A federal government guarantee or 100% reserve banking? Which is better?
Not long after arriving to teach economics at Colorado State University nearly four decades ago, I was introduced to a retired economist living in Fort Collins who had a simple idea for solving the problem of bank runs: require banks to have the cash on hand whenever the depositor wished to withdraw. Lloyd W. Mints had been one of the founders of the Chicago School of Economics along with Henry Simons and Frank Knight. The proposal, which has a history going back to at least the early 19th century, has variously been called 100% reserves, full reserve banking, or the Chicago Plan for Banking Reform.
Banks have traditionally served two important functions in our financial system. First, they provide a convenient type of money—checking accounts or demand deposits that are readily accepted as a means of payment and convertible to the ultimate money in our economy, Federal Reserve Notes that are issued by and are a liability for the Federal Reserve Banks. Secondly, banks use the funds collected from deposits to make loans to firms and individuals. Banks also hold some short-term government securities which can be quickly sold and the cash made available in the event of depositor withdrawals. Herein lies the problem: if banks make bad loans, they can become insolvent and fail. If banks cannot access adequate liquidity, then can face a bank run which can also lead to the failure of the bank. In the present environment with rising interest rates, institutions such as Silicon Valley Bank found that they had unrealized losses on their holdings of long-term government securities. Attempts to raise additional capital led to a quick and large run on the bank from its biggest depositors. The solution implemented by the Federal Reserve Board and the U.S. Treasury was to guarantee all deposits in the bank and to engage the FDIC as the conservator to reorganize the bank.
But is this the best solution? It not only creates a moral hazard situation such that all depositors now expect to be bailed out in a bank failure, but it also potentially puts the taxpayer on the hook for bailout funds.
As Mints remarked in an interview on his 100th birthday, bankers don’t always have such good judgment. Mints thought that Congress was the center of ignorance, though he readily admitted this statement was a little harsh. We have seen examples of this with recent bank failures. One could add that decisions at the Federal Reserve Board and the Department of the Treasury have also failed to resolve the failures in a way that reassures all parties that it won’t happen again.
Today, it is technologically possible to implement Mints’ idea and indeed, it is already occurring. It seems many firms want to get involved in the very lucrative industry of settling payments. Most everyone has used PayPal, ApplePay, or even Kroger Pay at the grocery store. There is no economic or technological reason why banks should be the exclusive financial institutions to clear payment transactions between two parties, whether they be businesses or individuals. There is even a 100% reserve bank operating in Cheyenne, Wyoming that is awaiting approval to join the payments system. Custodia Bank has been denied access to the Federal Reserve payments system for reasons that seem to be just an attempt to protect the vested interests of existing banks and their regulatory institutions such as the Federal Reserve.
Though the 100% reserve plan would solve the problem of providing a safe payments system, there would remain the question of providing adequate credit, especially for small businesses. This special relationship with borrowers and the information acquired by bank loan officers is where banks have excelled and helped fuel economic growth.
What will be the future of bank failures? A federal government guarantee that all depositors will be fully repaid beyond the present statutory limit of $250,000 or one in which you know your money is in the bank? Which is the better solution for you as a depositor and taxpayer?
