rethinking banking institutions in contemporary economies: are there alternatives to the status quo?

7/27/2019 Rethinking Banking Institutions in Contemporary Economies: Are There Alternatives to the Status Quo?

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Rethinking Banking Institutions in Contemporary Economies:

Are There Alternatives to the Status Quo?

Hassan Bougrine and Mario Seccareccia

Introduction

The theory of the monetary circuit (TMC), especially as developed and extended by

Alain Parguez over the last four decades, finds its origins in the broad post-Keynesian

theory of money as these ideas first emerged from the nineteenth-century anti-metalisttradition of the Banking School. Following the ideas of Thomas Tooke, John Fullarton

and other Banking School theorists, the TMC places the banking sector at the center-

stage of the money-supply process with banks creating endogenous credit-money (seeParguez and Seccareccia 2000). At the same time, as Hyman P. Minsky (1994) had noted,

there is a dual aspect to banking: Banking plays two roles in a modern capitalisteconomy: it supplies the means of payments and it channels resources into the capital

development of an economy (Minsky 1994, p. 1) As a byproduct of the financing ofproduction and capital accumulation but, also, as a result of banks legal status in being

able to issue their liability that would be generally accepted as means of payments,

already by the early nineteenth century the banking industry acquired a unique rolebecause its output, the communitys means of payments, could be produced ex nihilo atvirtually zero marginal resource cost.

With the nations money supply being purely demand-determined, and with thebanking industry being able to supply this private means of payments at practically zero

marginal cost, money can never be conceptualized or analyzed on the basis of the

neoclassical scarcity principle, with interest rates being determined in the moneymarket with a money demand schedule confronting a vertical money supply curve.

However, even with the rejection of the scarcity principle and the recognition that credit-

money creation is demand-determined, this does not mean that fluctuations in the supply

of credit are determined merely by simple changes in the volume of production and therate of capital accumulation. They are also affected by changes in a whole variety of

credit-worthiness considerations, which can have major consequences on the volume of

credit supplied or rationed and, therefore, on the entire macro-economy. Incommenting on the flux/reflux mechanism in the TMC, Parguez (1986) makes it quite

clear that while money is by its very nature endogenous, credit can be allocated via the

judicious use of both price and non-price criteria: The quantity of money is determined

by the desire of banks to supply credit to business enterprises. Banks can never create toomuch money! They can, however, create less than the finance demanded by businessenterprises! [authors translation] (Parguez 1986, p. 29) The experience of bank lending

during the financial crisis of 2008-9 certainly does attest to how credit restriction cansignificantly damage the real economy, as fears of insolvency and greater preference for

liquidity took hold of the financial markets (Seccareccia 2012-13).

The provision of credit-money, which would serve the traditional dual purpose offinancing production and creating the communitys means of payments at almost zero

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marginal resource cost and conferring beneficial externalities to the whole community, is

important to an understanding of the public good nature of money. If we were to apply,

therefore, some standard Pigouvian principles (pertaining to externalities) one wouldconclude that, despite its seemingly private nature, the banking sector, including the

central bank, produces what is perhaps one of the most public of public goods (because

of the tremendous externalities), in this case, by supplying an economys means ofpayments but also by supplying the credit-money advances to sustain production and

growth. Changes in what commercial banks produce, as well as changes in the costs of

what they produce, could permeate practically all economic activities. Historically, sincethe 19th Century, governments have recognized these externalities and banks were

offered a license or a charter to exploit this monetary commons by undertaking

commercial banking largely on the basis of their social role in providing the communitys

means of payments, namely bank deposits for safe-keeping.In addition, with the introduction of government deposit insurance and, more

broadly, the development of central banking, especially the all-important liquidity

provision that the central bank offers to commercial banks as lender of last resort, this

makes these producers of this public good privately-owned, yet quasi-public,institutions themselves because of the support they receive from a critical public

institution, the central bank, as dispenser of liquidity. Following Minsky who had arguedthat financial reform needs to confront the public nature of much that is private

(Minsky 1986, p. 354), Wray (2010) makes this point quite forcefully when he asserts:

Banks that receive government protection in the form of liquidity and (partial) solvencyguarantees are essentially public-private partnerships. (Wray 2010, p. 26) It is, therefore,

not surprising that, in the absence of a clear dividing line between the private and public

nature of these financial institutions, this can lead to undesirable outcomes whereby

private gains are often achieved at the expense of what eventually become socializedcosts, as experienced during the financial crisis of 2008.

The purpose of this chapter is to consider what options are available to address the

spectacular market failure that had been triggered by the dramatic institutionaltransformations preceding the financial crisis. During the last few decades, the center of

banking activity switched from the traditional sphere of financing production to the

financial sphere that fed a growing casino economy in which, as John Maynard Keyneshad already surmised in the 1930s, industry was being replaced by speculation as the

principal driving force of capitalist development. The question to which we wish to

address is: can the banking system be redesigned to meet the new challenges arising from

the financial crisis and how far can we really deviate from the status quo ante? Weconclude that perhaps the best route to follow is merely to revert back to a world where

the public ownership of a significant portion of the banking sector is the norm.

