In his recent essay for Goldmoney.com, titled Building
a Better Banking System, Alasdair Macleod agrees with the Austrian view
that sound money would help prevent a looming "combined currency, asset,
and banking crisis", yet challenges the practicality of the "Two
Bank" banking reform proposal that was popularized by Murray N. Rothbard
in his 1983 book The
Mystery of Banking. Macleod instead proposes that the key reform would be to
eliminate the limited liability protection for bank stockholders. The prospect
of having a bank's owners' personal assets seized to satisfy a bank's
depositors would be sufficient to instill discipline and probity in the place
of the current moral hazard risk fostered by limited liability and government
deposit insurance. The Austrian position is that the "Two Bank"
reform would eliminate one source of currency expansion; i.e., the ability of banks
and banks alone to create money ex nihilo (out of thin air) via their privilege
to engage in fractional reserve banking (FRB). Macleod believes that eliminating
this privilege would cause credit to dry up and the economy to suffer. (The
central bank's ability to create reserves ex nihilo is the other source of
money expansion and is not directly addressed by Macleod or the "Two Bank"
reform proponents.)
There is much more to Macleod's essay. It deserves to be read and
reread very carefully, for there is much to learn. Before we return to his
proposal to remove the limited liability for ownership for banks, let us
quickly review Rothbard's "Two Bank" proposal.
What
is the "Two Bank" proposal?
Under the Rothbard proposal, banking would be divided into two separate
legal entities--the Deposit Bank and the Loan Bank. Funds deposited in the
Deposit Bank would be backed one-hundred percent by reserves, whether gold,
silver, or even fiat currency. The Deposit Bank would not be allowed by law to
lend these funds. The deposit would be a form of bailment, in which the
ownership of the property does not change hands. The depositor still owns the
amount of his deposit, and the Deposit Bank is merely the custodian. The
depositor would use these funds just as he does now--to pay obligations--using
any of the modern methods of money transfer such as check, debit card, or reserve
certificates issued by the Deposit Bank or even the central bank. Of course,
the Deposit Bank would earn its funds only from fees for its services, since it
would not be allowed by law to lend these funds to earn interest income.
Macleod considers that these fees would be a major obstacle to public
acceptance of the system, since today most checking accounts are free and may
even earn some small amount of interest for the depositor. However, Deposit
Banks would be offering a valuable service in a competitive environment. The
cost of handling mostly electronic transfers of funds is very small, and banks
today actual earn money from every debit card transaction that they process. In
fact some banks require that the depositor engage in a certain number of debit card
transactions each month in order to get fee discounts. In addition, for many
years banks have earned substantial fee income for handling their customers' overdraft
transactions. Banks also earn substantial fee income from their ATM networks
for handling non-customer transactions. As a result for many years banks have
been offering free checking accounts with no minimum balance in order to
capture what can be substantial fee income. Therefore, there is every reason to
believe that checking accounts still would be widely accepted by the general
population.
The
Loan Bank
A depositor of the Deposit Bank who wishes to put his money to work
would transfer some of his funds to the Loan Bank in order to earn interest
income. At this point the Loan Bank owns the funds for some agreed upon period
of time. The Loan Bank invests these funds--it matters not whether to single projects,
such as an oil well, a basket of loans similar to a mutual fund portfolio, or
the bank's general loan portfolio--with a promise to return them to the
customer with interest.
Two facts become clear. One, lending funds to the Loan Bank, which are
further lent to the Loan Bank's customers, does not affect the money supply.
And, two, the lent funds carry some risk to the lender (the Loan Bank) and the
customer who lent his deposit funds to the Loan Bank. As is the case today,
some loans may not be repaid, will be repaid only partially, and perhaps not at
the agreed upon time. Depending upon the terms of the agreement between the
customer and the Loan Bank, the Loan Bank may absorb these losses with its
capital account and repay the customer in full and on time, or the customer may
lose all or part of his lent funds and/or not be repaid on time.
Such is the inescapable nature of banking and lending. All loans carry
some risk of non-repayment.
Two
Essential Reforms
There are two essential reforms that are key to the Rothbardian
"Two Bank" system. One, the Deposit Bank is subject to the same
commercial code as any other business. It does not enjoy any special protection
for using its customers' funds. If the Deposit Bank lent or leased the
customers' deposits, it would engage in fraud. Two, the Loan Bank does not
enjoy the privilege of engaging in fractional reserve banking, whereby it can
create deposit money out of thin air. All loans would be funded out of customer
savings. (The Deposit Bank's customer lends funds to the Loan Bank, which
further lends these same funds to its borrower. The Deposit Bank's reserves
remain unchanged; only the ownership of the funds changes.) The interest rate
would balance the demand for loans with the supply of customer savings.
