This archived content originally appeared at Freebanking.org, the predecessor site to Alt-M.org, and does not carry the sponsorship of the Cato Institute.

No, Virginia, there is no risk-free banking

(With apologies to the New York Sun of September 21, 1897.)

Dear Free Banking—

I am 18 years old. Some of my professors say there is a Santa Claus called "risk-free banking." Papa says, "If you see it in the Free Banking blog, it's so." Please tell me the truth, is there such a thing as risk-free banking?

Virginia O'Hanlon
115 West Ninety-Fifth Street

Virginia, your professors are wrong.

They have been affected by the credulity of a credulous age. They do not believe except they theorize. They think that something can be if only it is comprehensible by their little minds. All minds, Virginia, whether they be men's or children's, are little. In this great universe of ours, man is a mere insect, an ant, in his intellect as compared with the boundless world about him, as measured by the intelligence capable of grasping the whole of truth and knowledge.

No, Virginia, there is no risk-free banking.

Schemes to make banking risk-proof, or at least run-proof, fall under two general headings. The first restricts the kinds of assets banks can hold. The best-known scheme of this type is the "Chicago plan" of the 1930s, which would have required banks to hold 100% reserves against demand deposits in lawful money or deposits with Federal Reserve Banks. Proposals to institute something like the Chicago plan crop up periodically. The second type of scheme alters banks themselves, converting them into, for instance, a kind of mutual fund. There are also proposals to combine the two types of schemes.

Briefly, here are the problems with these schemes. My underlying assumption is that government regulation does not change. Even if mutual-fund banking, say, is coupled with the elimination of deposit insurance, most or all of the underlying problem still apply.

(1) Government or central bank liabilities are not risk-free. In a fiat currency system, purely nominal liabilities are generally free of the risk of nominal default, but not of the risk that the real value will be eaten away through inflation. Securities indexed to inflation, to foreign currency, or told remove the risk that inflation will erode their real value but bring back the risk of default, because under some readily conceivable scenarios, the ability or the willingness to repay can become questionable.

(2) Supposedly run-proof banking already exists or has existed in many countries, in the form of postal savings banks. (The United States had such an institution, the Postal Savings System, from 1911 to 1967.)  In some countries postal savings banks have had substantial market shares, but nowhere have they driven regular commercial banks out of business. Depositors apparently value the services of regular commercial  banks. Nor do financial systems with postal savings banks seem any less run-prone than those without them.

(3) There is no such thing as a run-proof financial institution. It is true that an institution whose liabilities contain no debt and consist entirely of equity cannot have its liabilities exceed its assets. Something very like a run against such an institution can happen, though, if many equity holders try to liquidate at once. The value of the equity will fall substantially, reducing the wealth of shareholders much as if they were depositors in a bank that had suspended payments.

(4) Banks provide a combination of services because depositors and other consumers want those services. (I am abstracting here from  the important possibility that banks provide some services because they have a legally privileged position that prevents potentially lower-cost competitors from providing the services and stripping them from banks.) Forcing depositors and banks into forms they do not want will result in a kind of regulatory arbitrage where other institutions arise to perform the same functions, albeit often with some attendant disadvantages. The so-called shadow banking system is in part a result of regulatory arbitrage.

In a word, Virginia, risk-free banking is humbug.

Yours truly,

Ebenezer Scrooge

Chief Accountant, Free Banking blog