Full Reserve Banking in Plain English

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Full-Reserve Banking in Plain English | 2

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CONTENTS

INTRODUCTION 4

HOW MUCH MONEY SHOULD WE CREATE? 7

HOW SHOULD WE SPEND NEWLYCREATED MONEY? 10

HOW CAN WE PAY DOWN THE NATIONAL DEBT? 13

HOW DO WE STOP INFLATION? 17

WHAT ABOUT MY CURRENT ACCOUNT? 20

WHAT ABOUT MY SAVINGS ACCOUNT? 23

HOW SAFE WILL MY SAVINGS BE? 25

THE BANK OF ENGLAND AND THE PAYMENTS SYSTEM 28

HOW WOULD BANKS MAKE LOANS? 31

WILL THERE BE ENOUGH LENDING & CREDIT? 33

WHAT ABOUT OVERDRAFTS? 35

WOULD THIS MAKE BANKS MORE STABLE? 36

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INTRODUCTION

This proposal for reform of the banking system explains, in plain English,how we can prevent commercial banks from being able to create money,

and move this power to create money into the hands of a transparent andaccountable body. It builds on the work of Irving Fisher in the 1930s, andJames Robertson and Joseph Huber in 2000.

Removing the power to create money from the

banks would end the instability and boom-and-bust

cycles that are caused when banks create far too

much money in a short period of me. It would also

ensure that banks could be allowed to fail without

bailouts from taxpayers. It would ensure that newly-

created money is spent into the economy, so that

it can reduce the overall debt-burden of the public,

rather than being lent into existence as happens

currently.

The content in this paper was wrien in May 2010,

and has been occasionally updated since then. In

mid-2012 Posive Money will release, as a book, a

much more comprehensive guide to these reforms,

which will also address some of the common objec-

ons and misconcepons about the implicaons of

‘full-reserve’ banking.

A QUICK OVERVIEWFirstly, the rules governing banking are changed so

that banks can no longer create bank deposits (the

numbers in your bank account). Currently these

deposits are considered a liability of the bank to the

customer - aer the reform, they would be classied

as real money and only the Bank of England would

be able to increase the total quanty of them.

The Bank of England would then take over the

role of creang the new money that the economy

requires each year to run smoothly, in line with

inaon targets set by the government. In order to

meet these targets, the decision on how much or

lile money needs to be created would be taken

by the Monetary Policy Commiee. To maintain

internaonal credibility and avoid ‘economic elec-

oneering’, the MPC would be completely separate

and insulated from any kind of polical control or

inuence - in other words, the elected government

would not be able to specify the quanty of money

that should be created.

The Monetary Policy Commiee would decide how

much money needs to be created in order to meet

the inaon targets by analysing the economy as a

whole - not the spending needs of the government,

nor the needs of the banking sector. They would

use ‘big picture’ stascs to judge whether meeng

the inaon targets requires more or less money

injecng each month. They would also have access

to all the research resources that they require to

make an informed decision.

Upon making a decision to increase the money

supply, the MPC would authorise the Bank of

England’s Issue Department to create the new

money by increasing the balance of the govern-

ment’s ‘Central Government Account’. This

newly-created money would be non-repayable and

therefore debt-free.

The newly-created money would then be added to

tax revenue and distributed according to the elected

government’s manifesto and priories. This could

mean that the newly-created money is used to

increase spending, pay down the naonal debt, or

replace taxaon revenue in order to reduce taxes,

although the exact mix of these opons would

depend enrely on the elected government of the

day.

Consequently, the decision over how newly-created

money is inially spent would be made by the







government, but the government would have

no control or inuence over how much money is

created.

IMPLICATIONS FOR

CUSTOMERS OF BANKSTo the average person, banks will appear to operate

very much as they do now. However, the necessary

‘behind the scenes’ changes required to prevent

banks from creang money will mean that there

would need to be a few subtle changes to the terms

of service on current accounts and savings accounts:

IMPLICATIONS FOR CURRENTACCOUNTS (KNOWN ASTRANSACTION ACCOUNTSAFTER THE REFORM:Post-reform, banks will not be permied to lend the

money held in Transacon Accounts (the equivalent

of today’s current accounts). Instead, any money

held in these accounts will be held in ‘duciary

trust’ by the bank on behalf of the customers, and

in praccal terms will be considered to be held in a

‘Customers’ Funds Account’ at the Bank of England

- the equivalent of pung the money into a safe-

deposit box with the customer’s name wrien on it.

These Transacon Accounts would then be 100%

safe - since the money is technically held at the Bank

of England, the customers are guaranteed to be

repaid, even if their bank was to become insolvent.

This guarantee does not expose either the govern-

ment or the Bank of England to any nancial risk

whatsoever, and also means that the government’s

guarantee on deposits can be withdrawn, since

Transacon Accounts are inherently risk-free for the

customer.

The implicaons of this for the customer are as

follows:

• Money in their Transacon Account is 100%

secure and can never be ‘lost’

• Transacon Accounts will not pay

interest, because the banks are unable to lend

this money. As the rates of interest on current

accounts are rarely higher than 0.5%, this is not

a signicant loss.

• There will probably be monthly or annual fees

for the use of a Transacon Account, since the

bank needs to recoup the cost of providing

payment services. However, compeon for

market share between the banks will keep those

fees as low as possible, and many banks are

likely to ‘swallow’ the costs and waive Transac-

on Account fees completely in order to aract

customers who are then more likely to take out

mortgages and other products with the bank (aloss-leader approach to markeng). These fees

will in any case be outweighed by the signicant

nancial benets to every individual that arise

from prevenng the privased creaon of

money as debt.

IMPLICATIONS FOR SAVINGS

ACCOUNTS (KNOWN AS‘INVESTMENT ACCOUNTS’AFTER THE REFORMIn order to lend money aer the reform is imple-

mented, banks will need to nd customers who

are willing to give up access to their money for a

certain period of me. In pracce, this means that

the customer will need to invest their money for a

dened me period (1 month, 6 months, 2 years, forexample) or set a minimum noce period that must

be given before the money can be withdrawn (e.g. 7

days, 30 days, 60 days, 6 months).

Banks will then operate in the way that most people

think they currently do - by taking money from

savers and lending it to borrowers (rather than

creang new money (deposits) whenever they make

a loan, and walking a ghtrope between maximizingprot and becoming insolvent).







For customers of the bank, this means they will only

be able to earn a rate of return (interest) if they are

willing to give up access to their money for a certain

period of me.

Note that this policy completely eliminates the

risk of a bank run and gives the bank much more

stability, as it is able to plan its future outgoings up

to 12 months into the future (a much greater degree

of stability than they have right now).







HOW MUCH MONEY SHOULD WECREATE?

Wouldn’t ‘prinng’ new money just push up prices and make everything

more expensive? Only if we ‘print’ too much. Over the last 30 years,commercial banks have been creang new money so quickly that the moneysupply has grown by an average of 7.8% every year. Because almost all of thisnewly-created money was lent into the economy and was matched by thesame amount of debt, it laid the foundaon for the recent nancial crisis.

The reforms that we are proposing would make

it impossible for high-street banks to create new

money when they make loans. As a result, they

won’t be able to increase the money supply of the

naon every single year.

But that doesn’t necessarily mean that the economy

will run smoothly on a xed amount of money - we

may sll need to increase the amount of money

in the economy in line with rises in populaon,

producvity or other fundamental changes in the

economy.

There are also issues as we make the transion from

a debt-fuelled economy that requires new money to

avoid collapsing under the weight of the debt, to the

stable, low-debt economy that this reform would

create. Like a junkie coming o heroin, our economy

might need to be weaned o connual injecons of

new money over a period of me.

Consequently, once we have stopped moneycreaon by commercial banks, we need an alterna-

ve source of new money. The following secon

explains what this source of new money should be,

and how it will work.

WHO DECIDES HOW MUCHNEW MONEY SHOULD BE

CREATED?The last few decades show that we cannot trust

prot-seeking banks with the power to create

money. Their incenves stack up rmly on the

side of always lending more money, and therefore

always increasing the money supply, regardless of

the needs of the economy as a whole.

Elected policians are unlikely to do much beer.

The temptaon the government to increase the

money supply in order to pay for things like high

speed rail and university tuion fees is likely to be

great, which would result in money being created

without any reference to the needs of the wider

economy.

If the person or organisaon making the decisionto create more money also stands to benet

personally from the creaon of that money - as do

prot-seeking bankers and vote-seeking policians

- then decisions over the supply of money to the

economy will be taken on the basis of the benet to

the decision maker, rather than the benet to the

economy as whole.

So if we can’t trust prot-seeking bankers or vote-seeking policians, then we must nd a neutral,

independent body who have no misaligned incen-

ves and who do not benet personally from

increasing the money supply.

Under our proposals the Bank of England’s exisng

Monetary Policy Commiee will become respon-

sible for making decisions on how much new money

should be injected into the economy in each periodof me.

They will stop making decisions to raise or lower

the base interest rate and will instead make a







decision to increase or reduce the money supply.

They will likely take a 12-month or 2-year view of

the economy, and then smooth any increase in the

money supply over each month.

The MPC will connue to be polically independent

and neutral. This is very important, as it preventsharmful polical ‘nkering’ with the economy. It

is important that the MPC cannot be overruled

by policians, whose decisions will be swayed by

polical maers rather than the long-term health

of the economy. It is also important that the MPC is

sheltered from conicts of interest, and lobbyists for

the nancial sector.

The Monetary Policy Commiee will also sll besubject to all the rules regarding transparency of

its decisions, and the amount of the authorised

increase in the money supply will be made publicly

known.

Note that they will not be creang as much money

as the government needs to full its elecon

manifesto promises – the needs of the government

will not be considered. As discussed in the secon‘Guarding Against Inaon’, suggesons that this

reform would cause a ‘Zimbabwe situaon’ have no

basis in reality.

SO HOW MUCH SHOULD THEYCREATE?The Monetary Policy Commiee (MPC) would

authorise the creaon of as much new moneyas they calculate the economy (in other words,

companies and households) needs to funcon

healthily, and no more.