From the Early Commercial Banking Phase to the Financialized Phase of Minskys

Money Manager Capitalism

The previous quote from Minsky (1994) regarding the dual nature of banking requires,

however, a certain modification in light of the TMC. It is, of course, true that banks

(including the central bank) issue the publics means of payments appearing on the

liability side of their balance sheet (nowadays commercial banks do so through an array

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of bank deposits, electronic purses, etc., while, during the nineteenth century, it was

through the issue of their own private bank notes). On the other hand, according to the

basic model of commercial banking, banks traditionally only supported capital formationindirectly (on the asset side of their balance sheet) by advancing short-term credit for the

financing ofproduction in both the consumption- and investment-goods sectors. This was

done historically in accordance with the Real Bills doctrine, namely via the financing ofcirculating capital expenditures, even though banks did not always abide by this simple

doctrine and frequently did finance fixed-capital investments at their peril, as during the

railway boom era in the nineteenth century.This is well depicted in the standard model of the monetary circuit to be found

already in Parguez (1975), illustrated below, and which has been elsewhere described as

the model of the pre-financialization phase of capitalist development (see Seccareccia

2012-3).

Figure 1: The Logical Structure of the Monetary Circuit within the Commercial

Banking Phase

As discussed in detail in Seccareccia (1996) and Bougrine and Seccareccia (2002), theold Banking School principle that highlighted the flux/reflux mechanism is well

understood within the context of this circuitist perspective on banking. Banks first

advance the initial credit (M) to business enterprises (they also pay some interest onoutstanding deposits, as well as provide income to their bank workers, namely iMand Yb)who then spend it on generating household employment income (Yw) (with s being thepropensity to save). The portion of overall household income (Yw + iM + Yb ) that isconsumed ((1-s)Y) goes directly towards allowing firms to extinguish their debts, while

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the remainder must be obtained by firms via the floating of securities (B) in the financialmarkets to capture household saving (Sh).

This model of commercial banking depicts well the role that the State had legallybestowed on banks as creators of money through their loan/deposit making activity which

generated the initial financing of production. Saving and the long-term financing of

investment (or final finance) were brought together in the intermediation process withinthe financial markets (via the purchase/sale of stocks and bonds), but the latter played a

subordinate role in ensuring the flux/reflux mechanism. Eventually, as the financial

system evolved, commercial banking became the initial layer upon which were createdmultiple layers of banking. Once specialized institutions began to appear in the

intermediation process already by the end of the 19th Century with trust and mortgage

companies (or what generically can be termed investment banks and non-bank financial

intermediaries (NBFI)), these institutions sought actively to capture household savings inthe financial markets, thereby channeling these funds for long-term borrowing. This

system was stable as long as waves of optimism would not induce agents in these

financial markets to leverage themselves excessively, which can then implode into a debt

deflation of the type analyzed by Irving Fisher during the 1930s. When it did, as in theGreat Crash of 1929, the financial markets could bring down the whole house of cards,

including the commercial banks because of the contagion, as agents sought to becomeliquid (as highlighted by the broken line at the bottom of Figure 1), thereby preventing

the closure of the circuit as liquidity preference () rises.

Perhaps, more importantly, the system was stable as long as commercial banksthemselves would not move away from the primary supportive role of financing

production, and would not themselves play an active, and more incestuous, role in the

financial markets. A product of the Great Depression was the Glass-Steagall Act which

sought the institutional separation of commercial and investment banking exactly becauseof the dangers of this explosive mixture (Russell 2008).

During the postwar period and especially over the last few decades, there have

been important institutional developments which have made this relationship betweenbanking institutions and the financial markets ever more insidious (see Tymoigne, 2011,

and Carvalho de Rezende, 2011). The most important of these is the emergence of a more

dangerous form of securitization which, while better separating the initial issuer of a loanand the final holder, has actually led to a de facto fusion between the activities ofcommercial banks and those of the financial markets with universal banks being

involved in all the various layers of banking, thereby generating important perverse

incentives.Both Tymoigne (2011) and Lavoie (2012-13) show why securitization is not a

new phenomenon. Indeed, as Lavoie (2012-13) points out, this is analogous to a form of

liability management originating already in the nineteenth century whereby a bank wouldissue a mortgage and, instead of passively waiting as a mere deposit taker, would actively

issue securities based on the mortgage loans. In this case, however, the mortgage

remained on the asset side of the originating banks balance sheet, even though engagedin securitization on the liability side. Instead, the 1980s brand of asset securitization

became something else that was progressively quite pernicious in spawning systemic risk,

because of all the moral hazard and perverse incentives that it generated. With the

loosening of the earlier regulatory structure together with the hardening of capital

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adequacy requirements in the late 1980s, the modern form of securitization and the use of

off-balance sheet vehicles or conduits, associated with the increasing financialization of

the economy, had now to do with asset management rather than liability management(Lavoie 2012-13) 1 a financial innovation that contributed to a Minsky-style Ponzi

process in the mortgage industry (Tymoigne, 2011) about which Minsky himself showed

serious concern (Minsky 1987). As displayed in Figure 2 below, which has been adaptedfrom Durbin (2010, p. 207), the original bank mortgages appearing on the asset side of a

banks balance sheet would be sold to a special purpose entity (SPE) or vehicle (SPV).

Once off the original banks balance sheet, these pooled mortgages would then beredesigned and packaged into various tranches of mortgage-backed securities (MBS) or

collateralized debt obligations (CDO) and sold to investment banks internationally. Given

the perverse incentives generated by this new originate to distribute model of banking,

these transformed multi-product banks moved away from the traditional model ofbanking that had earlier been focused on advancing credit for productive purposes.

Figure 2: The Modern Process of Securitization

As shown in Figure 3 below, during this modern era of financialization the

banks/financial markets nexus was solidified. Especially since the 1990s, where the focus

of bank lending shifted from the business sector to the household sector, banks found it

more profitable to transform the banking process into one giant transactions machinemore interested in making commissions in the financial markets than in lending for

productive purposes. As shown by the solid lines, what moved the system forward was

household borrowing, Mh, while the business sector was becoming a net lender. Wewitnessed, therefore, a reversal of the firms/bank nexus, as the household sector became

ever more caught up in this casino-type economy and dependent on bank lending to

finance both its consumption and the speculative frenzy, especially in the housing market.

