Another Banking Proposal from Toby Baxendale

Steven Horwitz

Although, as we have discussed before, Toby Baxendale is skeptical of fractional reserve free banking as might be defended by Selgin, White, and myself, he is seriously engaging both sides of the debate within Austrian Economics and is genuinely interested in finding some common ground.  With that in mind, he has asked me to post the following proposal to see what sort of reaction it gets from our readers.  I believe that it will also be posted on the Mises blog with the same purpose in mind.

I would be particularly interested to hear what George and Larry have to say.  Toby's proposal follows.

***

“Come the Revolution, in a free banking world, where there is at least no lender of last resort, commodity backed money with no possibility of over issuing above that commodity in reserve and no deposit insurance, it would be possible for safe deposit accounts and savings accounts where money is lent to borrowers to exist. Both 100% Reserve Free Bankers and Fractional Reserve Free Bankers would be happy thus far. If an instant access demand deposit is offered that is fractional in nature, we get heated debate within the free banking community, the arguments will be familiar to readers of this site. So I am going to throw in a left field ball and see what comes out in debate about what I see as a potential solution to this. I will remain silent on the thread until all comments are in.

The Third Type of Account (not named yet, will not use 100% or Fractional in the title due to fear of the verbal abuse that will come forth!)

Consider this, a depositor goes into his bank, he is offered a safe deposit account that is safe, but gives no interest, his time preference is such that he wants to earn some interest. The bank worker shows him to his colleague who offers him a savings account. Our depositor loves the rate of interest offered, but notes that he has to put his money away for at least a month, 3,6,9 18 months X number of years to get a proceedingly better rate of interest. This does not satisfy our depositor as he wants to have instant access and interest. He wants to have his cake and eat it. He gets taken to see the Third Type of Account manager. This manager says this account is a timed deposit account in nature i.e. your money is locked away for at least a month, 3,6,9 18 months X number of years, but the bank will allow instant access , by exception  for the liquidity that it keeps in reserve all the time. However, should there be too much call on liquidity, the bank reserves the right to point out that you the depositor are actually a de jure timed depositor / creditor to the bank for at least a month, 3,6,9 18 months X number of years and are going to he held to the time period you freely signed up to.

This third type of account always allows the bank to be reliant on no legal privilege and no accounting standard that is different to other commercial organisation to keep its current and long term creditors whole at all points in time as the creditor in question is in fact a timed depositor who has instant liquidity by exception and not by demand. The reality is this liquidity would be almost at all times there bar the period of bank runs. In fact dare I say it, I can feel the avalanche of invective  building up already, that this is a robust 100% reserve type account form an accounting an legal point of view, with all the benefits of a fractional reserve account of instant access, with non of the inflationary business cycle inducing consequences hotly alleged by the 100% Reserve Bankers."

Comments

[Jerry O'Driscoll]

Why not all allow access to the third account by allowing the account holder to borrow against it? The interest rate would respond to demand changes.

The system actually already exists. NOW accounts (interest-bearing checking accounts) are technically 7-day time deposits, which banks allow by discretion holders to draw on for current funds. I don't believe the 7-day wait has ever been imposed. In the midst of the crisis, Citibank notified all its customers of its rights to impose the wait.

[Steve Horwitz]

And, it's worth noting, what Toby is proposing is how savings accounts in the US sort of work today. The bank can, at its discretion, invoke a 30-day clause that allows it that period of time to pay out your savings. That clause is, I believe, the underlying contractual arrangement and they provide you "on demand" liquidity because they wish to and have the necessary reserves.

I'd happily be corrected if I have this wrong.

[Jerry O'Driscoll]

Does he want to impose transparency? Should banks be compelled to publish their reserves in a timely fashion so that depositors would be able to judge the likelihood of getting current access to their funds?

[Current]

> And, it's worth noting, what Toby is proposing is how
> savings accounts in the US sort of work today. The
> bank can, at its discretion, invoke a 30-day clause
> that allows it that period of time to pay out your
> savings. That clause is, I believe, the underlying
> contractual arrangement and they provide you "on
> demand" liquidity because they wish to and have the
> necessary reserves.