The Commiee will connue to base its decisions

on the basis of ‘inaon targeng’ - the policy of

trying to ensure that inaon stays within a small

range - such as between 1.5% and 2.5% per annum.

In other words, they should try to ensure that any

change in the money supply is neither inaonary

nor deaonary - neither too much nor too lile.

Note that for this to be eecve, the measure of

inaon used must be redesigned to take account

of asset price inaon (such as a housing price

bubble). It is pointless to aempt to make decisions

aecng the whole economy using a measure of

inaon that ignores inaon of 10% per annum in

house prices when housing is the most expensive

item in anyone’s ‘basket of goods’.

Under this requirement, if inaon starts to rise,

the MPC will need to stop creang new money

unl inaon has started to fall again. This makes it

impossible for the MPC to create a Zimbabwe-esque

inaonary spiral.

In absolute gures, the amount of money that

should be created each year will probably start ataround £100billion - less than the banks have been

creang for the last few years. Over me, as the

economy stabilises and the overall level of debt falls,

the amount of money that we can create each year

before inaon starts to rise will probably stabilise

at around £50billion a year.

THE MECHANICS OF CREATINGNEW MONEYWhen the Monetary Policy Commiee has autho-

rised the creaon of a specied amount of new

money, it will be created in the following way:

1. The government will hold an account, known

as the ‘Central Government Account’ with the

Bank of England.

2. The Bank of England’s Issue Department willsimply increase the balance of this account by

the amount authorised by the Monetary Policy

Commiee. They will not simultaneously reduce

the balance of any other account - by making

a credit without making a matching debit, they

are creang new money.

3. The government can then withdraw the money

from its Central Government Account and add

it to the pool of tax revenue, and then use it in

accordance with the principles discussed in the







secon ‘How Should We Spend Newly-Created

Money?’.

In contrast to prinng physical cash or coins - which

costs a few pence for every £1 created (According

to the Bank of England’s annual reports, they

spent £38million in 2010 prinng physical bank

notes), - a creaon of money electronically is

costless. To create £20bn or £200bn both requires

one authorised ocial with the right passwords

and a computer connected to the Bank of England’s

central accounts system. Of course, it would also

require witnesses and formalies to be observed,

but all in all, £20bn could be added to the economy

in a lile under 20 minutes, at the admin cost of just

a few hundred pounds.

AN IMPROVEMENT ON THEEXISTING SYSTEMIn the exisng monetary system, the total amount

of money (dened as ‘bank deposits’ - the numbers

in your bank account) is increased whenever a bank

makes a loan. Consequently, the money supply

increases as a result of the individual decisions of

thousands of loan ocers and mortgage advisors,

and the lending priories of bank directors. Each

of these individuals is movated by a bonus on

each mortgage or loan that is issued, and therefore

their only incenve is to issue as many loans and

mortgages as possible. They have absolutely no

concepon of how their acvies t into the wider

health of the economy. As revealed in the nancial

crisis that started in 2007, this tends to lead to

disaster.

Post-reform, the health of the whole economy will

be considered before a decision is made to increase

or decrease the money supply. While there are

always issues when decisions are made by small

commiees of ‘wise men’, we believe that it would

be hard for the Monetary Policy Commiee to do a

worse job of managing the money supply than the

banks have done to date. With a holisc view of the

economy, and an incenve to support the economy

rather than to maximise their own bonuses, this

should lead to a beer outcome overall.







HOW SHOULD WE SPEND NEWLYCREATED MONEY?

When the Monetary Policy Commiee authorises the creaon of a certain

amount of new money, the Bank of England’s Issue Department willadd that money to the government’s Central Government Account. Thegovernment is free to use this money however it chooses in order to achieveits democracally-mandated policy objecves. Therefore the government maychoose to:

a) reduce the overall tax burden

b) increase government spending

c) make direct payments to cizens (somemesreferred to as a ‘cizen’s dividend’)

d) pay down the naonal debt

The exact mix of the above will depend on the

priories and ideology of the government of the

day. Since the newly created money will simply be

added to tax revenue, there is no need for a special

process to decide how to spend it. If the public have

elected a government that promises to increasepublic spending, then the government can jus-

ably use the money for this purpose. Likewise, if

the public elected a government that promised to

reduce the overall tax take, then the government

can use the money to this end (by using this money

to cover exisng spending and reducing the overall

tax take).

We will now look at each of the opons above inmore detail.

REDUCTION OF THE OVERALLTAX BURDENRather than increasing government spending, the

elected government of the day could choose to

reduce the overall tax burden.

The tax burden could be reduced in one of three

ways (or a combinaon of all):

1) through maintaining the current tax regime but

redistribung the newly-created money back to the

public via tax rebates (payments) aer the year’s

taxes have been received

2) by actually reducing the rates of tax charged on

income, VAT, corporaon tax, Naonal Insurance

etc, therefore collecng less money from taxaon.

They would then make up the shorall with the

newly-created money.

3) by completely cancelling parcular taxes – VAT

(the UK’s sales tax) would be a strong contender for

eliminaon, being both hugely regressive (hurng

the poor more than the rich) and a distoron to

markets.

Tax reform is a huge issue, and one that is outside of

our work, but any government using the proceeds of

this reform to reduce taxaon should aim to reduce

or eliminate some of the worst market-distorng or

most regressive taxes.

INCREASING GOVERNMENTSPENDINGBy using the newly-created money to increase

government spending, the government can increase

the provision or quality of public services such as

educaon, health care or public transport, without

increasing the tax burden on the public. Decisions

on exactly how the newly-created money is spent

would fall to the democracally elected governmentof the day.

Although the money has not been raised via

taxaon and therefore doesn’t ‘cost’ anything at this







point, it sll has a massive ‘opportunity cost’ – if the

government chooses to use the money to build a

Millennium Dome, the same money can’t be spent

to build 5 large hospitals or a couple of hundred

schools.

Consequently the government has a public duty toensure that the newly-created money is spent on

the projects that will bring the greatest benet to

society as a whole, and to ensure that the money

is not wasted. In reality, the same issues apply to

newly created money as apply to all tax revenue – is

it well spent, and do the public get value for money?

DIRECT PAYMENTS TOCITIZENSOne alternave to both increasing public spending

and reducing taxes is to make direct payments to

cizens. If the amount of newly-created money in

a parcular year was £100billion, a direct payment

of £2,222 could be made to every eligible voter

(regardless of income). £100bn may sound like a lot,

but it is less than the banks have created in every

year since 2004.

There are some signicant advantages to this – the

most democrac way of spending newly-created

money is to give every single cizen power over how

to spend their share. It would also reduce the risk of

the newly-created money being spent ineciently

by central government.

PAYING DOWN THE NATIONALDEBTWe believe that it is in the public interest for the

‘naonal’ (i.e. government) debt, to be phased out,

or at least reduced to within a small percentage of

the naon’s GDP. Over me, the government would

likely use a proporon of the newly created money

to gradually pay o the debt.

These provisions are discussed more comprehen-

sively in the ‘How Do We Pay Down the Naonal

Debt?‘.

OUR RECOMMENDATIONSThe current staggering level of household and

corporate debt is a consequence of the debt-based

monetary system that we have had in place for the

last few hundred years. Once we stop issuing all new

money as debt, the rst priority should be to reduceour overall debt burden (at a household, corporate

and government level) back to a ‘healthy’, natural

level.

Consequently, our personal recommendaon is that

in the 5-8 years following the implementaon of

the reform, the newly-created money should not

be used to increase government spending. Instead,

government spending should remain at, avoidingthe impending cuts to public services but with no

major new spending projects. (Of course the public

sector should connue to try to reduce waste and

provide maximum value for money).

Any newly-created money should then be used as

much as possible to reduce the overall tax burden,

ideally by 20-25%, by actually reducing tax rates and

allowing the public to keep and spend more of their

income. This will leave people with around 20%

more disposable income, which – considering the

highly indebted state of the vast majority of house-

holds right now – will most likely be used to pay o

debts, credit cards, personal loans and mortgages,

in the same way that many households are currently

taking advantage of low interest rates to over-pay

on their mortgages.

In short, we would reduce the tax burden to allow

cizens to pay down their own debts. At the same

me, if part of the tax reducon falls on employer’s

Naonal Insurance contribuons, or on VAT, then

companies will themselves be able to reduce their

debts, which should make it easier for them to

expand and increase employment.

It could be made explicit that this would be a 5-8

year paral ‘tax holiday’, with taxes to rise at the

end of it. It is likely that as the economy stabilises

and the debt burden falls, the amount of money

that the Monetary Policy Commiee decided to







create in any year would fall, making it necessary

for the government to collect more revenue via

taxaon.

There is a praccal consideraon involved in this

suggeson too. In the current environment, it is

hard to believe that any UK government will havethe capacity to successfully engage in big infrastruc-

ture projects over the next few years, whilst simul-

taneously baling the aer-shocks of the nancial

crisis and also implemenng this reform. If they

tried to, it is likely that much of the money would

be wasted. As a result, the smulus from using the

newly-created money to increase spending would

come later, and be less eecve, than a direct

smulus from reducing taxes. When the economy

has stabilised, the overall level of debt has fallen

signicantly, and the banking system has adapted

to this new nancial regime – in other words, when

things are less ‘hecc’ – the government could then

look at using the newly-created money for public

infrastructure projects.







HOW CAN WE PAY DOWN THENATIONAL DEBT?

HOW WILL THIS REFORMALLOW US TO PAY OFF THENATIONAL DEBT?Our proposed reform allows the state to take back

the exclusive power to create new money and to

use any newly-created money to increase public

spending, reduce taxes. The government may

choose to use some of the newly-created money to

pay down the naonal debt. This would not simplybe prinng money to pay o the debt (which would

be considered to be an underhand way of defaulng

or reneging on the debt), as the amount of money

created will be restricted to be just enough to keep

inaon low and steady. By giving the govern-

ment an addional source of revenue (the newly-

created money coming from the Monetary Policy

Commiee), there is more chance that they will be

able to use some of their revenue to make down-

payments on the naonal debt.