Macleod quotes Ludwig von Mises from "Senior's Lecture on Monetary
Problems (1931)" that the danger arises when the central bank intervenes
(presumably via deposit insurance) to protect the banks from their own
irresponsible lending and that fluctuations in bank credit are behind the
boom/bust cycle. The former danger is cured by making the Deposit Bank purely a
custodian of the depositors' funds. The latter is cured by prohibiting the
extension of bank credit that is not funded by savings; i.e., eliminating
fractional reserve banking.
The
"Two Bank" reform and Roman Law
Macleod goes to great length to explain the origin of credit in the
West as emanating from Roman Law. It is a very interesting discussion and well
worth studying. In Roman Law there was a distinction between ownership of
property and a duty to repay it, which I understand as the difference in the
status of money in the Deposit Bank (still owned by the customer) and the Loan
Bank (owned by the Loan Bank but with a duty to repay it according to contract).
According to Macleod, these are at the heart of the "difficulties of
overturning the entrenched legal position of Roman, or natural law." But
it appears that Rothbard's "Two Bank" reform is compatible with Roman
Law. Ownership would not be transferred when a customer places funds in the
Deposit Bank, but he would transfer ownership of the funds to the Loan Bank and
the Loan Bank would have a duty to repay the loan. The risk of non-repayment
clearly is with the latter and not the former. It is acceptance of this risk
that allows the Loan Bank customer to earn interest. There is no such thing as
a risk-free loan or risk-free investment.
Macleod sees one further difficulty of the "Two Bank" reform.
Only a fraction of the population own gold or silver; therefore, Macleod fears
that most of the citizenry would not be able to participate in the system. First
of all, there is no requirement that tying the currency to gold is a necessary
step in creating the "Two Bank" reform. In fact, it is more than
likely that initially the central bank would still exist and money would still
be fiat, with fiat currency used as reserves just as they are used as reserves
now. Secondly, eventually Congress could abolish the Fed and distribute its
gold reserves among the banks according to their level of demand deposits,
thereby establishing a fixed relationship between the dollar and gold. At this
point the dollar would simply be a shorthand for a certain amount of gold.
Eventually, the term "dollar" could be dropped and the unit of
currency would become a certain amount of gold. It's been done before. This was
the situation in the US from after the Civil War (1865) to the founding of the
Federal Reserve System (1913). The US enjoyed one of its most expansionist
periods in its history and no central bank existed at the time.
Regarding
Removing Limited Liability Protection
Macleod's proposal to eliminate limited liability protection for banks
has much merit. But other businesses enjoy this protection, so why remove it
only for the banking business? An alternative approach would allow banks to
eschew limited liability in order to attract customers who are not willing to
accept as much risk. If the Loan Banks' owners accepted full/unlimited
liability, there would be much less (but not zero) risk of non-repayment of
funds. Therefore, the Loan Banks' customers must be willing to accept a lower
return. Those who want higher returns could open accounts at Loan Banks that
have limited liability. The risk of non-repayment of the customers' loans to
the Loan Banks would be somewhat greater, because the banks' owners' personal
assets could not be accessed in order to repay their customers. In either case
I am certain that both Macleod and the Rothbardians would recommend that
governments liquidate their so-called deposit insurance protection programs,
which are not compatible with any free market approach.
Conclusion
In conclusion, the Rothbardian "Two Bank" reform is
compatible with the free market. It would eliminate the source of the boom/bust
credit cycle by eliminating the ability of banks to create money ex nihilo via
lending. Bank lending (by the Loan Bank) would not affect the money supply,
because only savings would be lent. Customer deposits (into the Deposit Bank)
would be backed one-hundred percent by reserves, as is compatible with ordinary
commercial law. The only bank examination required of the Deposit Bank would be
periodic audits to ensure that the bank had sufficient reserves for its
deposits. Expensive and intrusive examinations and regulations by banking
authorities would be eliminated, because their reason for existence would be
gone; i.e., the liquidation of deposit insurance. Much great bank expense would
be reduced, and competition eventually would pass this reduced expense along to
the public via more services and more interest return. In short, bankers could
return to their primary task of being good bankers and not have the additional
task of being good followers of ever increasing regulations.
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