Yes, I mentioned that over at the Cobden centre site in a discussion. I also mentioned that:
* To outlaw fractional reserve accounts it would be necessary to outlaw banks from creating a account that is legally timed savings, but de-facto available on demand.
* Even if every debt certificate must be timed a secondary market will develop in them that may make them usable as money.
I think that's where this may have come from.

Another similar sort of situation is the North of England in the 19th century. Before the Bank of England opened a branch there notes were in short supply. Instead of using notes "sight bills" were used, which were high-quality commercial bills.

The idea is a bit like having a long notice period.

[Bill Woolsey]

It is a bit like the option clause without bonus interest (bonus for the depositor and penalty for the bank.)

[Lee Kelly]

Seems fine, though I suspect the third type of account manager would very quickly become the first, and people would start calling these accounts 'demand deposits' or something similar.Then, in 200 years, when average Joe is not so aware that he owns bank liabilities rather than base money, there'll be a group of people denouncing this arrangement as misleading (at best) and fraudulent (at worst).

And they will probably also claim that monetary expansion always causes malinvestment and business cycles. (I always wonder how the Mengerian story of the emergence of money fits into this theory -- the money supply can increase spontaneously through market interactions. Yet at some point, further increases in the money supply are just assumed to be bad. But why? Where is the line drawn? It seems to me the evolution of liabilities into money is just a continuing part of that Mengerian vision of money.)

[Steve Horwitz]

@Bill: it's sort of the option clause with the default reversed. The bank has the option to treat it as a demand deposit, but the "default" is that it's a time deposit.

[Richard Ebeling]

This proposal is sort of the other side of the coin of a view that has been presented by Kevin Dowd in his writings on free banking under fractional reserve.

Dowd argued that depositors of such demand deposits would be informed (in the large or small print, I suppose) that the bank promises to meet its obligations "on demand." But if due to liquidity shortages, it cannot, the the bank reserves the right to limit deposit withdraws during a period of the liquidity shortfall, but that it will pay a "penality" interest charge to the depositor for having failed to meet its promise to meet its obligations "on demand."

Either way, it gives the bank the ability to use the deposits left with it for lending purposes, while managing its cash flows in such a way that it tries to facilitate depositors' preferences to have more ready access to their funds in that institution.

In my view, whether the banks manage their affairs under the rules (or contractual arrangements) as proposed by Keven Dowd, or along the lines that Toby Baxendale suggests, from an economic perspective the system operates pretty much the same (in terms of lending and deposit activities). And as long as the bank and the depositors know these "rules," I see know reason to think that they are not consistent with classical liberal or libertarian views of honest exchange and contract.

Richard Ebeling

[Nikolaj]

Steve,

You may not be informed, but He Who Must Not Be Named delivered a lecture at the LSE http://blog.mises.org/14517/huerta-de-soto-at-lse-the-video/. You have a nice explanation there why this Baxendale's "third kind" of accounts where the depositor can eat its cake and have it is a nonsense.

As Lee Kelley said, the "third" type of account is just a fractional demand deposit account, pure and simple.

[Current]

Nikolaj,

How would you enforce banning something like that without banning all bond issues with short maturities?

[Nikolaj]

Current,

it does not matter whether you consider 100% system feasible, what is important is that this proposal is a fractional reserve banking.

[Current]

My point is, suppose that the government want a 100% reserve system. How would you suggest they set up the law so that they actually get one?

The point here is that Toby's acceptance of the "third type of account" comes from accepting freedom of contract.

[Mathieu Bédard]

What is the purpose of the first kind of account? Is there a demand for that kind of service that can't be met by jewelers or other such commerce?

How expensive would it be to have a risk less safe deposit box type of account and still have access to modern means of payment and withdrawal? Does that type of account preclude those?

How do we know that the first type of account's deposits won't be partly used to repay other creditors if a bank goes bankrupt because of its riskier activities? Is there an outline for a bankruptcy resolution procedure? I assume this plan implies a privilege for the 100% reserve accounts.

[David Hillary]

This proposal is not acceptible because it denies the bank the opportunity to bind itself to redeem the funds in the Third Type of Account.