At the same me, because our proposed reforms

would reduce instability in the economy (think of

the credit/debt-fuelled boom-bust cycle), there

would be fewer and less severe recessions, which

should lead to lower unemployment. This would

mean that the government will not need to spend

so much on unemployment benets, freeing upmore revenue for public services or to reduce the

naonal debt.

HOW DID THE DEBT GROW INTHE FIRST PLACE?The naonal debt is the total amount of money

that governments have borrowed over the last

few centuries. However, unlike a debt like yourmortgage, where your payments reduce the total

amount of debt every year, the government typically

does not pay o enough to reduce the total naonal

debt. Instead they just borrow the money they needto pay the interest on the debt, and typically borrow

a lile bit more for addional spending. Since 2002,

the government has simply borrowed the money

it needed to pay the interest on the naonal debt.

This is like paying o one credit card with another.

The naonal debt tends to shoot up during wars -

such as World War I (from £650m in 1914 to £7.4bn

in 1919) and World War II (from £7.1bn in (1939) to£24.7bn (1949)). It also shot up signicantly in 2008

onwards, for two main reasons:

1. The government borrowed £179.8bn to bail out

RBS, Lloyd’s and Northern Rock.

2. The recession triggered by the banking crisis

led to redundancies and bankruptcies, along

with less spending in the economy. This added

up to mean that less tax was being paid, so thegovernment’s revenue (income) fell.

3. At the same me, with more people redundant,

there were more people claiming unemploy-

ment benet, so government expenditures went

up

WHY THE DEBT WILL ONLY GO

UP IF WE KEEP THE CURRENTSYSTEMThe debt is currently higher (in absolute terms) than

it’s ever been before. While the government talks

about reducing the decit, the reality is that the

total naonal debt will keep growing. It is almost

impossible for the government to reduce the debt,

meaning that even if they stop the debt growing,

taxpayers will connue paying £120 million a day in

interest on the naonal debt for eternity.

To understand why, look at what would have to

happen to actually start paying down the debt:







1. Firstly, the government needs to start paying

the annual interest on the naonal debt each

year out of tax revenue, rather than simply

borrowing more money to pay the interest. As

the interest currently stands at £43bn this

year this means that in order to stop the

naonal debt growing, the government must

raise another £43bn this year in taxes, which

is equivalent to raising VAT (sales tax) to 30%

(from its current level of 20%).

2. However, in the ve years before the crisis,

excluding the eect of the banking crisis, the

government spent an average of 10.6% more

than it took in in taxes every single year. So even

aer the £43bn interest on the naonal debtis paid, to run a ‘balanced budget’ right now,

it would need to raise an extra £22bn in taxes,

or cut public services by £22bn - equivalent to

shung down a h of the NHS.

3. So far in this example, the government has

raised VAT by 30% and cut £22bn of public

services and has sll only managed to stop the

debt growing any further. In order to actually

reduce the debt, it needs to raise taxes even

further, or reduce public spending even more.

If we decided that we want to pay o £30bn of

naonal debt every single year, then we’d need

to raise another extra £30bn in taxes: equivalent

to doubling council tax. Even at this level, it

would take 30 years to pay down the naonal

debt.

In summary, simply to stop the debt growing,government would need to raise taxes so high that

it would be thrown out of oce at the next elecon.

As long as we keep the current banking system, the

naonal debt will never go down and tax money

that could have been used to fund public services

will be used to pay interest on the naonal debt.

WHY WE HAVE TO PAY THEDEBT OFF SLOWLYIf we paid o the naonal debt too quickly it could

destabilise nancial markets, which would most

likely reduce the value of pensions and therefore

harm pensioners.

REASON 1: Paying it o too quickly could harm

pensioners…

The bulk of government debt is not owed to the

banks. Around 40% is owned by foreign investors.

The big concern for us is the 40% of government

debt that is owed to pension funds and insurance

companies.

To see why it is crucial that we do not pay o the

debt too quickly, you need to step into the shoes of

a pension fund manager.

Pension funds like to buy government bonds (i.e.

Government debt) because they know these bonds

will always be repaid (as government can always tax

people to get more money). Bonds are therefore

considered as safe as cash, with the added bonus

that they pay interest. Consequently, pension funds,

especially those with a large number of customers

near rerement age, will use government bonds

to make up a large percentage of their porolios –

aer all, bonds are much safer than stocks and the

pension fund will not want stock market volality to

wipe out its (and its customers) assets.

The fund manager needs to ensure that the invest-ment porolio has a range of low-risk, steady return

investments, and higher-risk, higher-return invest-

ments. The lowest-risk investment that sll oers a

return (i.e. interest) is government bonds, so these

make up the ‘safe’ part of the porolio.

When we “pay o” part of the naonal debt, we are

actually reducing the quanty of government bonds

in the market. If we reduce the quanty of bonds inthe market too quickly, we force these pension fund

managers to shi their investments from bonds to







other investments, such as corporate bonds (riskier)

and the stock market (much riskier).

The eect of over £1trillion (the naonal debt)

shiing from the bond market to the stock market

and corporate bond market would be like pping

a bath of water into a small pond – creang hugewaves in the market. Firstly, prices of stocks would

start to rise, probably creang a bubble in the stock

market. However, as people started to fear that

the bubble was geng too big, they would start to

‘pull out’ of the market by selling shares. This may

trigger another stock market crash as pension funds

rapidly try to move their money into cash. The result

would be, once again, a decimaon of the value of

pensions, which would harm pensioners and those

in middle-age most of all.

To avoid this, we need to gradually remove bonds

from circulaon over a period of me. Fund

managers would be well aware that government

bonds were being ‘phased out’, but would have

around ten to een years in which they could

gradually shi their investments away from the

bond market and into corporate bonds and the

stock market. This would avoid causing any bubbles

in the market, avoid a ood of ‘cheap’ money into

the corporate bond market (which would most likely

lead to some pointless and badly chosen corporate

takeovers if done quickly), and safeguard the value

of pensions.

REASON 2: The Naonal Debt is ‘Cheap’ While

Personal Debt is ‘Expensive’

The overall interest rate on the naonal debt works

out at around 4.3% per annum (from 2000 to 2010).

It is realively low because government debt is

assumed to be risk free, so pension funds and other

buyers of government debt are willing to accept low

returns in return for a near-zero risk of default.

In contrast, the interest rate for household debt

ranges between 6% and above for mortgages, right

up to ~17% on credit cards and up to ~29% on store

cards. Overall, the average interest rate is undoubt-

edly higher for households than it is for the govern-

ment.

Let’s assume that the interest rate for all household

debt averages out at 8% per annum. Total

household debt is signicantly greater than total

government debt (£1,464billion compared toslightly over £1 trillion as of March 2012).

A basic principle in debt management is to pay o

the most expensive debt rst. If we acknowledge

that naonal debt is really the debt of the UK’s

taxpayers (amounng to approximately £20,555

per eligible voter), then the naonal debt is the

cheapest debt and should be paid o later than

household debt. For this reason, it is beer to divertmore money back to the public (via tax cuts, public

spending or direct payments to cizens) than to

aggressively pay down the naonal debt. The money

directed to the public will then allow them to pay

down their more expensive debts.

That doesn’t mean we shouldn’t make inroads

into paying down the naonal debt. As a general

principal, we would recommend that the naonaldebt should be paid down by around £30billion per

annum, using government revenue from taxaon

and/or the year’s newly-created money.

However, using all the newly created money to pay

down the naonal debt as quickly as possible would

be like taking £925+bn from the public in order to

pay o debt at 4.3% interest, when they are sll

paying an average of 8% on their own debts of£1,464 billion.

ONE BENEFICIAL SIDEEFFECTOF PAYING OFF THE NATIONALDEBTBesides saving up to £200 million per day on interest

costs (if naonal debt rises as expected up to 2014),

paying o the naonal debt has other benets forthe economy.

By phasing out government bonds as an investment

opon, we force pension funds and other investors







to look for alternave investment opons. The next

safest opon aer government debt is the debt of

the ‘blue chip’, FTSE 100 corporaons. By invesng

in bonds or even new share issues from these

companies, these companies should be able to pay

o more expensive debt, which in theory should

lead to lower costs for customers, or more jobs

being created, or more prot being declared and

therefore more tax being paid.

At the same me, when large corporaons can

borrow cheaply from pension funds looking for a

safe haven for their money, they will have no need

to borrow from banks. Consequently the banks

will themselves need to look for other investment

opportunies. They will need to shi their focus to

invesng in small and medium sized businesses.

The end result of phasing out government bonds is

that small and medium businesses will start to ndit much easier to get investment and funding from

banks, which should be benecial for the economy.

By clearing the naonal debt, we channel more

credit / investment to businesses rather than to

government.







HOW DO WE STOP INFLATION?

When we suggest that the state (or the Bank of

England) should be allowed to create new money,

some people automacally react with the sugges-

on that this would cause inaon. Indeed, the

most common misguided cricism of the type of

reform that we are proposing is that it will cause

signicant inaon, as an irresponsible government

prints as much money as it requires for its own

needs.

There is absolutely no risk of this happening in

the environment created by this reform. For one

thing, decisions on changes in the money supply

will be made not by vote-seeking policians but

by an independent body (the Monetary Policy

Commiee). Policians will have no inuence what-

soever in the amount of money that will be created.

The Monetary Policy Commiee will be instructed

to consider the needs of the economy as a whole in

deciding how much new money should be injected

into the economy. The needs or desires of the

elected government do not factor in this decision

at all. In fact, the members of the MPC should

be expressly forbidden from considering polical

maers or the intenons of the current government

in making the decision.

HOW WELL HAS THE CURRENT

SYSTEM PREVENTEDINFLATION?Over the last 30 years, the banks have been inang

the money supply by an average of 7.8% per year,

through creang endless amounts of new debt. This

has led to inaon over that me of hundreds of

percent, especially in the housing market.

