Reserve Banking: The New Radical Idea

Question MarksBanking is by nature a very conservative industry. Change is slow, incremental and deliberate. That’s why, as we’ve noted here before, bad times are sometimes attributed to financial instruments—such as credit-default swaps—that disrupt long-held industry processes and practices.

That’s why the current buzz over ‘reserve banking’ is so interesting. Even the term seems innocuous, but the scenario it proposes is nothing short of revolutionary. And on an even more curious note, the idea has conservative proponents who would normally be expected to eschew such ideas, and liberal critics who find it too radical.

While it’s not exactly a new idea (dating as far back as FDR and the New Deal), it just received a boost from John H. Cochrane, Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. In his paper, “Toward a Run-Free Financial System,” he suggests that banks be mandated to back every move they make—loans, bonds, everything.

Let’s put it another way: Even a gradual shift toward such a system would change banking as we know it.

Just to be clear, this is not some wild-eyed theorist who spends more time on Karl Marx than Adam Smith. Cochrane’s work includes extensive research on shocks in macroeconomic fluctuations, and he is respected for his studies on asset pricing (his book on the subject is standard text in graduate courses). But with his new paper, and the attention it’s getting, he’s effectively lobbed a grenade into the school of conventional thinking.

This is a densely complicated subject, but at its heart, it’s based on the premise that most modern banking isn’t founded on real money—banks making a loan to a consumer or a business don’t exactly hand over the money in cash, or set aside that amount in the vault, just to be sure they can cover it if the loan goes bad. Instead, they credit the recipient’s account with that amount. In a way, these transactions create money rather than passing it along. Putting it crudely, it’s sleight of hand backed (to an extent) by the taxpayer via the Federal Deposit Insurance Corp.

The system works. . . except when it doesn’t. Banks creating deposits as a byproduct of their lending can be extreme. Economist Martin Wolf, who seems to support at least some major changes, notes that in Britain, the ‘creating money’ approach “makes up about 97% of the money supply,” a potentially perilous environment. It can go badly wrong and cause a run on the bank, or even calamities like we saw with Lehman Brothers and AIG, among others, in 2008.

On principle, reserve banking would likely eliminate such disasters, since the institution would be required to ensure that it had enough assets on hand to cover every eventuality. But the new proposal, and others like it, call for a level of transformation that has many industry observers spooked. Even Nobel Prize winner and columnist Paul Krugman, normally a harsh critic of many industry practices, voices doubts about such sweeping changes.

There’s no question that this is a wild idea, and it’s surely not going to be implemented anytime soon. Even incremental changes—say, mandating financial services institutions to keep more in reserve than they do now—will take a major legislative push, which will surely be opposed with heavy lobbying. However, the very fact that such ideas are being discussed should be seen as a healthy sign.

The banking industry has long weathered criticism for not changing with the times, for unfairly risking depositors’ assets, and for representing free-market capitalism while counting on taxpayer-funded bailouts when things go wrong.  The odious phrase ‘too big to fail’—and it’s even more repellent sibling, ‘too big to jail’—have entered the pop culture lexicon, to our detriment. In this content, a change beginning with perception is good.

One scholarly proposal won’t cause a transformation of any kind. But change is healthy, and debate about change is a great place to start.