Bank Capitalization

“If the banks relinquish risk to the state, they must also relinquish interest in the same proportion.” [1]

Following the banking crisis of 2007 – 9 I read avidly into the question of Debt, Credit and Money Supply. I am particularly indebted to Tony Weekes & Sue Holden [2], Michael Rowbotham [3], and Richard Werner [4] for their clear expositions of the manner in which a very large fraction of our ‘money’ is generated as credit, and its corresponding debt. Their clarity triggered a train of thought in which I re-designed the whole banking system on a more logical and less pernicious basis. Let me explain.

When the owner of a business accumulates more capital than he can usefully employ, he is willing to lend it to friends to enable them to build or acquire plant and the means of producing goods and wealth. The borrower is willing to offer, and (depending on his religion) the lender is willing to accept, a small and regular fee proportional to the outstanding value of the loan, i.e. 'interest'. In a free market where there are numerous independent lenders and borrowers, the level of interest should indicate the real value of the loaned capital. Banks arise as clearing houses to link depositors and borrowers.

Banks are keen to lend at interest, for that is the way they make much of their profit. It soon became clear to banks that (in times of peace and stability) they could lend more money than they strictly owned, for the chance of all the depositors demanding repayment simultaneously was very small. As long as their borrowers eventually paid back all the borrowed money (or forfeited equivalent collateral) they could lend out their capital 5 times over, or 10 or 100 times. Lord Turner suggests [5] that banks should be allowed to lend 5 times as much money as they own, the Swiss bankers suggest 14 times; the risk-takers of Wall Street and the City of London may have dared to go to 30 times, but that seems to have been too far. (I am talking of ratios of capital to total lending of 20%, 7% and 3.3% respectively.) It does seem crazy that there is as yet no agreed ratio of total bank assets to capital held, and no mechanism of insisting that it is adhered to. The old mechanism was to let the over-extended banks fail, and then lock up the board of directors for debt [6]. That worked well enough to inculcate a generation or two of prudent bankers; but it created hardship for thousands of innocent depositors, and governments now-a-days step in and supply the missing money, with the consequence that bankers have become progressively less prudent.

It could be argued that the money that banks lend over and above their own capital, the debt-based money (or credit-based money), is not in any sense the banks’ money, and the interest on it should therefore not be their interest. I am going to argue that it could instead be regarded as a state asset. This is especially reasonable when it is ultimately the state that underwrites the bad debts. Under the present system it can be argued that when a bank makes a loan it takes a risk, and that risk gives it a right to the profit which is the interest; the bigger the risk the higher the interest. But it is the state that ultimately takes the risk. If the banks relinquish the risk to the state, they must also relinquish the interest. On this principle, banks would only keep the interest they earn on the capital they hold; interest they earn on their lending of debt-money must be handed to the treasury. On this basis there would be much less incentive for the banks to over-extend. They would still earn fees on the contracts they draw up; their income would consist of fee income plus interest on their lent capital, but it would not include interest on money they do not own –– which is the current anomalous position.

This rationalization effectively takes from banks the power of generating money and passes it to the government. The banks would be the brokers by which the treasurer generates debt. Fee income suffices for doctors and lawyers, so why not bankers?

Pursuing the argument further we can consider bad debts of two types: [a] when the debt is totally written off, and [b] when there is collateral. For clarity let us suppose that the bank that issued the loan is operating a ratio of capital to total assets of 10%. In case [a] the bank would lose its 10% portion of the loan, while the state loses its 90% portion. The bank would also lose its brokerage fee, as a punitive incentive towards prudent lending. In the case where there is collateral (type [b]), the collateral would revert to bank and government in the ratio 10:90; but the bank would again lose their brokerage fee as a punishment for arranging a ‘bad’ debt. (Or the collateral could revert wholly to the government with the bank being paid its lost capital minus its forfeited brokerage fee).

Note that a ‘bad’ debt with collateral is hardly a bad debt, for the lending bank can end with a more valuable real asset than the virtual debt they created in the first place. They lend money of which they own as little as 10% or even 3%, in exchange for the title-deeds of a real property worth 100%; so of course they are perfectly content to foreclose! This situation can lead to what is called ‘predatory lending’ whereby banks deliberately lend to someone who cannot easily pay back the loan, and where the object is to acquire the collateral; for example, the selling of ‘sub-prime mortgages’. This destructive practice is possible under the present laissez faire system; and indeed it is encouraged by the system, in so far as banks are encouraged to make profit. The cynical onlooker can shrug and say “We cannot stop stupid people signing stupid contacts”. But it is repugnant to the average citizen to see clever people taking money off simpler people in this way; or in any other of the manifold ways currently permitted, practiced, and encouraged by our corrosive financial system. The argument developed above would largely eliminate the problem of predatory lending.

How might this reform of the financial sector be implemented? It would be as simple as the Inland Revenue taxing all lending institution on their interest-income at a rate of not 20% nor 40% nor 50% but in proportion to their capitalization ratio; so at 97% if they are capitalized at 3%, and at 99% if they operate at 1% capitalization. This might seem a very high tax rate, but as argued above, the portion of the interest that I propose to tax in no way belongs to the banks, and letting them keep it seems even more anomalous than claiming it for the Inland Revenue.

References:
[1]  This idea stems from my post of 2011/11/ Debt-and-banks; it was also deployed (2014/8/12) on my IanWest2 blog: "Debt-Money, and the Banking system".
[2]  The Friend, 27 May & 3 June, 2011.
[3] http://www.freewebs.com/whosemoney/gripofdeathchapter1.htm.
[4] http://www.youtube.com/watch?v=wDHSUgA29L
[5]  https://www.theguardian.com/business/blog/2011/oct/12/financial-policy-committee-bankofenglandgovernor
[6]  Overend, Gurney and Co. crashed in 1866, City of Glasgow in 1878.