In fact, between 1950 and 2010, total general

inaon was 2,554%, while house price inaon has

been much higher at 8,613%!

From this we know that annual increase in the

money supply of 7-10% will cause inaon, so we

already know our upper-limit on how much new

money should be created. As long as the MPC

keeps the annual increase under 7% per annum

(the average growth rate since 1980) then inaon

should be less than it has been under the old

system.

In other words, inaon is signicantly less likely

under the reformed system than under the exisng

system.

FURTHER SAFEGUARDSAGAINST INFLATIONIf further safeguards are needed to reassure people

that hyper-inaon is not a risk, the following safe-

guards could be put in place (but note that they are

not included in the reform proposal at this stage):

• The absolute amount of the increase in any one

month must be no more than x% greater than

the previous month. This prevents any wild uc-

tuaons in the amount of money created from

month to month, and depending on the level of

‘x’, ensures that it would take decades before

they could create sucient levels of money to

cause hyperinaon.

• The total annual increase in the money supplyshould not exceed x% of the current total

money supply. If you doubled the money supply

in the space of one year, you would cause asset

price bubbles and very high inaon. If you

cut the money supply by 50%, in one year, you

would cause an economic collapse. Common

sense suggests that the ‘safe’ rate of growth in

the money supply will be somewhere close to

0%, and almost certainly in the single digits.

• At no point must the annual increase in the

money supply exceed the average of the last

30 years in which banks issued the money







supply. This would provide a limit of around

7.8% growth in the money supply per annum.

It seems logical that if creang 7.8% per annum

leads to a 6-fold increase in housing prices, and

the worst nancial crisis since the 1930s, then

staying below this limit should have a much less

destrucve eect.

THE DIFFERENCE BETWEENBANKCREATED DEBTMONEY AND STATECREATED‘POSITIVE’ MONEYA 10% rate of growth in money supply is a very

dierent thing when that addional money comes

from the state, rather than from commercial banks.

When commercial banks increase the money supply,

they do so by creang an equivalent amount of

debt. The new money acts as a smulus to the

economy, but the new debt acts as an immediate

drag on the economy. (If you accept and spend a

personal loan in August, you will start repayments

in September. In September you are immediately

poorer than you were before you took the loan

(even though you may have more ‘stu’) as your

disposable income is reduced by the amount of the

repayments. You spend less in the shops and the

real economy loses your regular spending).

Allowing banks to create money is therefore akin

to pressing both the accelerator and the brake at

the same me – and the results are equally painful

to watch! In contrast, the debt-free injecon ofmoney from the Bank of England is free from the

immediate sedave of an equivalent amount of

debt. This is akin to pressing the accelerator with

your foot clear o the brake. Which system would

you expect to have the greatest smulang eect

on the economy?

For that reason, we can assume that a 10% increase

in the money supply, when created as debt-freemoney by the Bank of England, would be far more

of a smulus to the economy than the same rate of

increase when caused by commercial banks issuing

debt. Whether we should therefore aim for 5%

instead (to avoid any risk of inaon) or stay at 10%

(to pull ourselves out of this recession with a quick

smulus) needs further analysis.

In short, however, inaon is much less of a threat

under the reformed system, whereby the statecreates all new money, than under the exisng

system (whereby new money is created as debt by

private commercial banks).

NOTE: THE MEASURE OFINFLATION MUST INCLUDEHOUSE PRICES

For inaon to be eecvely prevented, it isessenal that the measure of inaon used by the

Monetary Policy Commiee includes house prices.

For that reason, the Consumer Price Index (CPI)

currently used by the government is completely

inadequate. It is disingenuous to claim that inaon

is around 2.5% per annum and that the Bank of

England has successfully ‘managed’ inaon when

the cost of housing – which makes up the bulk ofpeople’s spending – is increasing at over 10% per

annum. Consequently, for the Monetary Policy

Commiee to be able to make good decisions about

the money supply, it must use a ‘basket of goods’

that really represents how ordinary people spend

their money, including housing costs.

One of the arguments for excluding housing cost

from the exisng Consumer Price Index is that,since mortgage costs are determined by the current

interest rate, under the current regime the MPC

may increase the interest rate to limit inaon, but

then see the CPI rise due to the eect of higher

interest rates on mortgage costs. This argument is

no longer relevant, as under this reform, the MPC

will cease to make a decision on the base interest

rate, and interest rates will be set by markets.

The actual measure of inaon that will be used

aer the reform is very important and requires

further consideraon.







WHAT ABOUT MY CURRENTACCOUNT?

Your ‘current account’ will be replaced by a Transac-

on Account, which will provide most of the same

services, but will be 100% safe and secure.

Present-day ‘current’ accounts, are generally used

for payment services (cheques, debit cards, cash

machines, electronic fund transfers), and receiving

money (such as a monthly salary). These current

accounts will be replaced by ‘Transacon Accounts’.

To the customer, a transacon account will appearto be almost exactly the same as a present-day

current account, and members of the public will

probably connue to call them ‘current’ accounts.

However, to dierenate between the pre- and

post-reform situaons, we’ll be using the technical

term Transacon Accounts.

WHAT IS STILL THE SAME1. Transacon Accounts will sll provide cheques,

debit cards, cash machines, electronic fund

transfers etc.

Salaries will sll be paid into Transacon

Accounts.

2. Payments between individuals and businesses

will sll be made from one Transacon Account

to another.

3. Customers will sll have instant access to money

in the Transacon Accounts.

4. These accounts may sll oer overdras. (The

provision of overdras is a key, but complex

part of the reform, which is dealt with in a later

chapter).

WHAT IS DIFFERENT1. A bank will no longer be able to use the money

in Transacon Accounts for making loans or

funding its own investments.

2. These accounts will all be held ‘o the balance

sheet’, and not be considered part of the liabili-

es of the bank.

3. The money paid into Transacon Accounts will

be held in full within an account at the Bank of

England. In other words, the money is ‘in the

bank’ at all mes, and could be repaid in full (to

all customers) at any me, without having any

impact on the bank’s overall nancial health.

It is technically impossible for the money to belost, and a bankrupt bank would sll be able to

repay all its Transacon Account holders.

4. Because the banks are unable to use the funds

placed in these accounts to invest or lend, they

will be unable to earn a return on these funds.

As they will sll incur the costs of providing

payment services (cheque books, ATM cards,

cash handling etc), they will almost certainly

need to implement account charges to cover

these costs.

BENEFITS OF THE CHANGESThe government and taxpayer would have abso-

lutely no exposure to problems with individual

banks.

It would now be impossible to suer a ‘run on the

bank’. Even if all Transacon Account customers of

one bank were to withdraw their money on a single

day, the bank would be able to pay with no impact

on its nancial health and no need for emergency

assistance from the Bank of England or government.

We would never see another ‘Northern Rock’ (or

Washington Mutual in the USA).

Money placed into a Transacon Account would

be 100% safe. There would be no ceiling limit on

the amount that is safe, and the ‘guarantee’ has no







real or potenal cost for the taxpayer (because the

money can not be lost).

Because of the way the clearing system under this

reform would work (see ‘The Payments System’),

the me for payments to show up in the recipi-

ent’s account could be as lile as 30 seconds (ascompared to 2 hours to 4 days as at the moment).

This would provide a beer service to both individ-

uals and companies and would make the economy

more ecient.

If a bank collapsed, it would only be an administra-

ve procedure to move the Transacon Accounts

over to other banks, and no money would ever be at

risk.

COSTS OF THE CHANGES ACCOUNT FEESAs menoned above, because the banks can not use

these funds any more to make loans, they will want

to recoup the costs of providing payment services

through charging account fees. In addion they will

no longer wish to pay interest on balances in theseaccounts.

While no-one likes to start paying for something

that was previously free (although it should be

noted that many banks are already introducing fees

on current accounts), the fee that banks charge

would be more than outweighed by the savings of

between £700 and £6,750 that the average working

adult could expect to make as a result of the reform(these savings are discussed later).

How much would the fees actually be? The

following is a realisc breakdown of the current

yearly costs of providing a current account, provided

by a consultancy rm that has set up new banks

(Cut Loose):

Checkbook £10 (per book)

Debit Card £2

Branch £5

Call Centre £8

Sta £15 Banking engine £4

CDD £8 (one me cost at account

opening for Customer Due Diligence)

MC/Visa £2

Link £2

BACS etc. £5

Hosng £2

Total £59

Source: Cut Loose - Making Banks Happen

This equates to a cost of around £5 per month, plus

a lile extra for prot.

Note that even today, these costs are incurred by

the bank, and recouped from customers via £30

unauthorised overdra charges and other unex-

pected charges.

It is also worth remembering that the interest ‘paid’

on current accounts is oen as low as 0.1% - in

other words, nothing. Someone who had an account

balance of £1000 for a whole year would only earn

£1 in interest at the end of the year. The loss of this

interest is therefore insignicant. In the current

system, many accounts pay no interest at all.

In addion, the post-reform payments system maybe signicantly cheaper to run than the present-day

clearing system, as there would be no need for a

complex ‘clearing’ system (transacons would be

instant and nal). This means that the only signi-

cant costs would be creang the physical ATM cards

and cheque books, oering customer service, and

maintaining the bank’s main computer systems.

In pracce, there will be signicant market pressureto keep account fees as low as possible.







As the next chapter shows, to be able to make loans,

post-reform banks will need to aract customers

who wish to make investments with them. One

way to aract customers and gain market share is

to run a ‘loss-leader’ campaign with their Transac-

on Accounts. They would do this for the same

reason that they currently oer free overdras to

students - someone who banks with you for normal

payment services is far more likely than the average

consumer to save with you and come to you rst for

overdras, credit cards and mortgages.

As a result, compeon between banks for market

share means that the costs of payment services may

be ‘absorbed’ by the banks as a cost of acquiring

market share, and recouped from their investmentearnings. In short, the cost passed on to customers

is likely to be minimal.