The banker's proper function and role, and the implied terms of the bank-customer contract at common law are that the bank is borrowing the funds, and that they are repayable on demand to the customer's order. To make them payable on the banker's discretion is to take away something from the customer's rights in contract, and from the bank's freedom of contract. For example, the customers could not sue their banker for improperly dishonouring cheques properly drawn and with available funds to meet them. Indeed the whole concept of a cheque -- a bill of exchange drawn on a banker and payable on demand, (a bill of exchange being an order (not a request) for payment of money) -- is negated by this proposal.

The practical effect of the proposal is to take away at least part of the bank's incentive to liquidate assets and to raise replacement funding on onerous terms (and/or improve its capital position) which means that suspensions of payment may happen that would otherwise not happen.

This proposal is like the prohibition of interest: the bank offers to pay interest as a gift at its discretion. Today few people would deny the bank the right to promise to pay interest and to legally bind itself to make interest payments or credits, and if anyone made such a proposal as being a compromise between, anti-interest and pro-interest stances, I doubt either side would find it a satisfactory resolution (in the past I understand this was more like a work-around than a solution).

The free banking position of allowing banks freedom of contract is best: it provides banks with the right to offer repayment on demand, and the bank also with the right to offer other types of service including storage, or borrowings secured over metallic reserves and subject to a 100% rule. Leave the banks free, and the customers free, there is no need to propose three products as being the exhaustive list of allowed terms.

[Lawrence H. White]

"This does not satisfy our depositor as he wants to have instant access and interest. He wants to have his cake and eat it."

A small quibble: To have an interest-bearing instant-access account isn't really to "eat one's cake and have it too", i.e. isn't really sacrifice-free for the account-holder, given than he can expect such an account to pay less interest than a time deposit without early withdrawal, and to be less slightly secure than a warehouse account.

"the Third Type of Account ... is a timed deposit account in nature i.e. your money is locked away for at least a month, 3,6,9 18 months X number of years, but the bank will allow instant access , by exception, for the liquidity that it keeps in reserve all the time. However, should there be too much call on liquidity, the bank reserves the right to point out that you the depositor are actually a de jure timed depositor / creditor to the bank for at least a month, 3,6,9 18 months X number of years and are going to he held to the time period you freely signed up to."

As others have suggested, this is basicaly the same as the historically common passbook savings account that carried a "notice of withdrawal" clause. It is normally demandable but the bank can invoke the notice requirement (giving them 60 or 90 days) in unusual circumstances (a run or panic) when the bank would otherwise find it ruinously costly to pay immediately. New York trust companies invoked their clauses during the Panic of 1907, for example, and thereby avoided fire-sale losses.

I see nothing objectionable about a notice of withdrawal clause, or a similar "option clause" used historically on the faces of banknotes. In the absence of deposit insurance such clauses might well become commonplace. But let the market sort that out. I'm with David Hillary in not wanting to make the clause mandatory for accounts that normally offer instant access.

[Mikekikon]

It's a good example, that--I think--pretty clearly exposes the mandatory 100% reserve argument as untenable.

[Lee Kelly]

I'm with David Hillary.

Baxendale's new proposal is certainly an improvement, I think. It would probably work fine enough, but I don't want to compromise on freedom of contract, especially with a libertarian! Something ironic about that.

[Lyle]

Actually the banking world proposed existed in the US from 1835 to 1864. There was no central bank and the feds eventually ran the treasury thru separation of bank and state. Banks at the time issued currency, and of course issued more of it than they had specie in the vaults. You then had the currency detector publication and your currency got worth less the further you got from the bank. So how short of regulation and jail do you make the bank limit itself to the role of the exchange bank in Amsterdam in the 18th century?

[Current]

Lyle,

Hopefully though we can do it without silly branch banking laws this time around.

[Steve Horwitz]

and the collateral requirements for currency issue. And the reserve requirements. "But aside from that, what have the Romans ever done for us...?"

[Current]

I didn't know the US had those laws back then.

[Steve Horwitz]

Current,

Even before the National Banking System (which had them and the limits on branching), individual state systems frequently required collateral for currency issue and had some reserve requirement

[Bill Woolsey]

Steve:

And all of those regulations were mostly counterproductive. (collateral and reserve requirements.)