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Figure 3: Financialized Monetary Circuit with Commercial Banking and Financial

Markets Nexus

The originate to distribute model of banking created a number of perverse incentives:(1) It led to fewer commitments from commercial banks to engage in the moresocially desirable, though less lucrative, traditional activity of bank lending based on the

capacity of credit-worthy borrowers to service their debts and banks became more

attracted by the commissions that they could collect via off-balance sheet asset

securitization; even if the whole process had become in essence a kind of Ponzi scheme,as was a significant portion of the sub-prime market.

(2) It led to perverse casino-type behavior with the dices stacked so that the bankoriginating the loan could exit by selling an overpriced security. At the same time, it

could be selling Credit Default Swaps (CDSs) by betting that the borrowing agent would

not be able to meet his/her obligations.As long as there were willing customers within the shadow banking system to hold

these CDOs or Mortgage-Backed securities (MBSs), and real estate prices continued to

rise, the Ponzi system could be sustained. Once an important link in the chain broke with

the bursting of the U.S. housing market, resulting partly from the rising interest rates in2005-2006, this whole fragile system would collapse, as occurred in 2007-2008.

How Can the Banking System Be Reformed?

There have been a number of new proposals, as well as actual recently-enacted

legislation, to regulate better the financial system, the most well known being the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the U.S. The

American legislation seeks to re-regulate better the financial industry, especially by

providing less opaqueness and more transparency in the derivatives market (by separating

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trading from banking proper via the adoption of a watered-down version of the Volcker

rule), tightening regulations of credit rating agencies, and ending the too big to fail"

culture that had apparently permeated the financial sector. The central focus on the issueof size (i.e., the too big to fail) and insufficient concern with deeper structural issues

having even more profound detrimental externalities that would have necessitated more

radical proposals, could very well insure the repeat of another banking and financial crisis(see comments especially by James K. Galbraith at the Levy Economics Institute (2011)).

Nothing in the Dodd-Frank Act, or some of the proposed legislated changes in

Europe, have attempted to revamp seriously the structure of financial markets andbanking incentives so that banks would return to their primary supportive role of the pre-

financialization era. This is because policymakers internationally all accept the same

neoclassical belief in the importance of a free market in financial instruments. As

Tropeano (2011) notes:The inspiring idea [behind these current reforms] is that financial innovation

must be encouraged because it increases consumers welfare and, by summing

across all individuals, the whole of societys welfare. All the effort is concentrated

in redesigning the regulatory and supervisory tools to deal with the whole rangeof new products and to be able to more accurately measure the risks arising from

them than was done in the past. (Tropeano 2011, p. 45)Hence, the primary purpose is not to question the current structure as depicted in Figures

2 and 3 above, but merely to see how the existing structure can be made to work better so

that some of the problems of moral hazard are sufficiently dealt with via some minorcorrective measures, such as the concern over the issue of too big to fail. This is why

these recent changes in the regulatory structure will not solve the underlying problems

that led to the crisis. Indeed, an obvious example of why, for instance, the focus on too

big to fail is not as critical as it has been made out to be by some policy makers, is tolook merely at the experience with Canadian banking during the financial crisis. The

major Canadian banks are relatively large and the Canadian banking sector is also highly

oligopolistic with many of these banks being within the top ten of North Americanranking (by asset size). Yet, Canada neither experienced a serious subprime crisis nor did

it require major outright bailouts as both American and European banks did (see Correa

and Seccareccia 2009; and Seccareccia, 2012-13), even though Canadian banks didobtain a high degree of government support as well (Macdonald 2012). Moreover, as

Kregel (2012a, p. 3) points out, the breaking up of large, complex financial

conglomerates would not lead to more effective regulation simply by creating a large

number of small financial institutions engaged in the same complex activities. Theproblem is not the size of these financial holding companies; it is primarily the nature of

these complex activities that needs to be regulated.

Among heterodox economists, there are at least three proposals that have been putforth in recent years:

(1) The across-the-board abolition of what Lavoie (2012-13) refers to as the

modern form of securitization;(2) Narrow banking (or 100% money) as first proposed by Chicago economists

in the 1930s and its modern variants;

(3) Public ownership of banking institutions and their treatment as public utilities.

Let us briefly look at these one by one.

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(i) Ban Securitization Banking Policy

There has been much discussion among heterodox economists historically even before

the financial crisis that supported some re-regulation of the banking sector. However,

prior to the financial crisis, much of the discussion in the United States was to considerretaining some variant of the Glass-Steagall features in a post-Glass-Steagall world and

opposition to universal banking (Minsky 1995). Some of the discussion pointed also to

reconsider creating a reserve system that focuses on the asset side of banks balance sheetand not the liability side so as to better control credit allocation. For instance, over the

last decade, Palley (2000, 2004) and DArista (2009) have favored some system of asset-

based reserve requirements as a way of chocking off speculative bubbles that are often at

the origin of financial crises. While such ideas have circulated, the latter proposal seemsto succumb to some of the same criticism going back to Moore (1988) that drew attention

to the ineffectiveness of reserve requirements, in this case on the liability side, because

they can be easily circumvented. Why would regulating the asset side be any different in

being able to circumvent such regulations, especially since reserves are fungible and anyreserves allocated for a specific purpose cannot be isolated in banks balance sheets

(Toporowski 2007)? Moreover, some would argue that, when off-balance sheet activitieshave become ever more prevalent, an approach to banking regulation that focuses on

imposing reserve requirements on the asset side of the balance sheet may seem to be

somewhat off the mark, since the problem is not only what remains on the asset side of acommercial banks balance sheet but also what has been removed via securitization.