WHAT ABOUT MY SAVINGSACCOUNT?

‘INVESTMENT ACCOUNTS’REPLACE SAVINGS ACCOUNTSYour savings account would be replaced by an

‘Investment Account’. We call them Investment

Accounts, for the sake of clarity and because it more

accurately describes the purpose of these accounts

- as a risk-bearing investment rather than as a ‘safe’

place to ‘save’ your money.

Aer the reform, the bank would need to aract

the funds that it wants to use for any investment

purpose (whether it is for loans, credit cards,

mortgages, long term invesng in stocks or short-

term proprietary trading). These funds would

be provided by customers, via their Investment

Accounts.

WHAT IS STILL THE SAME:1. Investment accounts will sll be used by

customers who wish to ‘put money aside’ or

earn interest on their spare money (‘savings’).

2. These accounts would sll pay varying rates of

interest.

3. They would sll be provided by normal ‘high-

street’ banks.

WHAT IS DIFFERENT:1. At the point of investment, customers lose

access to their money for a pre-agreed period

of me. There would no longer be any form of

‘Instant Access Savings Accounts’. This would be

a legal requirement .

2. Customers would agree to either a ‘maturity

date’ or a ‘noce period’ that would apply tothe account. The maturity date is a specic date

on which the customer wishes to be repaidthe full amount of the investment, plus any

interest/bonuses. The noce period refers to

an agreed number of days or weeks noce

that the customer will give to the bank before

demanding repayment.

3. The Investment Account will never actually

hold any money. Any money ‘placed in’ an

Investment Account by a customer will actually

be immediately transferred to a central ‘Invest-

ment Pool’ held by the bank, and then be used

for making various investments. At this point,

the money will belong to the bank, rather than

the Investment Account holder, and the bank

will note that it owes the Investment Account

holder the amount of money that they invested.

4. At the point of opening an account, the bank

should be required to inform the customer ofthe intended uses for the money that will be

invested, along with the expected risk level.

The broad categories of investment, and a

consumer-friendly rang system for the risk of

those investments, will be set by the authori-

es.

5. The risk of the investment now stays with the

bank and the investor, rather than falling on a

third party (i.e. the taxpayer). In some accounts,

the risk will fall enrely upon the bank, while

on others a large proporon of the risk will fall

on the investor. Any investor opening an Invest-

ment Account will be fully aware of the risks at

the me of the investment, and those who do

not wish to take any risk will be able to opt for

an (almost) no-risk (and consequently low-

return) account. See the later secon on Invest-ment Account guarantees for further details.







KEY ADVANTAGES OF THECHANGES:1. Banks will be beer able to manage their ‘cash

ow’. Since all the investment funds that will

be used by the bank come from Investment

Accounts, and every Investment Account has adened repayment date (or a maturity date),

the amounts that the bank will need to repay

on any one day will be stascally far more

predictable than under the current system.

For Investment Accounts with Maturity Dates,

they will know the exact amount that must be

repaid on any parcular date - they will also

know, from experience, what percentage of

customers with maturing accounts will ask for

the investment to be rolled over for another

period (in other words, what percentage of

accounts will not need to be repaid on the

maturity date). With regards to minimum noce

periods, they will know the stascal likelihood

of an account being redeemed within the next

‘x’ days, and so be able to plan the payments

that will come due on any parcular day for

up to 6 months into the future. In addion,

because they have, on their loans-made side, a

collecon of contracts with specied monthly

repayment dates and amount, they know

almost exactly how much money they will

receive on any parcular date up to 24 months

in the future (allowing for a small degree of

variance due to defaults and late payments).

Consequently the banks’ computer systemswill easily be able to forecast cash ow (money

coming in and out) over the next 6 months or

so, with a much greater degree of certainty than

under the present-day banking system, and

idenfy any future shoralls that need to be

prepared for (for example, by scaling back loan

making acvity and building up a buer). At the

same me, it will be able to idenfy periods

when the money coming in will be greater

than the repayments due to customers, and

therefore increase loan making acvity to soak

up the surplus.

2. The government and taxpayers will be neither

implicitly nor explicitly responsible for losses of

banks. Because the customer making an invest-

ment has explicitly agreed to accept the risks ofthe investment, there is no need (nor a jus-

able case) for the government to guarantee any

investments. If a bank makes bad decisions and

loses money, the customers who provided the

money for those investments will lose money.

See further discussion of this under ‘Risks to

Consumers’ below.

3. By retaining the strong similaries with present-

day ‘savings accounts’, we minimise confusion

for the public. There are already many savings

accounts with minimum noce periods or xed

term savings accounts of up to 5 years, so it

is not a big leap to apply this to every type of

savings account. We consider this to be easier

for members of the public to understand than

asking them to invest in mutual funds, or asking

them to buy some form of investment cer-cate or investment bond from the bank.







HOW SAFE WILL MY SAVINGS BE?

Under our reform proposals you have two opons:

Keep your money in a Transacon Account and

ensure that it is 100% secure (regardless of how

much money you keep in that account, there will be

no cap on the amount that is guaranteed)

Put your money into an Investment Account and

accept some risk in exchange for a return (i.e.

interest)

PROBLEMS WITH THE

CURRENT SYSTEMUnder the exisng system, if a bank fails due to

bad investments, a third party (the taxpayer) will

reimburse the savers who have money invested with

that bank. (This scheme is called deposit insurance,

or the ‘Financial Services Compensaon Scheme’

in the UK. In the USA a similar scheme is run by the

FDIC - Federal Deposit Insurance Corporaon).

This creates a few serious aws or ‘distorons’ in

the economic system:

1. It means that the banks can gamble with their

customers’ money in the knowledge that the

government will step in to cover any serious

losses. This creates ‘moral hazard’ and encour-

ages the banks to take greater risks in their

investments.

2. It means that one group stands to benet if

the bank is successful in its investments, while

another group (taxpayers) stands to lose if the

bank is unsuccessful. The government-backed

guarantee on funds in any UK bank accounts

means that bank account customers do not

need to pay any aenon to the acvies of

the bank that they choose to invest with. If

customers bear at least some of the risk of

the investment, it should encourage them to

be more vocal in how the banks invests their

customers’ money - maybe expressing concern

that large sums of money go in to risky propri-

etary trading, or requesng accounts where the

money is ring-fenced for certain types of invest-

ment.

Our proposal contains a few simple rules that

collecvely ‘x’ these fundamental problems in the

current design of the banking system. Praccally, it

works as follows:

1. An instuon has the opon of oering Invest-

ment Account holders a guarantee that they

will be repaid a minimum percentage of theiroriginal investment. For example, the bank

may say that a parcular Investment Account

product guarantees to repay the investor at

least 100%, or 80%, or 60%, of the amount

originally invested.

2. The instuon may also oer a guarantee on

the rate of interest that will be paid on the

Investment Account product, for example,

guaranteeing to pay 2%, 4% or 5% interest.

A WORKED EXAMPLE:Let’s look at a worked example. Imagine that a

bank wants to aract funds to fund conservave

housing market loans to middle-income families.

It charges an interest rate of 8% on the mortgages,

and it knows that only a ny percentage of the loans

that it makes to these middle-income families willactually default. Consequently, allowing for defaults,

the normal case rate-of-return will probably be

around 7.8% overall (over all the funds invested in

this type of mortgage), and in the very worst case

scenario, with a high rate of defaults, the rate of

return might drop to 2% (with the losses of the

defaults being canceled out by the interest paid by

those who don’t default).

Because the bank knows that, in the very worst case

scenario it is sll likely to make a return of 2%, then

it knows that invesng in this market is eecvely







‘risk free’, in that it is highly unlikely to lose more

than the bank originally invests.

Consequently, in order to aract more funds into

its Investment Accounts in order to fund more

lending in this parcular market (i.e. mortgages for

middle-income families), it may oer to guaranteethe original sum invested, and guarantee a rate of

return of 2%. This makes this a ‘risk-free’ investment

for the Investment Account holders, and provides

a good investment vehicle for savers/investors who

don’t want to take much risk and don’t need a very

high return.

In this situaon, the bank holds all the risk of the

investment. If the investments were made badly andthe bank actually lost 20% of everything it invested,

it would sll need to repay the enre original sum to

each Investment Account holders, plus 2% interest.

It would then need to cover its losses with its own

prots - in other words, bad investments by the

banks would wipe out their prots for the year (or

the next few years, if they really miscalculated their

investments).

Let’s look at another scenario. Imagine that the

bank wants to raise funds for invesng in a risky,

emerging market. The possible return here is much

higher, but the risk of loss is much greater too. The

bank wants to limit its own risk by sharing some of

the risk with customers. The potenal interest rate

that it will oer if its investments are successful is

8%. However, if it is unsuccessful, and the market

turns out to be a bubble about to burst, it could endup losing up to 50% of the funds invested.

In this case, the bank may opt to oer no guarantee

on the rate of return, and to oer a guarantee of

60% of the principal invested. This would aract

funds but would force the investors to share the risk

with the bank. If the investments failed badly, the

investors would lose 40% of the principal, and the

bank would need to make up the other 10% of thelosses from its own prots.

Some of us may read the gures above and say that

it is not ‘fair’ that the bank only risks 10% while the

investors risk 40% of their investment. However, in

every case, each investor would have been made

aware of the guarantees, and therefore made their

own decision to invest in a parcular Investment

Account, knowing the risk to them and the potenal

upside.

These two ‘guarantees’ set up the condions in

which compeon between the banks will lead

them to oer a full range of products for every type

of investor. Investors who want a high rate of return

will need to take on some of the risk themselves,

and investors who are happy with a low rate of

return will be able to invest eecvely risk-free.

NO GOVERNMENTGUARANTEE ON INVESTMENTACCOUNTSThe Treasury and government do not back the guar-

antees made by the banks. If a bank went bankrupt,

Investment Account holders would become

creditors of the bank and would have to wait for

normal liquidaon procedures to take place to see

if they will get back part of their investment. While

this is likely to be unpopular with savers who have,

to date, been able to save without taking any risk at

all (thanks to the taxpayer-funded guarantee) there

is no morally or economically jusable reason

why savers/investors should have their investments

eecvely insured by UK taxpayers.