[Lyle]

But the state regulations were honored more in the breach, and the amount of regulation varied greatly from state to state. Some states said there would be only a state bank, and actually made commercial type banks illegal. Others pretty much let anything go. Read the stories about the political disputes over banking leading up to the election of Jackson, and also the issues in 1837-1845 over banks.
Many of the bank regs date from Andrew Jackson generallized hatred of all banks and bankers, thinking they were basically crooked and rotten to the core. (He felt he had been shafted by banks so he got back at them) Nicholas Biddle and the bank of the United states was worst, since Biddle activly worked to prevent Jackson from being elected.

[Bill Woolsey]

Lyle:

The "stories" I have read about the free banking era suggest that bond collateral schemes were enforced. The problem was that all of the money was backed by especially "safe" bonds chosen by the politicians. When the canal project the politicians favor went broke, the banknotes lost most of their value. Even general obligation state bonds defaulted sometimes.

[Justin]

"...in a free banking world."

In free banking with competing currencies, merchants, consumers and so on might simply reject the 'third option' as a medium of exchange if they deem it too risky to hold. Or they might accept it. Or they might charge a premium for accepting that currency for their products/services over say a competing 100% reserve currency. Who knows.

I don't see this debate as having much value in a "free banking world." As David Hillary said above: "Leave the banks free, and the customers free, there is no need to propose three products as being the exhaustive list of allowed terms."

However, the chances of a "free banking world" in our lifetime seems rather remote. So we should instead be debating second-best options or how to best transition to free banking.

[Lee Kelly]

Justin,

The Fed needs to first commit to some nominal income level target -- 2-3% per year. A monetary constitution should then enforce this rule -- perhaps central bankers should face automatic dismissal for failure. Why? Unstable monetary policy would quickly threaten burgeoning free banking reforms.

I want competitive note issue, no reserve requirements, and an end to the FDIC, but it is all so complicated. Interventions and regulations often complement one another, so that partial deregulation actually makes things worse. Removing regulation A and leaving regulation B may be worse than leaving both A and B, even though removing both A and B would be ideal. It's like biological evolution: sometimes having a pair of wings might be a great advantage, but if there are no beneficial intermediary steps, then it cannot evolve regardless of what advantage it would bring.

[David Hillary]

Lee Kelly,

The steps to free banking and a gold standard aren't really hard to institute, even given deposit insurance, central banking, and prudential regulation. Neither are they necessarily dependent on each other.

For example, deposit insurance could be phased out gradually (by reducing the maximum per depositor per bank) or abolished outright without any other changes. In New Zealand and Australia there is no deposit insurance, but they do have central banking and a modest level of prudential regulation.

Another example is, the central bank's monopoly on note issue could be ended without moving to a commodity standard or abolishing the central bank. For example in Hong Kong, Macau, Scotland and Northern Ireland, there are multiple commercial banks that issue bank notes, but they still have central banks or monetary authorities.

A commodity standard could be restored without abolishing central banking, also: the central bank would be required to pay its notes in gold coin.

Fortunately, for the issue of frb, we don't have to propose that it can only work with free banking and a commodity standard: it also works with central banking and a fait standard.

Frb actually is an aid to the restoration of a commodity standard: the central bank need not carry out the silly exercise postulated by anti-frb Gary North, whereby the existing gold stock is distributed ratably as full and final payment of all claims on the central bank. This would involve a devaluation of the monetary unit by 90%+, with a 1000%+ inflation effect, and this proposal is a symbol of the extent of the misunderstanding of its promoter. Retaining frb means that the central bank can restore convertibility to gold at the market exchange rate between gold and its currency, thereby minimising a) the need for getting extremely large amounts of additional gold reserves and b) any impact on the purchasing power of money in the short term.

[Lee Kelly]

David,

Perhaps it would be as simple as you describe, but I am not so confident. For example, the existence of deposit insurance has prompted complementary regulations of bank capital, because the discipline that would normally be exerted by bank creditors is lifted. Perhaps other regulations that I am not aware of also have this complementary structure, so that removing anything less than the whole set would be politically unstable. It seems to me that deconstructing the present system, in all its complexity, would lead to similar knowledge problems as constructing it did in the first place. Now I do not mean to argue for the status quo, but it would be dishonest to not raise these kinds of concerns.

Interestingly, this line of argument may present a problem for those who advocate Popperian piecemeal social engineering.

