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Post details: A Call for Sane Banking

A Call for Sane Banking

We have a somewhat conflicted variety of capitalism. Capital is supposed to be a surplus wealth for which its creators have no immediate use and so they set it aside and invest it in a worthy enterprise that will generate an additional income later on. But the machinations of the modern banking system and its never ending quest for liquidity are increasingly blurring the lines between the real and imaginary wealth and in the process make the tracking of capital rather difficult.

The mechanics of investing/loaning is not the rocket science. Here is an easy example. Joe has an extra $10,000 lying around, Carl has a great business idea that could multiply this $10,000 into $12,000 over the next 12 months, so Joe lends Carl the money for 12 months say at 5% interest and at the end of the year Joe collects his $500 in interest, Carl makes a nice overall profit of $1500 and everyone is happy. The problem is that in real life Joes with extra money do not have time to wait for Carls with brilliant ideas to waltz around and there arises the need for a middleman - the banking system. A banker is effectively a matchmaker who matches people with capital to people with ideas and takes a cut for this service.

But modern day finance has strayed far from that ideal. The funny monopoly money which central banks print at will these days gave investment banks an opportunity to turn the world's markets into giant casinos with little oversight or accountability. Trillions of dollars are swirling in the abstract monetary space without any backing and if there is collateral involved, you can bet that no one has any idea how much it is really worth. And I mean it - you can literally bet on it. The system got so far out of whack that the saver - the original creator of the capital - gets only a bit more than 0% interest for his or her effort these days. Who exactly profits from the capital flows and how much is an issue that has been successfully obscured by the gargantuan amount of global "money printing" effort which makes any real accounting virtually impossible.

I think that the original sin that brought about this perversity happened when bankers in the Middle Ages realized that they could lend out the deposited money many times over and unless the depositors conspired and demanded all of their money back at the same time, no one would really find out. Say you have some extra money and deposit it at a local bank which then lends it out to some Carl and collects interest on it. Some of that interest goes to you - the capital creator - and some stays with the bank as a payment for this service. So far so good. However, at some point the bankers realized that they could make another loan against this deposit and just pocket the interest themselves this time. In other words, they learned they could "print money" for their own private purposes.

Printing money is not a bad idea per se. In some instances injecting liquidity/credit into the larger economy may be just what the doctor ordered. The crucial question is, however, who really has the right to extend our money supply and - even more importantly - who is supposed to benefit from this operation? In a democratic society I would assume that the right to create money out of nothing belongs to the people themselves, although in practice this right would probably be transferred to some governmental institution, say the Treasury department.

The fractional reserve banking - which is the contemporary term for the system in which you loan our more money than you take in - is really a legalized form of counterfeiting, because bankers make no effort to share the interest collected from the "newly printed money" (which is what those unbacked subsequent loans are) with the depositors (the original providers of the capital) or with the Treasury (representing the people with whom the money printing rights should reside). And since the full reserve lending (where each dollar loaned out would be backed with a dollar deposited) may be economically too restrictive, we should look for a mechanism which would permit some money printing (to keep the economy well lubricated) but would do so so in a way that allowed for profit sharing with the depositors and the Treasury. The principle should be simple. The more often the bank loans out a given sum of money, the more profits it will have to share. This negative feedback loop itself should discourage excessive leverage (the multiple of the deposit that is being lent out) which nearly destroyed our current financial system.

So let us revisit the loan process and see how this scheme would work.

First, the recap of the actors.

Joe - the person who has capital
Carl - the person who has a business idea
Bank - which manages the loan
Treasury - which represents the people

In the present case Joe gets some interest on his mediated loan to Carl while the bank pockets all of the profits from subsequent loans. Let's suppose the interest rate for a loan (such as Carl's is 5%), the savings rate is 3% and the leverage is 10 (the bank lends any deposited money 10 times over). The profit sharing looks more or less like this:

1st loan (Joe gets 3%, the Bank gets 2%)
2nd-10th (Joe gets nothing, the Bank pockets all 5%)

Such division of spoils is conducive to higher and higher leverage and with it to riskier and riskier behavior. So what if we tried to tame this hazardous - almost gambling like - behavior by a distribution like this.

1st loan (Joe gets 3%, Bank 2%, Treasury gets nothing - no money was created)
2nd-3rd loan (Joe gets 2%, Bank gets 2%, Treasury gets 1%)
4th-5th loan (Joe gets 1%, Bank gets 3%, Treasury gets 2%)
6th-7th loan (Joe gets 0%, Bank gets 2%, Treasury gets 3%
8th-10th loan (Joe gets 0%, Bank gets 1%, Treasury gets 4%)

The above numbers are just made up, of course. They are whole for convenience. The actual interest rates would have to be finer and subject to expert discussion and/or some market mechanisms. But in this simple example you can actually do the math to see who ends up with what portion of the overall lending pie.

My point is that such a scheme would be fairer to both the creators of the capital and the taxpayers who get nothing under the current system although the money expansion is (or should be) their prerogative. Not to mention the fact that they implicitly guarantee the functionality of the banking system as a whole, so one would think they should be rewarded for it. Also note that the bank will think twice before going into very risky businesses because the higher its leverage, the more of its profits will have to be shared with the Treasury. At some point the bankers will have to conclude that the rewards are just not worth the risks, and stay away from leveraging their deposits to the point of near self destruction. Sure - they may lose some of their stellar profits, but over the course of time their profession may regain some of its lost respect.

And that is how it should be, in my humble opinion.

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