THE FSA OR BANK OFENGLAND MAY FORBIDSPECIFIC GUARANTEESWe have allowed whichever instuon that is

charged with supervising the UK banking system

to forbid an instuon from oering a parcular

rate of return on a parcular Investment Accountproduct. This provision is necessary to prevent

banks from oering unrealisc guarantees.







We know from history that professionals in the

nancial sector are not very good at idenfying

bubbles while they are in one. When a bubble

takes o in say, hotel construcon, a bank has an

incenve to oer a beer guarantee than all its

competors in a parcular Investment Account

product in order to aract the maximum amount of

funds for investment in the bubble. The guarantee

they oer may be one that is based on the ‘best

case scenario’.

If the bank tries to oer an Investment Account

product with a guaranteed rate of return of 8%, the

FSA may judge that it is highly likely that the invest-

ments themselves will not generate a return of 8%,

and therefore the bank will end up with a shorall,

which will increase the likelihood of the bank going

bankrupt or appealing to the Bank of England for

emergency funding. In short, oering a guarantee

(on either the rate of return or the principal) which

bears no relaon to the real risks of the invest-

ment makes it more likely that the bank will run

into nancial dicules, and therefore the FSA or

Bank of England should be allowed to disallow any

guarantee in order to maintain the stability of the

banking system.







THE BANK OF ENGLAND AND THEPAYMENTS SYSTEM

We now look at the bigger picture and explain how

the payments system works in the post-reform

economy. Understanding the payments system is a

pre-requisite for understanding how loan making

and investment will take place in the post-reform

banking system.

It is important to understand that money - at least,

97% of it - now has no physical form. It is merely

numbers in computer systems. With that in mind, it

should be remembered that unless you are referring

to physical cash, money is never actually ‘kept’

or ‘stored’ anywhere. It is only recorded in one

computer system or another.

This is important because our reform requires some

subtle changes to the computer systems used in

the banking network, and these changes are easily

misunderstood if the nature of money itself is

misunderstood.

BANK OF ENGLAND HOLDSALL DIGITAL MONEYFirstly, all digital money (other than cash and coin)

would be ‘held’ in a central computer system

under control of the Bank of England. The Bank of

England already has a computer system, known as

the ‘RTGS (Real-Time Gross Selement) Processor’,

which records the amount of ‘central bank money’

or ‘reserves’ in the reserve account of each bank in

the UK. This computer system handles millions of

transacons every day, and with a few small tweaks

can be used to handle full-reserve banking under

the Posive Money proposals.

EACH BANK WOULD ‘BANK’WITH THE BANK OF ENGLANDIn the same way that you or I might hold personal

bank accounts with HSBC or Naonwide, HSBC and

Naonwide (and every other bank) would in turn

hold accounts with the Bank of England. Each indi-

vidual bank would have three main accounts (stored

in the Bank of England’s RTGS Processor):

1. THE CUSTOMER FUNDSACCOUNTThis is the account in which all of each bank’s Trans-

acon Account funds are held. When a payment is

made to a Transacon Account holder by someone

at another bank, the balance of this account will

increase. When a Transacon Account holder makes

a payment to someone who uses a dierent bank,

the balance of this account will decrease.

2. THE INVESTMENT POOLACCOUNTThis is the account that the bank uses to receive

investments from customers, receive repayments

from borrowers, make payments back to Investment

Account holders and make loans to borrowers.

3. THE BANK’S OPERATIONALACCOUNTSThis is the account where the bank can hold funds

for its own purposes - retained prots, own capital,

money to pay sta wages etc.

Each of these accounts may be split into sub-

accounts to help the bank manage and segment its

own funds.







INDIVIDUAL BANKS MANAGEINDIVIDUAL CUSTOMERACCOUNTSWhile the Bank of England would hold the real

‘money’ (in digital form), it would not hold any

informaon on individual customers or customer

accounts. This would be the responsibility of the

individual banks.

The three accounts at the Bank of England would

be huge ‘pots’ of money. Legally, the money would

belong to the banks (with the excepon of the

Customer Funds Account, where it would belong to

the individual customers).

For its Customer Funds Account, each bank would

record the amount of this money that is owned by

each and every one of its individual customers, and

the transacons made in and out of each customer’s

account. As a simplisc example, a bank’s database

may look something like this:

Mrs K Smith: balance £546.21

Mr W Riley: balance £1942.52

Mr J Heath: balance £26.78

The Investment Pool Account is money that techni-

cally belongs to the bank, so the bank would not

have corresponding records to divide this pool up

between customers.

However, each bank would need to keep records of

all its ‘contracts’ and agreements, both to Invest-

ment Account holders and to borrowers.

For borrowers, it needs to know:

• the amount lent

• the agreed interest rate

• the date of monthly repayments

• the quanty of repayments to be taken,

• and so on.

For each Investment Account, the bank will need to

have a record of:

• the amount invested

• the date the investment was made

• the maturity date or minimum noce period

• whether the minimum noce period has been

exercised

• the interest rate agreed

MAKING TRANSACTIONSBETWEEN ACCOUNTSUnderstanding the following is not essenal to

understanding the wider reform. However, an

understanding of the following will dispel a few

misconcepons and misunderstandings about how

the reform works.

In the present day, money is simply informaon.

Consequently, we need to look at computer systems

to understand how the monetary system will work.

The rst thing that must be understood is that,

under the new system, a commercial bank will not

have the power to create money electronically,

just as you do not have the ability to log into your

internet banking and change your own account

balance. Since all real digital money will be held in

the Bank of England computer systems, the Bank

of England gets to determine how the commercial

banks can interact with this money. As a result, they

can ensure with 100% certainty that it is impossible

for money to be created by anyone other than the

Bank of England’s Issue department, even in digital

form.

A WORKED EXAMPLE:PAYMENT BETWEEN TWOACCOUNTSImagine that a customer, Jack, banks with HSBC and

pays using internet banking to transfer £400 in rent

to his landlord.

Jack logs in to his internet banking and lls in the

landlord’s account number and sort code, the

amount he wants to pay, and clicks ‘Make Payment’.

If the landlord banks with HSBC, then HSBC will

simply adjust its internal records to reduce the

balance of Jack’s Transacon Account by £400,







and increase the balance of the landlord’s Transac-

on Account by £400. The payment has now been

completed and cleared within fracons of a second.

The balance of HSBC’s Customer Funds Account at

the Bank of England remains unchanged, since this

was an internal transfer within HSBC.

However, if the recipient (the landlord) is at another

bank, say Barclays, then HSBC must:

1. Reduce the balance of Jack’s Transacon

Account by £400.

2. Send a message (via the computer system) to

the Bank of England. The message, in plain

English, will read something like this:

Transfer £400 from our Customer Funds

Account (CFA) to Barclay’s CFA. Tell Barclays that

the payment is for account number 295283742,

on behalf of account 192384192 (‘Jack Smith’),

with the sender’s reference ‘Here’s the rent...’

3. The Bank of England will then decrease the

balance of HSBC’s Customer Funds Account by

£400, and simultaneously increase the balance

of Barclay’s Customer Funds Account by £400

(in other words, it will transfer £400 from HSBCto Barclays).

4. The Bank of England’s computer system will

then send a message to Barclays that will

read, in plain English, something like the

following: You have received a payment of £400

for Customer Account No. 295283742. The

payment was sent from HSBC Account number

192384192 (‘Jack Smith’), with the sender’s

reference ‘Here’s the rent...’

5. The computer systems at Barclays’ would then

update their own customer account record by

increasing the balance of the landlord’s Transac-

on Account by £400.

The enre process outlined above could be done

in less than 30 seconds, and the funds would have

‘cleared’ instantly and be immediately available

to the landlord for making payments to other

accounts.

(For those with lile experience of computer

programming, the above may sound complicated,

but in reality the technology behind this process

is actually much simpler than the technology that

allows you to order a book at Amazon.co.uk - just a

lile more heavy-duty to handle billions of transac-

ons a day!)

With an understanding of the post-reform payments

system, we can now look at how loans will be made

aer the reform.







HOW WOULD BANKS MAKELOANS?

Unlike the current system, the process of making

loans aer the reform is very mechanical. The

process would move money from A to B, rather than

creang new money (unlike the current system).

In the post-reform banking system, a bank will only

be able to make loans using money from one of the

following sources:

a) the money that bank customers have given

to the bank for the purposes of investment(specically, the money that bank customers

have used to open Investment Accounts)

b) the bank’s own funds, for example from share-

holders or retained prots

c) any borrowings from the Bank of England (when

permied).

In contrast with the current system, all money in

Transacon Accounts (which would currently be

held in ‘current’ accounts) is ‘o limits’ to the bank’s

loan-making side of the business.

THE INVESTMENT POOL:Each bank will hold an account at the Bank of

England, known as the Investment Pool. This

account will be held at the Bank of England. All

loans will be made from this account, and all loanrepayments will be paid back into this account.

FILLING UP THE POOL:When a customer opens an Investment Account, the

behind-the-scenes transacon will actually involve

money being taken from the customer’s Transacon

Account and transferred into the bank’s own Invest-

ment Pool.

(Recall that the customer’s Investment Account is

really just a customer-friendly way of represenng

the investment contract made between the bank

and the customer).

HOW BANKS WOULD MAKELOANS:When the bank wishes to make a loan, it will

eecvely transfer the amount of the loan from

its Investment Pool into the borrower’s Transac-

on Account. To do this, it will need to instruct the

Bank of England’s computer system to transfer the

amount of the loan from the bank’s Investment

Pool into the bank’s Customer Funds Account,

and update its internal records for the borrower’s

Transacon Account.

HOW CUSTOMERS WOULDREPAY LOANSWhen a customer wishes to make a repayment

on the whole or part of a loan (or when the bank

regularly takes its deposit), money will be trans-

ferred from the customer’s Transacon Account

back into the bank’s Investment Pool.

