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Free Banking at the rescue of an ailing banking system

Free Banking at the rescue of an ailing banking system . Nathalie Janson. Why is the banking system ailing ?. The major banking systems went to the worst banking and financial crisis in 2007 since the G reat Depression Concern : the worst may not be behind us

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Free Banking at the rescue of an ailing banking system

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  1. Free Bankingat the rescue of an ailingbanking system Nathalie Janson

  2. Whyis the banking system ailing? • The major bankingsystemswent to the worstbanking and financialcrisis in 2007 since the Great Depression • Concern: the worstmay not bebehind us • Since the 1990’s thereis an acceleration of the number of banking and financial crises at the international level • The reasons are: • the international monetary system basedexclusively on fiat money for the first time in economichistoryallowing for • central bankfoolishmonetarypoliciescombinedwithinconsistentbankingregulations

  3. The Banking System Poisonned by MisguidedMonetaryPolicies • For the first time since the end of the BrettonWoods agreement in the early 70’s the monetary system isexclusivelybased on fiat money • Consequence: thereisvirtually no limit to money creationsince gold is no longer a reference • In this new contextitiseasier for governments to create money beforebeingsanctionned • First poison pill: easyliquidity • To that regard 2013 has been an interestingyear in terms of competition in money creation: Japandecided to join the contestearlierthisyearwhere USA, Europe, China, Indiawerealreadycompetingfiercely

  4. The Banking System Poisonned by MisguidedMonetaryPolicies • Second poison pill: central monetarypolicycreates the condition for systemiccrisis • Central monetarypolicy tends to uniformizesbanks’ balance sheetssincebanksneed to hold instruments for central bankmonetarypolicyoperations: • In most of the countries monetarypolicyisconductedthrough open marketoperations (OMO). Central banks have a list of securitiestheyaccept for thoseoperations • By controlling short terminterest rates and influencing the yieldcurvecentral banksalters the value of assetsuniformelyand so the economic value of banks

  5. The Banking System Poisonned by InconsistentBankingRegulation • Third poison pill: bankingregulationthatuniformizesfurtherbank mangement strategies, stimulatesfinancial innovation to circumventregulation and increasebank sizes • Bankingregulationstandardizesbank management practices sincebanksneed to complywiththoseregulation (seeinternal control processes) • Bankingregulationuniformizesbanksstrategies: • In the US (but not only) the Fed encouraged the development of subprimesmortages by penalizingbanksthatwere not sufficientlycreative in adding new criteria to the standard onesused for screening loans application in order to boostmortgagemarket

  6. The Banking System Poisonned by InconsistentBankingRegulation • Bankingregulationcreatesincentive for financial innovation in particular the Basel regulationsinceitis a risk-based capital ratio. Assigningriskweights to assetsbanksseek to createsecurities out of range likesecuritized portfolios in the last crisis • Toobig to failpolicy (whether explicit or implicit) gives an incentive for banks to getbigger in order to benefitfrom the governmentsafety net. A toobig to failbankingintitution has an easieraccess to capital markets and itscost of fundingislessdependentfromits « true » riskexposure.

  7. Banking System Outlook • Given the currentcontextthereis no reason for the banking system to improve or if ititimproves, itwillbejustbe on the surface • Banks are stillsufferingfrominflated and distorted balance sheetsince the quantitative easingmonetarypolicyprevented the sharpdecrease of assets value, the adjustmentthatwould have been necessary to restart the system on healthierground • The new Basel accord does not solveany of the bankingregulation contradiction and justmakes the regulationeven more complicatedcreating new loopholes

  8. Free Banking: the Alternative? • In thiscontext free bankingis the only viable projectthatwould cure the banking system for good • Free bankingwillcreate a more diversifiedbanking system with no competition in bank size • Free banking ends the uniformization of bankslendingpolicy, banks’ balance sheet and bank mangement strategies • In a free bankingenvironmentcustomerswilldecidewether or not theywantbankswillfractionalreservesbanks • fractionalreservesbanksimplythatcustomers are willing to let bankslending out a fraction of theirdeposits and take the risk of not being able to bewithdrawtheir full deposit

  9. Free Banking: the Alternative? • In a free bankingenvironmentbankswilldecidewhether or not theywant to issue bank notes • If a bankdecides to issue bank notes, itneeds to makecustomerswilling to holdit and mostlikely by makingitredeemable in an alreadyexisting store of value • Indeed the main characteristicrequired for a currency to beheldis to be a storage of value • The longer customersholdbank notes, the higherisbanklendingactivity and bank profit

  10. Free Banking: the Alternative? • Giventhis basic factthereis no incentive for a free bank to expandtoomuchitssupply of bank notes sinceitwill face a higherdemand of redemption • On the contrary to earnmarketshare free banksneed to produce stable bank notes solessthan more bank notes • Doesitmeanthat a free banking system is a complicatedword for customers to live in sincethey deal with exchange rates betweenbank notes ? • Not necessarilycompetingbanks have an incentive to arrange mutualagreements to accepttheir notes at par value

  11. Free Banking: the Alternative? • Could free banksdecide to form a cartel to expand in concert theirbank notes? • Free bankscouldtry but as economictheory shows cartel isunstablesothereisalways the riskthat one of the bankwould free ride causing the end of the cartel • Moreoverwhen free banksexpand in concert theywillevnetually face a higherdemand for redemption • Whathappens in case of liquiditycrisis? • First of all liquiditycrisis has less chance to affect the wholebanking system at the same time sincebanks are lesslikely to have similar balance sheets

  12. Free Banking: the Alternative? • Doesitmeanthat a free bankexperiencing a liquiditycrisiswill go bankrupt? • Banks being free does not meanthatthere are not of part of the same network. In case theyagree to redeemat par their notes they have chance to be part of clearinghouses • Clearinghouses are institutions processing the daily transactions of banks. They have theirownrules and canstepin in case of liquiditycrisis acting temporarily as a lender of last resort. • Major differencewithcurrent central banks: their action istemporarysincethey face the risk of loosingreserves and eventuallyworsenning the liquidityproblems

  13. Free Banking: the Alternative? • Last and not least free bankingmeans the end for good of the « toobig to failpolicy » lowering the incentive for banks to getbigger and the risk of experiencingsystemiccrisis • If thereis no longer anygovernmentsafety net how free bankswillenforce trust? • By being stable • By havingfree banksshareholdersresponsible for the actions taken by their managers withextendedliability • Woulditbesodifficult to put in place today? • Lesstodaythanevergiven the dematerialization of money and the number of existingprivatecurrencies • The main obstacle: bigbanks lobby and governments

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