29 September 2008

Stop Protecting the Savers

Throughout the banking crisis, one thing that all sections of the mainstream political spectrum seem to have agreed on is that savers must have their deposits protected at all costs. That's a shame, because it is precisely that approach which has got us into this mess.

It all comes down to a muddying of the distinction between a "depositor" and an "investor." Under the original meanings, a depositor was somebody who put their money in a bank for safe keeping. Somebody with a safety deposit box is probably the closest thing we have to a genuine depositor today. They make no profit from leaving their assets with the bank; in fact, it costs them money. In contrast, an investor was someone who gave their money to a third party with the intention of making a profit on it, but also with the risk that they might make a loss.

The problem with savings accounts at banks is that they are treated as if they should have the risk free characteristics of a deposit, but also enjoy the risk taking profits of an investment through the interest they get paid. That obviously means that somebody else has to shoulder the risk which is involved in creating the profits and in this case, it is ultimately the taxpayer. The saver gets to take the profits when things are going well, but when they go badly, the taxpayers has to guarantee that the saver doesn't lose any of their original investment.

The mainstream attitude all comes down to the perception of the individual players. Directors, corporate investors and shareholders are criticised for making profit in the good times but being bailed out in the bad, while savers are portrayed as passive victims who must be protected, in spite of the fact that they are just as much beneficiaries of the "privatised profit but socialised risk" scam as the others, if not more so.

This is why, as I've said previously, this crisis is not a result of the free market, but government intervention. In a genuine free market, savers, just like shareholders, would have to accept the losses that arise from bad investment decisions. This is how it works in other industries, where creditors queue up to get what is left after a business fails. By guaranteeing deposits and creating the impression that savers are involved in a risk free activity, successive governments have created the conditions that have resulted in this crisis.

The first step that should be taken now is to re-establish the distinction between "depositor" and "investor."

A depositor, who puts their money with a bank for safe keeping and makes no profit from it, should be well protected, just as they would be if they'd put it in a safety deposit box. The law should treat the bank in much the same way it treats postal services; it is a custodian that has no right to use the property it holds. Any attempt to use that money for investment should be treated as a serious criminal offence for which the Board of Directors of the bank should be ultimately criminally liable, just as they should be if they allow their staff to take assets out of safety deposit boxes. The bank would therefore hold cash and central bank deposits equal to its genuine deposits, which would be paid out to the depositor immediately should the bank fail. In contrast, an investor who puts their money in an account with the intention of earning interest on it should have much less protection. They should be treated as a creditor of the bank and if the bank fails, they would have to wait for the bank to be wound up and its assets sold and then collect whatever percentage of their deposit is available from the proceeds. This leads on to an area where I disagree with many of those with libertarian leanings - the fractional reserve system.

The fractional reserve system of banking allows banks to lend money that is saved with them in such a way that, if all the savers were to try to withdraw their money at the earliest possible opportunity, the bank wouldn't have the cash available, because it is tied up in loans. It is what makes bank runs such a problem. Many libertarians think the fractional reserve system is inherently wrong because of that, but I don't view it that way. Any individual could do the same as the banks do; I could borrow ten pounds from you and write you and IOU. I could then spend the ten pounds, while you treat the IOU as ten pounds available to you whenever you want it, just as you would treat ten pounds in an instant access savings account. The problem arises if you try to get your ten pounds back from me and I don't have the cash, just as it would if you went to the bank and it couldn't pay you back because your deposit is tied up in a loan.

The real problem with the fractional reserve system arises because the government takes the risk out of it. If the banks can't pay their IOUs, the central bank lends them the money. If a bank fails, the government makes sure the IOUs get paid back. If IOUs written by individuals had the same guarantees, IOUs would get written, accepted and spent recklessly, just as the ones issued by the banks are.

We don't need to get rid of the fractional reserve system; we just need to make sure that it is clear to all what risks are and that those risks stay with those who are trying to profit from them. Savers who are trying to profit from their money being lent to others should be told that, if there is a run on their bank and there isn't the cash available to pay out their investment, they will have to wait in line until a loan is paid back and the cash is there, even if that takes years, unless the bank is forced out of business, in which case the saver might not get back their original investment in full.

By putting the consequences of risk taking back with the people taking the risks, we would solve the fractional reserve problem. People would treat putting money in an interest paying account like buying shares - an activity which can bring rewards, but also has risks. People wanting genuine security would put their money in non-interest paying deposit accounts or safety deposit boxes. All of the risks associated with the banking system would stay in the system, rather than being passed on to the government and by extension the taxpayer. The amount of reckless risk taking would reduce and the system would stabilise.

In short, if you want a sound banking system, stop protecting the savers.

No comments: