European Banking Union Problems Due To Nature Of Fractional Reserve Banking

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2. A hierarchy of loss-absorbing bank liabilities: Once we have established reserve-backed deposits as safe assets, all other bank liabilities would of course be risky. We can now define a hierarchy of loss absorption in a bank resolution regime. The first loss would of course be borne by the equity tranche on the liability side of banks’ balance sheets. After having set aside assets pledged to cover secured debt (e.g., covered bonds), the second and third losses would be borne by junior and senior unsecured bank debt. The fourth and last loss would accrue to deposits uncovered by central bank reserves. When all bank liabilities except deposits fully covered by central bank reserves contribute to cover losses on bank assets, taxpayer-funded bank bailouts would eventually become unnecessary.

3. Divest banks from governments by revised regulations for government debt: To be able to fund their assets at reasonable costs, banks would need to have a well diversified and reasonably liquid portfolio of assets. Most importantly, they would have to reduce their exposure to government debt to a level consistent with this debt being subject to default risk. To allow banks to divest from government debt, the European Central Bank could buy in a one-off operation the government bonds that banks have pledged to the central bank as collateral for obtaining central bank credit. As a result of this operation, risky claims of the banks on governments would be replaced by risk-free claims of the banks on the ECB or, in other words, by central bank reserves.

Deposits earlier created by fractional reserve banking could be “insured” by the central bank money acquired by banks from the sale of their government bond holdings to the central bank that are necessary to reduce their exposure to government debt. In the future, banks in need of central bank reserves could borrow the necessary amount from the central bank and keep it on deposit with the central bank.

The cost of safe deposits for the banks would be determined by the difference between the lending rate for central bank reserves and the deposit rate for central bank money. The cost for the bank customer would be determined by the net cost of central bank funds for the banks and the banks’ operating costs for the insured deposits. The benefit for the customer would be to have a safe asset other than only central bank notes, and the ability to use this asset to make non-cash payments. A quantitative limit for safe deposits would not be necessary as the central bank could adjust the supply of reserves to the demand for safe deposits. But the central bank could influence the demand for safe deposits by changing the variable costs, which are given by the difference between the cost of central bank reserves and the rate that the central bank pays on deposits.

This could be used for stabilisation policy: By influencing the demand for safe deposits relative to other deposits, the ECB would also influence credit extension by the banks. Assume that customers switch from Investor Deposits to Safe Deposits. If the ECB kept the supply of central bank reserves constant, banks would need to reduce credit to free funds for deposit with the ECB as cover for the additional Safe Deposits. Credit to the non-bank sector would go down, and the credit multiplier, defined as credit relative to central bank money, would fall.

Alternatively, if the ECB wanted to accommodate the switch and keep credit to the non-bank sector constant, they could increase the supply by central bank reserves to meet the additional demand. Still the credit multiplier would decline, albeit by less than before, because the central bank money stock would increase. Finally, if the ECB wanted the credit multiplier to remain constant, they could raise the alternative costs of holding Safe Deposits by lowering the deposit rate.

The reduction of the deposit rate needed to achieve the target level of Safe Deposits could be determined in a reverse refinancing operation, where banks submit bids for the deposit rate they are willing to accept (or pay when the deposit rate is negative).

What Could Banking Union Do?

To help banks divest from government bonds the central bank initially acquires these bonds. Since it is doubtful that all highly indebted euro area countries could repay their debt, governments and the ECB could agree that all income from seigniorage would be used to cancel the government debt held by the ECB in a special account. Since the present discounted value of seigniorage can be very large, reaching several trillion euros in the case of the euro area, depending on interest rates on central bank credit and the growth rate of non-interest-bearing central bank money, it seems likely that this would be sufficient to eventually retire the government debt acquired by the ECB from the banks. Moreover, since a significant part of the government bonds acquired by the ECB from banks would have fairly short maturities, the position of the ECB could be reduced by simply letting the bonds run down.

Table 1 shows the structure of banks’ balance sheets after the introduction of safe deposits. Abstracting from assets earmarked for covered bonds, banks would have central bank reserves and credit on the asset side of the balance sheet, as before. However, central bank reserves would be tied to cover Safe Deposits on the liability side of the balance sheet. All other liabilities would participate in loss absorption in a clearly defined hierarchy, with equity providing the first layer and Investor Deposits (not covered to 100% by central bank reserves) the last.

Given our definition of a Safe Deposit, it corresponds to present sight deposits. In April 2013, sight deposits in the euro area amounted to EUR4,4trn, representing about 38% of total deposits or 44% of GDP. Since customers would probably not choose to have all sight deposits in the form of Safe Deposits this would represent an upper boundary to the level of Safe Deposits.

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