Because of this latter concern, some have pointed to the need for dealing with

what has been the most disruptive of these developments that precipitated the subprime

crisis and, eventually, the 2008 financial crisis the new form of securitization thatbecame popular over the last two decades. While there are a number of heterodox

economists who would like to see the abolition of this perverse form of securitization

with a return to a more restricted system of originate and hold banking, that is, astraight hold to maturity approach to banking (Auerback, 2009), no one has perhaps

been as clear and articulate on this policy as Warren Mosler (2012). Much of the shadow

banking associated with the so-called deepening of the financial markets and theirflooding with ever more exotic financial derivatives (as shown in Figure 3 above) and

with the FIRA sector reaching ever new heights as an unproductive share of GDP, can

perhaps be easily reined in via a number of key legislative changes that would remove

this harmful, yet lucrative, form of securitization. The purpose would be to bring undercontrol the casino instincts rampant in the financial markets. Instead of seeking to provide

stability by regulating the liability side of the banking system, as had happened

historically since the 19th Century, Mosler has argued in favor of regulating the assetside, by defining more precisely the assets that ought to be heldby the banks once loans

are issued, including possibly the minimum capital requirements, and by preventing them

from being sold off in the financial markets, thereby removing them from bank balancesheets. The objective would be to ban the new form of securitization which was at the

heart of the crisis in 2007-2009.

The Mosler proposal can be reduced to the following policy directives, which we

hereby paraphrase:

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1. Banks should only be permitted to lend directly to borrowers and to keep their loans in

their balance sheets. Banks should not be engaged in any secondary market activity by

selling loans and other financial assets to a third party.2. Domestic banks should not be allowed to contract in LIBOR (this pertains to

controlling the cost of credit financing domestically).

3. Banks should not be allowed to hold any assets off balance sheets, which wouldmean no ownership of subsidiaries, namely in the form of special purpose vehicles

(SPVs).

4. Banks should not be allowed to accept financial assets as collateral for loans.5. No offshore lending.

6. Banks should not be allowed to buy/sell credit default insurance (CDSs).

7. Banks should not be allowed to engage in proprietary trading or any profit lending

beyond basic lending.8. Banks should provide loans on the basis of good underwriting via credit analysis rather

than market evaluation and the authorities should prohibit mark to market of bank assets.

Mosler (2012, pp. 54-56)

Although not all pertain to securitization, most of these rules are easilyunderstood in a common sense way so as to remove perverse incentives that have plagued

the financial sector. Indeed, they have been discussed a great deal in the literature, sincethey pertain to many aspects of bank behavior and not merely to the issue of

securitization per se, especially points 1, 4, 5, and 8. For instance, the first of these

proposals is by far the most important since securitization is all about the creation of asecondary market for bank loans via collateral debt obligations (CDOs); while the sixth

proposal seeks to remove some of the moral hazard problems that are associated with the

selling of CDSs.

However, an important problem with these proposals is that they rest heavily onthe ability of regulators in their supervisory role to detect and remove altogether these

illicit activities. Indeed, in addition to the perennial problem of circumventing

innovations, to which we already referred when discussing asset-based reserverequirements, there are no incentive systems within the private banking sector itself that

would work to enforce these regulations as, perhaps, might be the case with a publicly-

owned institution that would be accountable to parliament or the government and whosejob of the bank administrator would depend on enforcing those regulations a standard

principal-agent problem. Even mainstream economists would recognize that there are at

least three main forms of market failure in the area of finance: (i) the problem of

information asymmetry which the prohibition of asset securitization would only partlysucceed in dealing with; (ii) the problem of systemic risk arising from the existence of

externalities or spillover effects, which, once again, the elimination of securitization

would not fully remove, and (iii) the problem of fraud epidemics, which, as WilliamBlack (2005) has recognized, does not pertain only to the securitization process but

permeates all aspects of financial activities. For these reasons, some have pointed to the

need for greater structural measures to prevent another financial crisis.

Narrow Banking: Varieties of Options to Reduce the Elasticity of the Monetary

System

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While attempts to restrict bank behavior, as with the Mosler proposal, which can be seen

as a process of narrowing the scope of banking operations, under the portmanteau term

narrow banking, one finds a number of distinct plans whose objective is not alwaysclear but which has a long history going back to the 1930s original Chicago Plan of the

New Deal era, by regulating through the liability side of banks balance sheets. The

original 100% money plan going back to Irving Fisher and Henry Simons was, in asense, an attempt to stand on its head the standard commercial banking model as

described in the traditional theory of the monetary circuit. Based on a neoclassical

assessment of the causes of the crisis and the ensuing debt deflation (resulting fromexcessive private spending in relation to savings), these writers had concluded that what

was necessary was to ensure that the economy ought to behave much as it would under an

ideal pure commodity money system in which banks would be reduced to the role of pure

financial intermediation. The essence of the Fisher plan was to break the link betweenmoney and credit advances, which was the by-product of fractional reserve banking and

hence to divorce the process of creating and destroying money from the business of

banking (Fisher 1935, p. xvii), all in an attempt to restore the conservative safety-

deposit system of the old goldsmiths, before they began lending out improperly what wasentrusted to them for safe-keeping. (Fisher 1935, p. 18).

The Fisher plan sought to restore the traditional neoclassical mechanism bypreventing commercial banks from financing the flow of production in excess of business

revenues, thereby preventing banks from creating money, by legislating 100% reserve

requirements, or what may be dubbed nationalizing money (Seccareccia 1994). Theplan may well have prevented banks from engaging in excessive leveraging and thus

avoiding bank failures as a result of the debt deflation; however, the plan would also have

prevented commercial banks from performing their normal function in creating ex nihilocredit-money to sustain production and growth. Banks would become pure financialintermediaries between borrowers and lenders. Unless there is deficit spending by the

state (as even recognized by Friedman (1960), a system of full reserve banking would be

stuck in a world in which, at best, only zero growth could be achieved.Moreover, already during the 1930s, a number of mainstream writers, such as Lin

(1937) and Hayek (1937), questioned the efficacy of a policy that rested on controls of

the liability side of the banks. The question was: a 100% of which deposits? For instance,Hayeks (1937) critique may well be worth quoting in extenso:

The most serious question which it raises is whether by abolishing deposit

banking as we know it we would effectively prevent the principle on which it

rests from manifesting itself in other forms. the question is whether, when weprevent it from appearing in its traditional form, we will not just drive it into other

and less easily controllable forms. Historical precedent rather suggests that we

must be wary in this respect. The Act of 1844 was designed to control what thenseemed to be the only important substitute for gold as a widely used medium of

exchange and yet failed completely in its intention because of the rapid growth of

bank deposits. Is it not possible that if similar restrictions to those placed on banknotes were now placed on the expansion of bank deposits, new forms of money

substitutes would rapidly spring up or existing ones would assume increasing

importance? And can we even to-day draw a sharp line between what is money

and what is not? Are there not already all sorts of near-moneys like saving

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deposits, overdraft facilities, bills of exchange, etc., which satisfy at any rate the

demand for liquid reserves nearly as well as money? Hayeks (1937, pp. 82-3)

In part, perhaps, because of these types of criticisms, the Chicago Plan had beenrejected by the U.S. Congress in 1935 and to this day there are few examples of full

reserve commercial banking. On the other hand, some of the current proposals in favor of

narrow banking do find their origins in the New Deal discussions over both the 100%reserve requirements and Glass-Steagall separation of banking activities, but, not at all

along the same lines as the original New Deal Act. As emphasized by some of its

contemporary supporters, such as John Kay (2009), narrow banking would protect thenon financial sector from the instabilities in the financial sector by insulating the

commercial banking sector from the consequences of the casino behavior of the

investment banking sector. Indeed, groups such as the American Monetary Institute in

the U.S. and the Committee on Monetary and Economic Reform in Canada still subscribelargely to the original Fisher plan. However, the list is quite long both among mainstream

and heterodox economists in support of hybrid versions of this banking proposal. In

addition to Maurice Allais and Milton Friedman, numerous variants of this basic model

of narrow banking have been proposed over the last quarter century by James Tobin(1987), Robert Litan (1987), Ronnie Phillips (1992, 1995a), and more recently by such

disparate economists as Paul de Grauwe (2009) and John Kay (2009). As Kregel (2012a,2012b) points out, even Hyman P. Minsky once dabbled with it, perhaps under the

influence of Ronnie Phillips at the Jerome Levy Economics Institute, even though he

eventually abandoned it (see Phillips 1995b, p. 171; Kregel 2012b, pp. 5-6).There are a variety of hybrid models of narrow banking that do not go as far as

the original 100% reserve requirements that seek to create a subset of the financial sector

that would be prevented from engaging in credit creation and thereby leading to the

socialization of the transactions and payments side of the banking system and ensuringthat the latter functions as a public utility. For instance, Kay (2009) proposed what he

describes as a new Glass-Steagall with two types of banking institutions. The narrow

banks would be focused on providing two key services to the non-financial sector,namely the payment systems and deposit taking. Hence, only narrow banks would be

allowed to specialize in these services by taking deposits from the public (including

qualifying for deposit protection) and accessing the payments systems. Moreover, theywould be strictly regulated on the asset side. The proposals in place differ as to degree to

which these banks would be permitted to engage in lending. Some, who would like to see

the system much closer to the 1930s 100% reserves, would permit only the holding of

low risk type of securities, such as government securities, and therefore would not belending, while other proposals would permit some degree of lending, by obtaining the

money from suppliers of wholesale funds (Kay 2009, p. 52). Clearly, if allowed, they

would not be holding a monopoly of bank lending, since the other investment banks andfinancial institutions would be engaged in providing lending for capital formation. The

tradeoff for the depositors would be that the lower interest returns on their deposits would

be compensated by lower risk of loss because of the reduced threat of bank insolvency. Itis argued that, by separating the deposit and lending activities, a greater element of

stability throughout the financial system would be ensured and the casino features of

highly leveraged institutions on the lending side would not be able to do serious damages

to the narrow banks.

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A number of writers have found such proposals strongly appealing since they do

appear to address an important concern pertaining to the need for stability in the financial

system. However, circuitist economists would feel somewhat uncomfortable with theconsequences of these proposed institutional transformations of the banking system. First,

as also emphasized by Kregel (2012b), these proposals contradict the very essence of the

Post-Keynesian and circuitist conception of banks as creators of money through theircredit expansion. By preventing this credit creation process altogether (as with the 100%

reserve requirement) or by severely circumscribing their domain (as with narrow

banking), the elasticity of supply of the banking system to meet the public demand forcredit would either decline sharply or fall to zero, as in the extreme case of 100% reserve

requirements. Indeed, in commenting on Minskys view on narrow banking, Wray (2010)

points out that, although not categorically rejecting narrow banking, Minsky simply

believed it addresses only a peripheral problem, safety and soundness of the paymentsand savings systems. It does not address promotion of the capital development of the

economy. Wray (2010: 28) Indeed, on the Minskian criteria of the twin role of banks, as

Kregel (2012b) affirms: A narrow bank on this definition is not a bank, but simply a safe

house or piggy bank for government issue of coins and currency. Kregel (2012b, p. 7)Secondly, the purpose of most of these proposals in support of narrow banking is

that they would set-up deposit-taking safe banks (such as the quintessential post-officesavings bank) that would eliminate losses on deposits and prevent bank runs, as during

the 1930s. However, the problem faced during the financial crisis was not one of deposit

losses. In fact, an institution like Lehman was not even involved in retail banking and,yet, its failure practically brought down the whole banking system. The problem was the

domino effect arising from the loss of confidence within the banking system triggered by

the widespread holding of securitized toxic assets. Thirdly, as pointed out by Goodhart

(2009), the boundary problem between the narrow banks and the other lending bankscould actually accentuate pro-cyclical movements rather than mitigate them. Goodhart

(2009) writes:

So, during normal conditions there will be an incentive for savers and depositorsto put their money with the unprotected, but higher yielding, institutions beyond

the boundary. Of course, when there is a crisis the savers and depositors who

shifted towards the higher-yielding institutions will come rushing back either tocash or to the protected sector. But that will worsen the pro-cyclicality of the

whole system by encouraging pro-cyclical fluctuations across the boundary as the

economy moves from good times to bad. (Goodhart 2009, p. 2)

Hence, while the narrow banking proposal does address some of the concerns notpresently addressed within the current system of universal banks, many on the Post-

Keynesian and circuitist camp would feel somewhat uneasy with this proposal, much as

Minsky did.

From Nationalizing Money to Nationalizing Commercial Banks

It is often argued that, if the banking sector is in fact characterized by such significant

externalities and ought to be run as a public utility, it ought also to be owned by the

government, as is often the case in certain strategic industries, such as electricity, water

and sewage systems, and public transport. Moreover, as certain circuitist writers have

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argued, unlike the non-financial business sector, the banking sector as a whole is not

really constrained by the amount of capital that it owns to conduct the business of

banking. In contrast to the Basil Accords, if banking can be properly performedregardless of the paid-up capital, then why should banks be private for-profit capitalistic

firms run on the basis of an incentive system that is inappropriate to that industry (see

Vallageas 2012)?One of the widely used arguments by neoclassical economists and advocates of

free markets is that government ownership of enterprises is politically motivated,

inefficient and inevitably results in slower economic growth. In most countries, thisserved as a justification for a major wave of deregulation of markets and privatization of

public enterprises that began in the 1970s. As is well known, the liberalization policies

that ensued targeted all sectors of the economy, including the financial sector (see Figure

4). It was argued that financial liberalization would bring about a more efficient andcompetitive banking system, which in turn will promote growth and development.

In a study from a decade ago using cross-country regressions based on data from

92 countries, La Porta, Lopez-de-Silanes, and Shleifer (2002) concluded:

First, government ownership of banks is large and pervasive around the worldeven in the 1990s. Second, such ownership is larger in countries with low levels

of per capita income, underdeveloped financial systems, interventionist andinefficient governments, and poor protection of property rights. Third,

government ownership of banks in 1970 is associated with slower subsequent

financial development. Finally, government ownership of banks is associated withlower subsequent growth of per capita income, and in particular with lower

productivity growth . . . These negative associations are not weaker in the less

developed countries. (La Porta, Lopez-de-Silanes, and Shleifer, 2002, p. 290)

In other words, the authors claim that government ownership of banks appears to be theculprit and cause of the major ills modern economies have suffered. Their policy

recommendations are obvious: financial and economic development, particularly in poor

countries, requires the elimination of government ownership of banks, furtherprivatization, and more deregulation.

The available data between 1970 and 2005 indicate that these recommendations

have been taken literally and implemented rigorously in most countries. As can be seen inFigure 4, from 1970 to 1995, privatization of public banks occurred in every country in

our sample with the exception of Ireland, the Netherlands and Sweden. By 1995, public

banks as defined in the data were completely eliminated in four of the G-7 countries

(Canada, Japan, UK and US). Some of the other drastic reductions of government-ownedbanks during this period took place in Russia, which underwent the shock therapy

program of fast-track privatization thus lowering the governments share from 100 to

just over 30%. Interestingly, the same trend occurred in France (from nearly 75% to17%), Italy (from 75% to 35%), and Portugal (from 100% to 25%).

In their assessment of the macroeconomic effects of the banking-sector

liberalization during this period, Goodhart et al. (2004, p. 592) argued that therelationship between liberalization and a subsequent asset price boombust has been a

common phenomenon, common to Western as well as Asian countries, in developed as

well as developing countries, and that financial liberalization appears to have

strengthened the financial accelerator mechanism by increasing the sensitivity of bank

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lending to property price fluctuations adding that . . . the result was a danger of a

boombust cycle . . . [and that] . . . this became the experience in Scandinavia in the early

1990s, Japan in the 1990s, and much of East Asia in 1997/8; much the same syndromemay await India and China when they eventually liberalize. (Goodhart et al. 2004, p.

594).

Figure 4

Government ownership of banks: Share of the assets of the top 10 banks owned or

controlled by the government

Source: La Porta et al., 2002. GB70 and GB95 refer to governments share in the top 10 banks in 1970 and1995, respectively.

In spite of these results, the trend toward more liberalization continued during the

period 1995-2005, as shown in Figure 5. The data in Figure 5 refer to the share of assetsin banks that are 50% or more government-owned and therefore are not directlycomparable with data from Figure 4. However, using this somewhat different definition

of government ownership, we note that with the exceptions of Germany and Portugal,

government ownership was reduced dramatically everywhere or completely eliminated.The most dramatic changes during this period occurred in Greece, Iceland and Norway

where government ownership of banks was eliminated by 2005 whereas in 1995 it was as

high as 84%, 71.3% and 62.4%, respectively. Although no data are available after 2005,we know that this trend of privatizing public banks has continued in most countries

throughout the rest of the decade and certainly up until the beginning of the worldwide

financial crisis that began in 2007-8. In fact, the crisis coincided with the climax of

financial deregulation and privatization in the banking sector.Figure 5

Government ownership of banks: Share of assets in banks that are

50% or more government owned

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Source: The World Bank data (WB 2005) are for the year 2005 and are available from

http://econ.worldbank.org/, data for 1995 (LaPorta 95) are taken from La Porta et al., 2002.It is important to note that the current crisis prompted several governments to

bailout some failing banks and other financial institutions, usually by wholly acquiring orby purchasing a large share of assets in these corporations, which increased government

ownership of banks in several countries. Indeed, Hau and Thum (2009) found that [a]s a

consequence of recent government sponsored bank recapitalization plans, state ownershipin banks is likely to experience a dramatic increase. Even countries like the US and the

UK, where state ownership in banks was never important, now feature a partially state-

owned banking sector. Hau and Thum (2009, p. 704) Nationalization and other bailouttransactions in time of crisis explain the relative rise in public banks in Germany, for

instance, as can be seen in Figure 5.

However, after experimenting with financial liberalization for almost half acentury, it is now widely accepted that the global financial system has become moreunstable and bank failures more frequent so that, as a result, banks have not always

served the economy as well as the proponents of liberalization had argued. According to

various accounts, the latest global financial crisis was the worst since the GreatDepression because it shook the very foundations of the capitalist system. Indeed, as the

crisis worsened, governments around the world injected massive sums of money to bail

out or to purchase some failing private enterprises, including banks. The latter action isclearly contrary to the fast-track privatization that has been going on since the 1970s.

This raises important questions: Is public banking a viable alternative to private banking?

Can public banks be made more efficient? And can they serve the public interest better?

As we have argued previously, in the circuit theory (Parguez, 1996) it is impossible forfirms to carry out their production plans unless they receive financing from banks in the

form of liquidity advances. Banks therefore play the central role in promoting and

sustaining economic activity. The primary function of banks is to finance productiveactivity, which creates jobs and contributes to the well-being of citizens. A priori, it does

not matter whether these banks are private or public institutions as long as the credit

flow is running smoothly and credit is not arbitrarily withheld to create artificial scarcity.

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The artificial scarcity of (credit) capital is something that had in fact preoccupied

Keynes already in the 1930s. Indeed, Keynes (1936, p. 376) noted that [t]he owner of

capital can obtain interest because capital is scarce just as the owner of land can obtainrent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of

land, there are no intrinsic reasons for the scarcity of capital. One of Keynes concerns

was to eliminate the cumulative oppressive power of the capitalist to exploit thescarcity-value of capital. Keynes (1936, pp. 375-376) believed that . . . it will still be

possible for communal saving through the agency of the State to be maintained at a level

which will allow the growth of capital up to the point where it ceases to be scarce..However, in order to achieve this objective and . . . on the basis of the general social

advantage, Keynes expected to see the State ... taking an ever greater responsibility for

directly organizing investment ... (Keynes 1936, p. 164) because the duty of ordering

the current volume of investment cannot safely be left in private hands (Keynes 1936, p.320).

Given that a government-owned bank does not have to be motivated by profit-

making, we expect public banks to be different from private banks in their lending

behaviour. Moreover, public banks should be and often are created with the specificmandate that they must support the local economy, particularly during a slowdown or arecession. The overriding objective of a public bank and indeed its very raison dtre should be to serve local businesses and households by advancing credit and not to engage

in the high stakes derivatives market as occurred prior to the financial crisis. In fact, this

restriction should also apply and much more so to a private bank because, as wasdiscussed earlier, when banks start acting as intermediaries between their customers and

complex financial markets, they lose their primary function as substitutes andbecomesimple complementary institutions to these markets. This shift marked the evolution ofbanking toward what Minsky (1992) referred to as the money manager phase ofcapitalism and is considered as the source of financial instability (Wray, 2011). It can

therefore be legitimately argued that, the presence of public banks can actually contribute

to improving the efficiency of credit markets.In most developed countries, publicbanks have traditionally been a major source

of funding for small businesses, infrastructure development, housing construction, and

other investments for social purposes. For example, since the end of the Second WorldWar, Germany developed (and maintained up until now) a large system of public banks

to finance the re-building of its economy. These banks acted as universal banks in the

sense that they provided short-term lending as well as financing for long-term

investment. Mattey (2010) reports that according to legislation in Germany local publicbanks (Sparkassen) are obliged to ensure an appropriate and sufficient provision ofmoney and loans to all parts of the population and especially to small and medium-sized

enterprises (emphasis added). Mattey (2010, p. 45)Indeed, data from the German loan market indicate that . . . a relatively higher

share of firms with a low (self-reported) degree of creditworthiness, i.e. risky firms,

borrow from public banks (73%) than from private banks (19%). For firms with a highdegree of creditworthiness, i.e. safe firms, the difference is less pronounced (51% vs.30%) (Mattey 2010, p. 46). For this reason, in its annual consumer survey in 16