[Bill Woolsey]

The greatest challenge to moving to a gold standard is picking the initial price of gold. After that, the problem with the operation of the gold standard is possibly sharp changes in the relative price of gold, mostly likely due to sharp changes in the demand to hold gold for investment purposes.

[Jerry O'Driscoll]

@Bill Woolsey,

I agree on #1, but not so much on #2. Investors don't buy gold under a gold standard. The investment demand is a product of having a fiat standard.

There was a conference about 5 years ago at AIER on the transition issue. Larry White presented a very good paper addressing the first issue.

[Bill Woolsey]

Jerry,

The investment demand for gold under a gold standard is a default hedge rather than a conventional inflation hedge. With default on government bonds, an explicit default and devaluation are closely related, however, so there is an inflation risk. If government bonds and the gold standard are secure, then investment in gold is what generates the zero nominal bound. If the risk of these things recedes, lower demand for gold. If the risk of these things rises, higher demand for gold.

In libertopia, with no government debt and free banking, gold is the default hedge for private debt and temporary devaluations occur when the option clause is exercized.

Of course, a fad to look like Mr. T is delflationary. The end of rap is inflationary. But that really isn't investment demand.

[David Hillary]

Lee Kelly, deposit insurance implies a need for prudential regulation, I can accept that, but apart from that I still reckon any one intervention can be removed without upsetting the apple cart. So, deposit insurance should be the first to go, or be phased out.

On the deposit insurance front, perhaps there is some reason for hope, notwithstanding recent moves to increase coverage. The FDIC is keen on creditor recapitalisation for large bank failures and has taken action to require large banks to be able to effect rapid creditor recapitalisation. This kind of move could, along with reductions in coverage amounts, reduce the impact of deposit insurance in distorting banking markets, and potentially support liberalisation of prudential regulations on banks.

[David Hillary]

See this post here for details about FDIC actions (and RBNZ consideration) about prompt creditor recapitalisation requirements for large bank failures. http://www.lostsoulblog.com/2010/06/living-wills-for-big-banks.html

[Current]

Part of the issue here is that deposit insurance seems much more prominent in US political debates than it is in one in Britain. I think David Hillary is from New Zealand where things are different to the US, and possibly more like Britain.

When I've visited the US I've notices that banks there show signs saying they are FDIC insured. People like Krugman praise deposit insurance as part of the holy legacy of the new deal. Whereas is Britain few people knew that deposit insurance even existed or applied to their account before the crisis. The banks in Britain are large here and were often taken to be stable. None of them advertise that accounts are insured. Certainly many people know deposit insurance exists now, but even now it's not seen as part of some grand social experiment. In fact it's not seen as a particularly left-wing policy at all.

[Lyle]

To answer the observation. From reports not that many banks failed in the depression in the UK, while many did in the us and a lot of grandparents and now great grandparents lost money on the deal. Recall that FDR had to close all the banks for a week to determine which ones were sound. (Partly because the US had so many little 1 branch banks). History makes deposit insurance important in the us. Of course we could provide an alternative by making purchasing government bonds more easy, then you build a ladder of them.

[David Hillary]

Here in New Zealand and Australia we have 4 giant banks with 90% combined market share, that are extremely strong, prudently managed, and rated at or about AA -- and no deposit insurance. Deposit insurance isn't wanted nor needed, it is not really feasible given that the banking industry here is so concentrated.

The contrast with the thousands of shitty little single-office 'community' banks in the US could not be more stark. If you tried to open such an institution here the market would laugh you out of town these days. The only small institutions that seem to be viable here are the customer-owned institutions - credit unions and building societies, as the 'finance companies' here have been dying like flies for the last few years. And by small I'm talking $100m to $2b in total assets, which I understand is larger than the US single office 'community' banks.

[Lyle]

David Hints at why the US has deposit insurance and others do not. The US had and still has many small banks, and until the last 20 years no bank really reached over many states, there were no truly national (in the sense that they had branches in all states banks) It still might be the case due to holes in bank coverage, I know Citi is not widely distributed. Wells Fargo does not do business in Missouri also and JPMorgan does not do business in all 50 states. So the situation due to Andrew Jacksons hatred of banks and bankers, (not just Nicholas Biddle but all) lead to a situation where there were lots of little banks and they could fail.

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