the recording business grows, the trustworthy person might need to charge a small fee for the service, but this specialisation would allow other people to focussing on doing what they did best. They would eventually give up trading and make their living from record-keeping. The trusted person could only specialise in this way, if they were scrupulous about maintaining the trust of the community. If the record-keeper were to start making mistakes, or was to shift credits onto their own account, people would quickly stop trusting them, and their business would die very fast.

Money emerged this way in many traditional communities. Most people would be self-sufficient for food. If they wanted to buy shoes from a local cobbler or clothing from a local garment maker, they would often buy it on credit, because, they might not be able to pay for it until the harvest had come. The cobbler would know his neighbours, so he would only give credit to those he knew to be creditworthy, ie those he trusted. The garment maker might buy some shoes by swapping some debts with the cobbler. Trade emerged with local traders keeping a slate of those who owed payment to them. Banking emerged when responsibility for recording uncompleted exchanges was taken over by a specialist.

The full series is at Community Banks.

Rotten Banks

Andrew Haldane is Executive Director for Financial Stability at the Bank of England. In article in the London Review of Books, he describes banking in the nineteenth century.

In the first half of the 19th century, the business of banking was simple. The UK had around five hundred banks and seven hundred building societies. Most of the former operated as unlimited liability partnerships: the owners-cum-managers backed the banks’ losses with every last penny of their own personal wealth. The building societies operated as mutually owned co-operatives, with ownership, control and liability all pooled. Financial sector assets amounted to less than 50 per cent of annual UK GDP.

Banks’ balance sheets were heavily cushioned. Shareholder funds – so-called equity capital – protected depositors from loss and often accounted for as much as half of the balance sheet. Cash, and liquid securities such as government bonds, enabled banks to meet their payment obligations to depositors. They accounted for about a third of banks’ assets. Banking systems maintained broadly similar arrangements across the US and Europe. This relationship between governance and balance sheet was mutually compatible. Owing to unlimited liability, control was exercised by investors whose personal wealth was on the line – a potent incentive to be prudent with depositors’ money. Bank directors – the major shareholders responsible for day to day management – excluded investors who didn’t have sufficiently deep pockets to bear the risk. Shareholders were firmly on the hook, and had a strong incentive, in turn, to make sure that managers didn’t step out of line. Managers monitored shareholders and shareholders managers. In this way, the 19th-century banking model kept risk-taking in check.

He then explains how the introduction of limited liability laws in 1855 led to a massive increase in leverage and appetite for risk.

As unlimited liability was phased out, leverage among banks rose from about three or four in the middle of the 19th century to about five or six at its close. Leverage continued its upward march when extended liability was removed, and by the end of the 20th century it was higher than twenty. In 2007, at its high-water mark, bank leverage hit thirty or more.

This strategy translated, by the arithmetical magic of leverage, into higher shareholder returns. Having begun the 20th century in modest single figures, equity returns to banks were, on average, close to 20 per cent by its end. At the height of the boom, bank equity returns touched 30 per cent. Higher leverage accounted for almost all of this. Bank managers no longer had to sweat their assets: they simply had to borrow against them.

The downside of this strategy is now only too clear. With leverage of two (UK banks in 1850), 50 per cent of your assets must go bad before your equity is wiped out and you go bust. But with leverage of twenty (UK banks in 2000), you will go bust if you lose only 5 per cent of your assets.

A related problem was the separation of management from shareholder discipline.

By the end of the 1930s, only six British banks still maintained reserve liability. The governance and balance sheets of banks were, by this time, unrecognisable from those a century earlier. Banks were now controlled by arms-length managers, no longer major shareholders, while ownership was held by a widely dispersed set of shareholders, unvetted and anonymous, their upside pay-offs unlimited but their downside risks now capped by limited liability.

This article by Andrew Haldane is worth a read, for those who want to understand the causes of the rottenness in the modern banking system. He is not so strong on solutions.
See Limited Liability for more.

