Review: Why banking is flawed and how to fix it

January 16, 2015

By Dominic Elliott

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

“The End of Banking” is an important book about finance. Jonathan McMillan, the nom de plume taken by an investment banker and a macroeconomist, provides a holistic and compelling explanation of the crisis of 2008. The authors predict a repeat, barring a revolution in finance.

McMillan, as the co-authors can be called, defines banking as the private sector creation of money from extending credit. Loans create deposits – private money. The monetary liabilities are distinct from the physical or electronic money which comes out of central banks.

The book’s central argument is that private money creation is impossible to control in the digital age. Until computers became widespread in the 1970s, banks could keep track of borrowers. But with electronic systems, transactions became more complex as lenders repackaged loans. Financial assets were spread across myriad interlocking chains of balance sheets, both of traditional banks and so-called shadow banks, which have grown into a $35 trillion monster in the United States and European Union.

The illustration of how balance sheets multiply and money grows in “The End of Banking” is illuminating. The focus is on how computing permitted massive regulatory arbitrage. “Over the last 40 years, IT has turned the stick [of capital requirements] into a toothpick.”

Financial watchdogs are alert to shadow banking’s risks, but their efforts to bring non-regulated firms into a defined perimeter are akin to using a net to gather water. Thanks to electronic bookkeeping, firms can shift balance sheets out of the authorities’ purview at the tap of a button. Whether to prevent runs on banks or to firm up the financial stability of quasi-banks, weak governments have steadily extended guarantees to bigger portions of the private sector.

McMillan has a solution. It starts with an accounting distinction. Bank assets would be classified either as real, in other words claims on physical or distinct immaterial objects; or as financial, assets which appear as liabilities on the balance sheet of some other institution.

Next, regulators would ensure that financial assets were 100 percent-backed by common equity. And lastly, in a combined regulatory and accounting change, the value of a company’s real assets would have to be greater or equal to the value of the total of its liabilities.

This final fix is where the book goes beyond previous proposals to mend finance through concepts such as narrow- or limited-purpose banking. The implication of McMillan’s recommendation is that many derivatives, for which a counterparty’s losses could be infinite, would be banned. What’s more, the intended application to financial and non-financial companies alike would include shadow banking, addressing the so-called “boundary problem” of regulation that other approaches to improve the system fail to solve.

Under these rules, banks would no longer create money. Rather, independent central banks would take on that task. McMillan suggests they could moderate inflation or deflation by charging companies a fee for gathering liquidity, or by distributing cash directly to citizens. The requirement for a surplus of real assets over financial liabilities would crush the $691 trillion over-the-counter global derivatives market at a stroke. At least in the short term, the quantity of credit in the economy would shrink sharply.

That sounds like a better and safer financial world, but the McMillan system has a potential serious flaw. The idea of an all-powerful price-setting central bank which is truly independent sounds utopian. As Felix Martin shows in his book “Money: The Unauthorised Biography,” governments do not give up control of money creation entirely.

The book is purposely impractical. It does not discuss how to get from here to there. The influential banking lobby is hardly going to surrender without a generously financed fight. Still, the next time a financial crisis erupts, the revolutionary ideas in the “The End of Banking” may get a serious hearing.

At just 180 pages, including footnotes and many charts and tables, “The End of Banking” is succinct. Its prescriptions for a better banking system may be excessively ambitious. But wild ideas may be more helpful for fixing finance than an endless series of enhancements of a system which is unsuitable for the modern age.

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