HOW BANKS WOULD REPAYCUSTOMERS’ INVESTMENT

ACCOUNTS:When an Investment Account reaches its maturity

date or noce period, the bank transfers the money

that it owes to its customer from its Investment Pool

into the customer’s Transacon Account.

WORKED EXAMPLE: MAKINGA LOAN:Let’s look at a worked example, starng with a

customer who wishes to invest some money.







1. The customer decides to invest £1000 in an

Investment Account with the same bank that he

normally uses for his Transacon Account. He

chooses the account type and agrees to accept

the terms and condions of the account.

2. The bank then transfers £1000 from this

customer’s Transacon Account into the bank’s

Investment Pool. At the same me, it creates

a record of an Investment Account of £1000,

belonging to the customer, and records details

of the maturity date, interest rate paid and

so on. The Investment Account does not hold

any money – it is simply a user-friendly way of

represenng this investment.

3. The bank now has £1000 in its Investment Pool

Account at the Bank of England, which it can use

to fund new loans.

4. A dierent customer applies for a loan of

£1000. The bank makes this loan by transfer-

ring £1000 from the Investment Pool into the

bank’s Customer Funds Account and increasing

the borrower’s Transacon Account balance by

£1000 in its internal records.

(Note that in the example above, the gure of

£1000 is used for simplicity. There is no need for

the amount of a loan to match the amount of an

individual investment – the £1000 loan could just as

well have been funded by 5 people invesng £200

each. On a bigger scale, there would be thousands

of investors and thousands of loans, with parts of

each investment going into each loan.)

NOTE THE MAJOR CHANGE:Note that in all these transacons, every me the

balance of one account is increased, the balance of

another account is decreased by an equal amount.

In other words, money can only be moved from one

account to another.

This is in direct contrast to the current loan making

process, whereby the borrower’s account is credited

with the amount of the loan but the original deposi-

tors are never told that their money is ‘on loan’. It

is impossible under this reformed system for new

money, purchasing power or ‘credit’ to be created

within the banking system as a result of the loan-

making process (or indeed any other process).

INTERBANK LENDINGInterbank lending in the post-reform system is very

simple. If Bank A wishes to lend £1bn to Bank B,

it simply instructs the Bank of England’s clearing

system to transfer £1bn from its own Operaonal

Account to the Operaonal Account or InvestmentPool of Bank B. The legal contract or agreement

dictang how and when the loan will be repaid is a

maer for Bank A and Bank B to arrange between

themselves. The Bank of England will have no

interest in, or record of, which bank owes what to

who. It will only record the amount of money in

each of the banks’ accounts at any one me.

As with loans to the general public, a bank may onlymake a loan to another bank using:

a) Funds in the bank’s Investment Pool

b) The bank’s own capital (retained prots, share-

holders’ funds etc)

c) Banks should not make interbank loans with

funds that they have borrowed from the Bank of

England.

Consequently, with interbank lending, it is impos-

sible for both banks to use the same money at the

same me. If the money is with Bank A, it can’t be

used by Bank B. Clearing between the two banks

would be instantaneous and nal, and no money

creaon would take place at any point in the

process.







WILL THERE BE ENOUGHLENDING & CREDIT?

This reform will reduce the amount of ‘credit’ – or

more accurately, lending – available in the economy,

from around 100% of the exisng money supply

to around 50-60%. Considering that the authori-

es focused on the ‘credit squeeze’ as the biggest

problem in the recent nancial crisis, the idea of

signicantly reducing the amount of available credit

(lending) raises alarm bells for many people.

However, most of these concerns stem from an

incomplete understanding of how the monetary

system works. The reality is that our dependence on

credit is not a natural aspect of the economy – it is a

direct result of allowing banks to create the naon’s

money as debt. When 97.5% of the exisng money

supply was created as debt, and is therefore earning

interest, it creates inaon (especially in housing)

that necessitates people borrowing more simply to

survive.

Before we explain why a reducon in credit

(lending) will not be a problem aer the reform,

we need to clear up a few misconcepons about

‘credit’, ‘debt’ and ‘lending’.

CREDIT = DEBTThe term ‘credit’ is used misleadingly. ‘Credit’ has

posive associaons – everyone wants a goodcredit rang, and your salary appears in your bank

account under the ‘credit’ column. But in this case,

bank ‘credit’ means ‘debt’. If we say that businesses

depend on access to credit, we are saying that

their nancial situaon is poor enough that they

urgently need to go into debt. Of course, very new

businesses and businesses which are expanding

rapidly will need access to credit/debt, but the fact

that many businesses will go bankrupt as soon as

banks stop oering them further debt points to the

poor nancial health of most businesses. This poor

nancial health is not the natural state of aairs – it

is a symptom of a monetary system where all new

money is created by the banks.

WE ARE DEPENDENT ONCREDIT/DEBT BECAUSE OURMONEY SUPPLY IS DEBTThe absolute dependence on ‘credit’, and the

fact that the economy grinds to a halt whenever

‘credit’ dries up, is used to point to the importance

of credit in a modern economy. In reality, it points

to a chronic shortage of debt-free money in the

economy. By denion, if the economy needs

‘credit’ to connue funconing, we are dependent

on debt.

Under the exisng fraconal reserve banking

system, the only way the public can get money is to

borrow it from banks. Consequently, if banks don’t

lend, the economy doesn’t have a money supply.

This is the main cause of our dependence on debt/

credit.

Over the last few decades we have all become

accustomed to having total debts equal to 5 or 6

mes our annual salary, and businesses having

debts as much as their annual turnover. However,

this is not a natural state of aairs – it is a product

of a system where almost all money only comes into

existence when someone takes out a loan.

This means that, while economists argue that easy

access to credit is essenal to a well-funconing

economy, in reality, dependence on credit is a

symptom of a malfunconing economy and a

malfunconing money supply. The debt-based

monetary system actually creates the need for

companies and households to access credit (debt).

In other words, we are all so far in debt because we

allow our money to be created as debt.







The answer to our debt-dependency is not more

debt (despite polical leaders shoung “We must

get banks lending again!”) but newly created,

debt-free money, which can help to cancel out the

debt and reduce our debt-dependency.

AS DEBTFREE MONEYCANCELS OUT THE DEBT, WEWILL HAVE LESS NEED FORCREDITAs we create and inject debt-free money into the

economy, this will allow individuals and companies

to gradually pay down their own debts and start to

increase their savings. With greater savings, people

have less dependence on debt, and therefore access

to credit (debt) becomes less crical to the health of

the economy.

AS THE AMOUNT OF CREDITFALLS AFTER THE REFORM,DEMAND FOR LENDING WILL

ALSO BE FALLINGThe amount of credit/lending available aer the

reform may gradually fall to around 50% of the

current level. At the same me, newly-created

money will be injected into the economy, not as a

debt into the housing market, but as tax cuts, tax

rebates and government spending.

This newly created debt-free money provides a

stronger smulus than debt-based money createdby the banks, since there is no need to pay an

interest charge on the money as soon as it is

created. As a result, the economy should improve,

and people will be beer able to pay o their

exisng debts, pay down mortgages, and improve

their nancial posion. With lower taxes and a

more buoyant economy, the need to go into debt

will fall and apply to fewer people. In other words,

the demand for credit will fall in tandem with the

availability of credit.

If there are any shoralls in the amount of credit

available during the ‘transion’ phase between

the two systems, these can be met by the MPC

choosing to create more money (if all the other

economic indicators also point to the need for more

money), or by lending money directly to banks on

the condion that this money goes into ‘producve’

lending – funding businesses rather than consumer

credit cards, for example.

THE CURRENT SYSTEMSUPPLIES TOO MUCH CREDIT/DEBTBank assets (loans) and liabilies (bank deposits,

the money in your account) have increased by a

staggering amount in the last 30 years (by a factor of

ten, relave to GDP). This has brought with it some

lending which has been clearly irresponsible and

on a massive scale, e.g. NINJA mortgages. Thus the

idea that there is something inherently wrong with

a reduced amount of lending is clearly nonsense (if

not posively hilarious). A system that provides less

credit than fraconal reserve banking is much more

likely to lead to a steady and stable economy, rather

than the stop-go economy that we’ve had for the

last few decades.







WHAT ABOUT OVERDRAFTS?

Overdras on Transacon Accounts can play a key

part in the post-reform banking system. Firstly, they

will provide a short-term ‘liquidity buer’ to house-

holds and businesses. Secondly, they will provide a

very useful indicator on the need for more (or less)

new money to be injected into the economy.

‘THE LIQUIDITY BUFFER’Overdras provide short-term liquidity and allow

businesses and individuals to smooth out temporary

mismatches between their incoming and outgoing

cash ows (for example, if an individual’s bills need

to be paid just a few days before their salary is paid

into the account). There would be no advantage to

the bank, to the customer, and to the economy as a

whole of removing the overdra funconality from

Transacon Accounts.

INDICATING CHANGES IN THE

NEED FOR MONEY IN THEECONOMYThe balance of one overdra may uctuate wildly

through the month and at dierent mes in the

year. However, averaged over millions of Transac-

on Account holders, the average balance will

be fairly stable. This means that changes in this

average balance will indicate signicant changes in

the economy. If this average balance is increasing

(i.e. people on average are going further into their

overdras) then it indicates that people do not have

enough money to meet their regular expenses, and

could therefore mean that the economy needs a

greater injecon of new money. On the other hand,

if average overdra balances are falling (people are

– on average – paying o their overdras) it could

mean that there is ‘spare’ money in the economyand point to the possibility of inaon in the near

future.

HOW OVERDRAFTS WILL BEFUNDEDOverdras will be funded like any other loan, from

money that the bank has borrowed from customers

(who will have put the money into investmentaccounts).







WOULD THIS MAKE BANKS MORESTABLE?

These reforms would make banks signicantly more

stable. There are some major sources of instability

in the current system that can be removed with

a few simple changes to the way that banks do

business.