Transforming Society (11) - Money

A great deal of giving and sharing will take place in A Street, but there will also be some market transactions. Jack has always paid for someone to mow his lawns. When he realised that a man from D Street had a lawn mowing business, he gave him the business. Jack could afford to pay for getting his lawn mown, so he preferred to keep on paying.

When the money broke down, Bert started recording transactions between people in the two streets to allow trade to continue. When the time is right, Bert and some friends will start new bank to serve the people of A Street. It will become essential for the functioning of society, during a time of economic collapse, but that it is too big a story to tell here.

The full story is told in this parable.

UK Banking Reform

Douglas Carswell recently introduced a Banking Reform Bill into the UK Parliament. His bill establishes the distinction between lending intermediary services account and custodial deposit account. His speech introducing the bill is worth a listen, because he hits the nail on the head. He explains that the problem with banking is that when I put my money in the bank, I think that I still own it, but banking law says that the bank owns it. That legal twist means the money has two owners, which leads to problems with runs on banks.

I was excited when I read his bill because his diagnosis of the problem and his proposal solution is very similar to the one that I outline in Bank Deposits and Loans. The only difference is that I refer to a safe-keeping service whereas he refers to custodial deposits, but they are exactly the same.

I hope that Douglas’s Bill succeeds, but I presume the financial powers will fight against it. They will not let such an essential change take place

The only thing that this bill lacks is my second proposal for sound banking, which matching of loans. His prescription for the lending intermediary service should specify that banks can only lend out money for the same term as that for which it is deposted. This would prevent Banks from borrowing short and lending long, which is the other problem with modern banking.

More at Money System

Three Prinicples for Honest Banking (3)

3. Banks should not record deposits on their balance sheet.

Modern banks record deposits as assets on their balance sheet. This is wrong. A bank is just a warehouse. A storage company does not record the furniture it stores for people who have gone overseas as an asset. If the owner transfers the furniture to another storage company, its business has declined, but it has not affected its balance sheet. It would want as much business as possible, but the value of the furniture stored would be largely irrelevant.

Similarly, a share registry is not concerned about the value of the shares for which it registers ownership. It is only interested in the number of companies that it has as clients. A bank would want to have as many as clients as possible. However, the size of the claims recorded would not matter to the bank.

A bank is recording an entitlement that belongs to someone else. The claim does not belong to the bank, so it is not entitled to include it on its balance sheet.

Modern money is just digits on a computer file. These digits are records of wealth that belong to other people, so they are not the banks assets at all. Digital records should not be recorded as assets.

More at Money.

Three Prinicples for Honest Banking (2)

2. Money on Call should not be loaned.

Money deposited on call is money that can be withdrawn at any time that the depositor chooses, ie whenever they call. The deposits in all cheque accounts and many savings accounts are on call. Modern banking practice is based on the fact that in general only a proportion of money deposited on call is withdrawn at any time. The rest is used to finance overdrafts and other short term loans or loans on call. Honest banks will not make loans against money on call.

This will eliminate the practice of paying interest on deposits that are on call. Banks can only pay interest, if they can earn interest by making a loan. Banks that do not loan money deposited on call would not be able to pay interest on it.

This change to banking practice would make depositing money on call less attractive, as there may be bank charges, but no interest. Therefore, people will only deposit money on call if they expect to use it fairly immediately. If they do not want to use it immediately, they will be better to deposit it for a fixed term (even if only a few weeks) so the bank can lend it and they can be paid interest.

Three Prinicples for Honest Banking (1)

1. All bank loans must be matched with a deposit for the same term.

If this principle is followed, then no theft will be possible. Every term loan issued by a bank will be matched by a deposit or group of deposits with the same term. All bank loans will be for a fixed term, so a loan could only be made, if the bank has already received a deposit or deposits with the same term. Banks will only lend money that has been assigned to them for lending to others.

