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How to put money in the bank Samuel Brittan Financial Times 26/10/07 I cannot be the only person who as an adolescent was shocked to discover that banks did not have enough cash in their vaults to repay more than a small proportion of their depositors. "Fractional reserve banking", as the system is called, arose when medieval goldsmiths discovered that they could safely relend most of the precious metals in their vaults as their depositors would not normally all ask to be repaid at the same time. The great virtue of the system was supposed to be that it economised on holdings of gold. But even when paper money came in the habit continued. One of the most sympathetic characters in Cranford by the 19th century novelist Elizabeth Gaskell lost all her money in a bank crash. The last really large UK bank run was on Overend & Gurney in 1866. There have been several near misses in modern times, such as the secondary bank crisis of the 1970s when the problems were averted by Bank of England action behind the scenes. In the US, small banks disappear every year, although deposits have normally been secured by a compulsory insurance scheme. The US subprime lending fiasco and its repercussions on Northern Rock and international credit markets in general have brought back questions about the banking system that most macroeconomists had hoped were over and long forgotten. The confidence of what are called, rather disdainfully, "retail depositors" is not the only problem of the world monetary system, but it is still the bedrock on which everything else stands. Outside the US, deposit insurance is rarely complete and there are usually delays before reliable cheques denominated in central bank money duly arrive. In the UK it is only since October 1 this year that the Financial Services Compensation Scheme has been extended to cover eligible deposits of up to £35,000 and the new official discussion paper leaves open the possibility of raising the amount. But the implications of sweeping guarantees have not been digested. They have the dubious feature of bringing questions such as "What is a bank?" and "What is money?" into practical politics. In fact, the fractional reserve system was severely queried by some US economists in the aftermath of the Great Depression when one-quarter of the US money stock disappeared almost overnight - a more important event than the better-known 1929 stock exchange crash. One of the principal critics was the Chicago professor Henry Simons, author of A Positive Program for Laissez Faire. At one time Simons had a great influence on Chicago economists such as Milton Friedman, but was later repudiated, presumably because he had too much positive programme and not enough laisser faire. Simons proposed the creation of pure deposit-taking institutions holding 100 per cent reserves whose assets had to be held in currency or Federal Reserve deposits. So, barring a break-up of the US or similar disasters, a depositor could always get his or her money back and quickly. Other financial institutions, whether or not called banks, would carry on paying interest and looking for more profitable investments. But the ordinary citizen would know that he was on his own if he invested in them and learn that higher returns came with higher risk. When I mentioned this idea to one of the few British economists who understands both banking and modern macroeconomics he recoiled in horror. His main argument was that, at the slightest sign of trouble, depositors would rush in their millions from profit-making financial institutions into these "narrow banks". This could surely be counteracted if the central bank, acting as lender of last resort, lent enough to the threatened institutions, of course at a penal rate. Nevertheless, I was sufficiently in awe of my interlocutor to postpone raising the subject. What has finally won me over is the realisation that we nearly have in the UK a government-sponsored narrow bank, entitled National Savings and Investment. It was originally set up by the Palmerston government of 1861 as the Post Office Savings Bank. It became under the last Conservative government "an executive agency of the chancellor". Until recently every chancellor of the exchequer put into his Budget speech a sentence of thanks to Lord Mackintosh, for a long time the head of the institution. Some of its instruments can already be cashed at short notice; and some are even indexed against inflation. Hitherto, they have been regarded as boring and dull compared with the attractions of marketable fixed interest securities; but clearly safety and risk aversion are now becoming more important. If NS&I were to become a "narrow bank", some modest changes would be required, such as enabling depositors to write cheques against at least some of its instruments and to be less exclusively concerned with government funding. It would also need to publicise the banking nature of its facilities. It could then become equivalent to "money under the mattress". We urgently need a more open approach than that of the City of London figures who oppose bail-outs and government support for all other industries but condemn the Bank of England for not doing secret deals to rescue threatened financial institutions.
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