The report written by John Kay, "Narrow banking: the reform of banking regulation" and ensuing discussion in the mainstream media, e.g. Martin Wolf in the FT, Anthony Hilton in The London Evening Standard and John Kay himself in The Daily Telegraph is worth analysis.
The growth of balance sheets (i.e. deposits and loans) can be classified according to risk and complexity as follows:
- 100% reserve banking, i.e. no risk, all deposits are repayable immediately on demand; this implies loan to deposit ratio 0%; this means that banking becomes a utility business which is what John Kay appears to be arguing for in his report.
- fractional-reserve banking, i.e. a certain level of risk as banks keep only a fraction of deposits; this model has worked for centuries based on trust in banks and a statistical principle that not all depositors need to withdraw money at the same time; therefore a "bank run" was possible if depositors lost trust, or there was no sufficient reserve accumulated; to counter the former governments routinely guarantee deposits to counter the latter loan to deposit ratio must be comfortably below 100% and banks were lending money to one another (including a central bank, the lender of last resort); as example to have 10% fractional-reserve banking i.e. £1 cash has to "serve" £10 on the balance sheets liabilities, loan to deposit ratio must be 90%; to have 25% fractional-reserve banking i.e. £1 cash has to "serve" £4 on the balance sheets liabilities, loan to deposit ratio must be 75%; to have 50% fractional-reserve banking i.e. £1 cash has to "serve" £2 on the balance sheets liabilities, loan to deposit ratio must be 50%; and incidentally to have 100% fractional-reserve banking i.e. £1 cash has to "serve" £1 on the balance sheets liabilities, loan to deposit ratio must be 0%.
- no reserve banking, i.e. banks lend with loan to deposit ratio of 100% (accumulating no cash reserves), a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is linear).
- depleting reserves banking, i.e. banks lend with loan to deposit ratio above 100%, not do they not accumulate any cash reserves, but they deplete the existing reserves, a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is exponential, therefore it is a very short time indeed). Depleting reserves banking amount to a classic and rudimentary example of a pyramid scheme.
It is important to have a debate whether we, as society, taxpayers, should have 100% reserve banking with no liquidity risk at all, or a fractional-reserve banking with some element of liquidity risk. However, this debate has very little to do with the causes and mechanics of the current crisis. It is similar to any debate what level risk society is prepared to accept: be it air travel, road travel, building nuclear electric plants and so on. It is a cost-benefit debate. For centuries, fractional-reserve banking on a level of 20% - 25% worked well circulating money in the economy. In this process sufficient reserves were accumulated and bank runs were a rarity.
A sufficient cause of the current financial crisis was the fact that banks were lending with loan to deposit ratio above 100%. They committed a crime of fraud: building a pyramid scheme. The current liquidity crunch is simply a collapse of this financial pyramid. (In the same way, a liquidity crunch was caused in Albania in 1996 – 1997.)
It seems that arguments in the financial community are moving with a grace of a drunkard walking in a corridor: from wall to wall, from one extreme to the other, from pyramid scheme practices to arcane 100% reserve banking. Whilst this may be a result of a lack of understanding of the fundamentals of mathematical complexity and risk assessment (based on probability theory), it also obfuscates the picture that the financial industry committed a massive fraud on the taxpayers using a pyramid scheme mechanism.
Even if 100% reserve banking will get its way, governments must prosecute many from the financial community (as well as regulators) not for practicing fractional reserve banking (which may be risky but still within what has been legally acceptable as commercial risk taking), but for practicing depleting reserve banking (which was excessive risk taking and amounting to an illegal financial pyramid selling).