European countries, Readers Digest (2011) reported that the most trusted banks byEuropeans (Europe-Wide Winners) during the period 2007-2011 were government-

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owned banks, cooperative banks, and credit unions. From this perspective, public banks

are performing a critical and indeed vital social function, much like public utilities,

and therefore their profitability should cause less concern for policymakers. The primarygoal of a bank should not be the focus on profit but the support of socially useful

initiatives and activities that generate a benefit for the whole community. These are the

essential elements of what can be called the portrait of an ideal bank.However, some writers have claimed that during the recent crises, state-owned

banks have suffered disproportionately higher losses in comparison to private banks and

attributed this poor performance to problems of inefficiency and incompetence of theirboard members (Hau and Thum, 2009). Others emphasized the presence of moral hazard

due to State guarantees1 and expected government bailout (Mishkin, 2006). These are

misleading and unfounded statements. For instance, the crucial variable in the study by

Hau and Thum (i.e., bank losses) is based on self-reported losses, which is problematicbecause as Tenreyro (2009) argued privately owned banks have a bigger incentive to

hide losses (temporarily at least) in the hope of better performance in the near future

and that not all banks use the same accounting method . . . A group of banks in the

sample [in Hau and Thums study] used market-value accounting; another usedhistorical-value accounting, and yet a third group ... switched from market- to historical-

value accounting in the midst of the crisis. Tenreyro (2009, p. 744)Moreover, there is no clear evidence to support the claim that public banks are

less efficient than private banks. In fact, a recent study of the Russian banking system by

Karas et al. (2010, p. 213) found that public banks are more efficient than private banks2.Chen et al. (2005) found that in China state-owned commercial banks are more efficient

that joint-stock commercial banks. Using data from 17 European transition economies,

Grigorian and Manole (2006) concluded that privatization of banks does not lead to

increased efficiency. A similar result was found by Bonin et al. (2005) who studied thesame issue in 11 transition economies and found that government-owned banks are not

significantly less efficient than domestic private banks. Bonin et al. (2005) added that

we find no discernible evidence that government ownership makes a difference to profitefficiency relative to private domestic ownership Bonin et al. (2005, p. 48). This is

further supported by Micco et al. (2007) who used a large dataset covering 179 countries.

The dataset was revised to focus on commercial banks during the period 1995-2002. Theresults of this study are interesting because while they support the idea that in

developing countries public banks are less profitable than private banks, the evidence is

not as clear in developed countries. Indeed, Micco et al. (2007) reported that When we

look at industrial countries, we find no statistically significant difference between theROA [return on assets] of public banks and that of similar private banks. (Micco et al.

2007, p. 227) Commenting on the difference in performance between public banks in

developing and industrial countries, Micco et al. (2007) concluded by saying that An

1There was a widespread argument that these state guarantees tend to distort competition in favor of publicbanks so in 2001 the European Commission took legal action against government-owned banks in

Germany, which lost their state guarantees following the EU decision in 2005.2Karas et al. (2010, p. 214) make it clear that their results are for the period after the 1998 crisis andemphasize the fact that At present, the vast majority of Russian banks are not burdened by lingering

Soviet deficiencies. Most private banks are de novo banks, as the privatized spetsbanki faltered in theperiod 19921999. Most public banks are also de novo. They were created after the collapse of the SovietUnion by government bodies such as state enterprises, cities and federal, regional or local governments.

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alternative interpretation is that in industrial countries public banks have ceased to play a

development role and merely mimic the behavior of private banks, whereas in developing

countries public banks still play a development role and their low profitability is due tothe fact that, rather than maximizing profits, they respond to a social mandate. (Micco et

al. 2007, p. 227)

Indeed, the difference in mandate is another reason why we should be doubtfulabout the supposed underperformance of government-owned banks. As mentioned above,

public banks are obliged to assist local businesses and contribute to other socially

beneficial expenditures, which are not directly profitable. In fact, if we compare themission statements of one public bank (Bayerische Landesbank) to a private bank

(Deutsche Bank) from the sample used by Hau and Thum (2009), heres what we find:The mission of Bayerische Landesbank is improving the welfare of society at large. The

Group is committed to furthering public causes in various ways from promoting the

economy through donations to charitable organizations, to actively protecting the

environment, and to fostering the arts, culture and sciences...

Deutsche Banks Mission: We compete to be the leading global provider of financial

solutions for demanding clients, creating exceptional value for our shareholders and

people. Identity: Deutsche Bank is a leading global investment bank with a strong andprofitable private clients franchise. Its businesses are mutually reinforcing. (quoted in

Tenreyro, 2009, p. 45)

The difference in mandate should not be underestimated or ignored: by definition public

banks have the obligation to assist low profitability projects as well as borrowers in

financial distress. As evidenced by the current crisis, excessive risk-taking (over-investment in subprime and other risky securities) was prevalent in private financial

institutions, perhaps under the pressure of greedy private shareholders and competent but

equally greedy managers who were motivated by pecuniary incentives to generate higherinvestment returns. This was particularly true in the case of too-big to-fail institutionswhere moral hazard behaviour is so common because of the absence of close supervision,

government regulation or even monitoring by shareholders. It was therefore thecompetence and perhaps even expert knowledge of managers in private institutions andtheir familiarity with new and complex financial instruments that led them to be more

audacious about taking higher risks whereas public banks were somewhat more

conservative. This explains why the current crisis originated in some of the biggestprivate financial institutions in the World and not in public banks whose losses were infact the result of the failure of these private institutions.

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rethinking banking institutions in contemporary economies: are there alternatives to the status quo?

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