This principle is incredibly simple, but it is the key to sound money. It means that whenever someone borrows a valid claim, there is someone else who is willing to give up an equivalent claim to goods and services at the same time (at a price). This will have the effect of raising the interest rates on longer term deposits. This is reasonable, as the longer the term of the loan, the greater is the risk of loss.

Lehman Brothers Collapse

Governemnts round the world are warning that bankers have not learned the lessons of the financial crisis.

A more serious problem is that governments have not learned the lessons from the financial collapse. Governments created the legal and banking system that allowed bankers to act foolishly. Assuming that further government regulation can solve problems caused by faulty laws and regulations is very foolish.

Good Banks

The powerful governments of the world are talking about starting a “bad bank”. Their idea is that other banks would sell all their toxic assets to the bad bank, where they could be isolated. The other banks could then get on with being normal banks.

This is a very expensive solution as the government will become responsible for all the losses on the toxic assets.

We do not need another bad bank. There are already plenty of them. What we really need is a good bank. I hope that a private business will take the opportunity presented by the current uncertain situation to establish a good bank.

We need a bank that does not claim money entrusted to it belong to it; that does not record deposits as assets of the bank.

We need a bank that does not take money that belongs to one person and loan it to another without permission.

We need a bank that does not rely on mathematical models or commission agents to make decisions about lending, but trusts relationship with borrowers and knowledge of their character.

We need a bank that does not chase profits from shonky speculations or random risk taking.

I have described how a good bank would function in Bank Deposits and Loans.

If a good bank started, depositors would move their money to it. Other good banks would start when they saw how well the good bank was doing. Good banks would spring up everywhere, as depositors look for a safe haven. The world would see a dramatic shift of money from the existing banks to the good banks.

The true nature of our existing banks would be revealed. They would be left holding their toxic assets and depending on funding by government bailouts. Everyone would see that they really are bad banks, and avoid them like the plague.

Mistrust (2)

During the last decade these practices broke down and were replaced by blind trust. Many financial innovations widened the gap between lenders and borrowers to the extent the final lender knew nothing about the trustworthiness of the borrower. They had no reason for not mistrusting them, but they chose to trust.

• Mortgage brokers stopped scrutinising potential borrows and started trusting anyone who asked for a housing loan.
• Credit ratings agencies stopped scrutinising financial institutions and starting taking payments for helping them to cook up their crazy financial concoctions.
• Banks lent money without knowing whether the borrower was creditable and with no certainty about the collateral.
• Hedge funds and pension funds purchased securitised mortgages without any idea whether they would be repaid or not. The just trusted the investment banks that issued the securities.
• Many of these securities have proved to be unworthy of trust, which is just what you expect.

The credit crisis emerged because mistrust disappeared and was replaced with blind faith and stupidity.

Nationalising Banks

Bill Bonner has some great economic insights and he writes well. Here is an interesting quotation.

Just a few months go, ‘nationalization’ was practically a dirty word. No one – except a brain-dead Bolshevik – would have thought it desirable for a government bureaucracy to manage capitalism’s money. Now, few people can think of anything better.

Here is another.

Among the queerest financial stories of the last week was the proposal to create a ‘bad bank.’ It hardly seemed necessary. There were already dozens of them.

And the consequences.

But if the 'bad bank' idea could work, why not create a super baaaddd bank? We could use it to get rid of all our mistakes. Writers could unload their bad novels. Businessmen could sweep their errors under its broad carpet. What the heck, let people get out of bad marriages without penalty; the super baaaddd bank could pay the alimony and divorce costs.

The hitch with the bad bank idea is so obvious even a banker could spot it. If the cost of mistakes is reduced, people might make more of them. Like the rest of us, bankers are neither good nor bad, but subject to influence. Unlike metallurgy or particle physics, banking does not have a rising learning curve. It's not science. Instead, it's more like love and gambling…with a circular learning pattern. They learn…and then they forget. They get carried away in the boom upswing; then they get whacked when it turns down.

So let them have a good beating. It will give them of a lesson that will last a lifetime…and give the next generation a solid banking sector.