SOURCES OF INSTABILITYUNDER THE CURRENTBANKING SYSTEMInstability under the current banking system comes

from a variety of sources:

1. Every loan that the banking system makes

creates more deposits (the numbers in your

account), and consequently funds more loans.

As a result, as people’s nancial situaon gets

worse and they take on more debt, the overall

availability of loans increases. This creates a

‘posive feedback loop’ – as we get further and

further into debt, banks become increasingly

willing to oer us more debt. This develops into

high levels of personal and household debt,

which eventually become impossible to repay.

This in turn triggers a wave of defaults, such

as seen in the sub-prime mortgage market in

America, which in turn triggers a domino eect

throughout the economy. This means that the

loans that banks originally expected to be repaid

are no longer likely to be repaid, creang a huge

shorall in their income and potenally bank-

rupng them. In short, the design of the current

banking system makes it fundamentally prone

to collapse.

2. The majority of the bank’s customers can

demand repayment at any me from any

accounts that do not have maturity dates or

noce periods. This could result in the bank

being required to pay back huge sums of

money in a short period of me, making the

bank illiquid (unable to make payments). If this

connues, the bank becomes ocially insolvent

and would therefore be bankrupt. This is what

happened to Northern Rock in 2007. The banks

try to guard against this by keeping back enough

reserves at the Bank of England to meet any

likely payments, but they connually walk a

knife-edge between keeping reserves high

enough to cover the maximum likely net with-

drawals, and keeping them as low as possible in

order to free money up for making further loans

(to maximise prots).

STABILITY IN THE POSTREFORM BANKING SYSTEMThe post-reform situaon is much more stable. The

stability arises from the fact that the funds a bank

uses to make loans are now ‘locked in’ – customers

can no longer demand them back whenever they

choose. As a result, the bank knows:

• What it will need to repay to customers who

have made investments, and when.

• What it will receive from borrowers making

repayments on their loans, and when.

Money withdrawn from Transacon Accountsdoesn’t aect the bank in any way, as the money is

stored in full at the Bank of England, and therefore

doesn’t need to be ‘found’ from anywhere when it

has to be repaid.

Since all the investment funds that will be used

by the bank come from Investment Accounts, and

every Investment Account has a dened repayment

date (or a maturity date), the amounts that the bankwill need to repay on any one day will be stas-

cally many mes more predictable than under the

current system.







For Investment Accounts with Maturity Dates, a

bank will know the exact amount that must be

repaid on any parcular date, and will also know,

from experience, what percentage of customers

with maturing accounts will ask for the investment

to be rolled over for another period (in other words,

what percentage of accounts will not need to be

repaid on the maturity date).

With regards to minimum noce periods, a bank will

know the stascal likelihood of an account being

redeemed within the next ‘x’ days, and so will be

able to forecast the payments that will come due

on any parcular day for up to 6-12 months into

the future. In addion, because a bank has, on its

‘loans-made’ side, a collecon of contracts with

specied monthly repayment dates and amount,

it knows almost exactly how much money it will

receive on any parcular date up to 6 months in the

future (allowing for a small degree of variaon due

to defaults and late payments).

Consequently, the bank’s computer systems will be

able to easily calculate how much money should

be required on any parcular day up to 2 years into

the future. If it idenes any potenal cashow

problems (such as a large number of Investment

Accounts maturing in a short period of me and

insucient income from loan repayments to cover

them all) the bank can rein back loan making acvity

unl it has built up a buer to cover the upcoming

shorall. On the other hand, if the cashow

forecasts idenfy a period when repayments from

exisng borrowers are in excess of the amounts

required to repay Investment Account holders, it can

increase loan making acvity to ensure that it does

not end up with a swelling Investment Pool Account

full of ‘idle’ funds.

SOURCES OF UNCERTAINTY INTHE POSTREFORM BANKINGSYSTEMThere are three sources of uncertainty in the post-

reform banking system. The rst source relates to

the bank’s ‘in-comings’, and the other two relate to

the bank’s potenal outgoings:

1. The risk of default by borrowers. However, it

should be remembered that the risk of defaults

will be signicantly lower throughout the enre

nancial system aer the reform

2. Uncertainty about the likely use of minimum

noce periods. At any one point in me, there

may be billions of pounds of liabilies subject

to short-term minimum noce periods. For

example, imagine that a parcular bank has

£10bn in Investment Accounts that are subject

to a 30-day minimum noce period. In an

extreme case, if a rumour spread that that bank

had made some bad investments, and all these

account holders exercised their minimum noce

period, the bank may be required to repay

£10bn in 30 days from now. Again, while this is

sll a source of instability, it is both less likely to

occur than under the current system, and if it

does occur, the total impact on the bank would

be far less.

3. Uncertainty about the proporon of customers

who will (or won’t) roll over their investment

accounts as they mature.

THE LOWER LEVEL OFSYSTEMIC RISK:We believe that the risk of any bank or all banks

suering a ‘cashow crisis’ is signicantly lower

post-reform than under the exisng banking system,

for the following reasons:

1. Unlike the present day banking system, the

post-reform banking system is counter-cyclical,

rather than pro-cyclical. This means that the

banking system will not create debt-fuelled







booms that soon turn into economic crashes,

causing a wave of defaults. Consequently, each

bank’s loan porolio is likely to be far safer than

under the current system.

2. The economy will be generally more benign.

Without regular banking-fuelled boom and bust

cycles, recessions will be less frequent and less

severe. If a million people are no longer thrown

out of employment every few years, then fewer

people will run into nancial dicules, and

therefore fewer borrowers will be forced to

default.

3. Because the bank has limited funds for making

loans (and because each loan does not create

new deposits), the incenve for loan-making

departments shis from lending as much as

possible, to nding good quality borrowers to

lend to. As a result, the banks are less likely to

lend to bad-risk borrowers, and consequently

the overall quality of a bank’s loan porolio

should be higher, making defaults less likely.

PROVISION FOREMERGENCIESWe have made provisions for the situaon where

a bank does not have sucient funds in the invest-

ment pool to re-pay maturing Investment Accounts.

In this situaon, the Bank of England has the discre-

on to make an emergency loan to the bank in

queson. This loan must always be used to re-credit

the maturing Investment Account – it can not beused to fund new loans.

This may sound a lile like the taxpayer-funded

bailouts that we have seen over the last few years.

In reality, it is completely dierent – the emergency

loan will consist of nothing more than numbers

added to a computer system; in other words, it

will be newly-created money, and will not cost the

taxpayers anything. The borrowing bank will need

to repay the loan in full, out of its future income. If

the bank needs to borrow signicant amounts, then

it is unlikely to earn a prot for a number of years.

However, as the bank repays the loan, this newly

created money will be ‘destroyed’ again, ensuring

that the emergency loan has no long-term eect on

the money supply. This emergency loan will merely

provide some liquidity for the individual bank in

unusual cash-ow circumstances.

Note that this emergency loan should only be

provided to meet a short-term liquidity problem

– for example, if a recession had caused a larger

withdrawal from short-term Investment Accounts

than normal. In deciding whether to support the

bank with such an emergency loan, the Bank of

England should look closely at the bank’s loan

porolio and future income. If this is purely a short-

term cash-ow problem (i.e. loan repayments are

out of synch with maturing Investment Accounts),

the loan porolio is healthy, and it’s clear that the

bank will soon be able to repay the emergency loan,

then the emergency loan should be made. However,

if the cash-ow problem arises because the bank’s

loan porolio is ‘toxic’ and a large proporon of

borrowers are defaulng, it may be unlikely the

Bank of England’s emergency loan will be repaid.

In this case, the Bank of England would probably

choose to iniate ‘wind-down’ procedures for the

bank in queson.

PENALISING BANKS FOR POOR‘CASHFLOW’ MANAGEMENTThe Bank of England or the banking regulator can

– and should – penalise banks that have to seek

emergency funding. There are a number of ways

that they could aempt to do this:

• By charging a punive rate of interest on the

emergency loan (reducing the bank’s future

prots)

• By charging a monetary ne

• By launching an in-depth invesgaon into the

bank by the banking regulator

• By any other method that the banking regulator

believes will prevent further transgressions by

the bank in queson or any other bank in the







industry.

Rather than a bank in trouble represenng a

huge nancial burden on the taxpayer, under

our proposed reform it could actually be an

opportunity for the state to prot in real and

absolute terms.

NO BAILOUTS OF BAD BANKSThe provisions above mean that the Bank of England

would have the power to lend money to a bank in

order to prevent it suering a temporary cash-ow

crisis, and that doing so would have absolutely no

nancial cost to the taxpayer.

However, we are keen that this should not be seen

as state support for banks that are fundamen-

tally unsound. We should not see governments

supporng ‘toxic banks’ in the way that we have

seen over the last three years.

If a bank is judged to be badly managed or have

made bad investments across the board, meaning

that all holders of Investment Accounts are likely

to lose money, then the bank in queson should

be wound down, broken up and sold o to either

healthier banks or debt collecon rms. (Note

that by ‘debt collecon rms‘, we are referring to

companies that would buy – at a discount – the legal

contracts between the bank and its borrowers, and

collect repayments over a period of me, according

to the payment terms in the individual contracts.

No borrower would be requested to repay the loan

earlier than originally agreed).

In the post-reform system, winding down a bank

would be far easier and cheaper than under the

exisng system, for the following reasons:

The funds placed in Transacon Accounts are 100%

safe, held separately from the bank’s investments inthe bank’s Customer Funds Account at the Bank of

England.

The taxpayer and government has no exposure or

responsibility whatsoever for the funds owed to

holders of Investment Accounts. The Investment

Account holders would become creditors of the

liquidated bank, and insolvency law would govern

whether and by how much they are repaid their

original investment.





Wrien By: Ben Dyson

Posive Money 205 Davina House 137-149 Goswell Road London EC1V 7ET

Tel: +44 (0) 207 253 3235

Email: [email protected]


© February 2012 Positive Money

(Version 1)



Documents

Full Reserve Banking in Plain English