Making the Reserve Bank a “people’s bank”
As the financial crisis continued wreaking its havoc in late 2010, Mervyn King, who, as governor of the Bank of England, sat at the apex of the banking system, made this observation: “Of all the many ways of organising banking, the worst is the one we have today.”
He was speaking of “fractional reserve banking”, the pea-and-thimble trick by which banks accept your deposits and assure you of access to them at all times while they’re actually lent out to others for lengthy periods.
This alchemy works so long as depositors don’t all withdraw their money at once. If they do, governments bail out banks. The alternative – the entire banking system seizing up and with it the commercial life by which we earn our daily bread – is too horrible to contemplate.
Greens leader Richard Di Natale recently floated the idea of a “people’s bank”. In the absence of further detail, pundits assume he means something like New Zealand’s government-owned Kiwibank. Adding another competitor to the four major and many minor banks in our market might win some applause on Q&A, but it doesn’t even try to address the structural problems of banking to which King referred.
In fact, we already have a “people’s bank”. Rethinking it for the internet age, using nothing more radical than the principle of competitive neutrality, could address King’s concerns while putting thousands of dollars each year into the pockets of most Australian households and into the economy.
Let me explain.
As much as your bank presents itself as the essence of market competition, it’s actually part of a public–private partnership. The central bank – in this country, the Reserve Bank of Australia – sits at the top of the banking system and provides two critical services.
First, banks have what’s called an “exchange settlement account” with the Reserve Bank. If you want to pay me, by writing a cheque or paying online, you get your bank to pay mine, which is done through their respective exchange settlement accounts.
Second, if a bank run threatens, the Reserve Bank becomes “lender of last resort”, lending any solvent bank all the money it needs until it can call in its loans.
The central bank is essentially the wholesaler of basic banking services with the commercial banks we use – such as NAB and Westpac – retailing those services to all.
Now, one industry after another is being disrupted as wholesalers offer their services directly to customers in competition with their own retailers. You can still buy plane tickets from travel agents or newspapers from newsagents, but you can also buy them online, direct from the wholesalers – airlines and newspaper publishers respectively.
Right now the Reserve Bank could provide us all with cheap, basic “exchange settlement accounts” enabling us to make payments to each other as we do today using our banks’ online facilities. It would be faster – instant, instead of 24 hours or more – cheaper and safer than the electronic cobweb connecting banks today.
The central bank could also lend to people and businesses that provide super-safe collateral. They could fund your home up to, say, 65 per cent of its value, or 45 per cent for prime business real estate.
Note that this form of people’s bank aims to improve the fairness and efficiency of the whole market rather than hankering for the world grandma knew with passbooks and glass milk bottles. The RBA could provide these online utility banking services to Australians without funding branches or providing retail services. Rather, it would provide the internet resources for retail users to access central banking online as banks can.
The provision of branch services, property valuation and the IT systems to service retail clients would ideally continue to be provided competitively and efficiently by competing private firms. No doubt banks would compete to provide the business. So too could other businesses such as Coles and Woolworths or Google and Apple or local start-ups.
The arrangements I’m proposing would generate vastly fairer, safer and more efficient banking.
Banks’ hefty interest rate margins fund their eye-watering profitability and executive bonuses. But most of it is waste.
About half of banks’ lending is super-safe. Yet private banks must nevertheless fund a hugely expensive supply chain of suppliers and receivers of funds, custodians, aggregators, auditors, lawyers. Due diligence is required at each stage, virtually all of it heavily regulated. Most of these costs would be unnecessary for utility banking services provided by the Reserve Bank.
Given the negligible risk of lending just 65 per cent of the value of prime residential real estate, the Reserve Bank would need to charge a margin of little more than the cost of account management – about half a per cent above the cash rate. That’s about one-sixth of existing bank margins. Slashing margins allows more effective economic management during downturns as more of the central bank’s interest rate cuts get through to borrowers. If the Reserve Bank cut the cash rate to zero today, we’d still be paying about 3 per cent compared with about half a per cent under my proposals.
The result would produce “narrow banking” – efficiently delivered and guaranteed by the central bank. To continue to get us to deposit money with them, banks would have to offer higher interest rates and build their skills in servicing particular financial needs, and assessing credit risks, to justify those higher margins. The private banking system would become more focused on risk-taking, and could manage with far less government support, bailouts, and the consequent regulation.
This new banking system would lower governments’ cost of borrowing as we deposited money with it – through the Reserve Bank – to access its services.
It would also open up a huge new source of revenue. Just as governments generate revenue by auctioning off the public good of scarce radio spectrum, or mineral exploration rights, they also profit from creating the public good of printed money. The RBA manufactures banknotes and sells them to banks. Under my proposal, note printing would continue, but both now and under my proposal, it would account for only about 3 per cent of the money supply. Commercial bank-lending – for instance, on your house – creates the rest.
Under my proposal, if the RBA came to lend about 50 per cent of home-lending, at the current record low cash rate that would return an additional $11 billion to the Commonwealth budget annually. At a more “normal” cash rate of 4 per cent, the return would be more than $30 billion.
Bank of England economists have calculated the benefits of the central bank issuing a digital currency, involving money issue of a similar magnitude. They predict huge gains in economic output, up to 3 per cent of gross domestic profit.
By the principle of “competitive neutrality”, businesses should compete on a level playing field. The idea has mostly been championed by businesses keen to avoid unfair competition from government competitors enjoying special arrangements – for instance, via tax exemptions or special monopoly or planning privileges. But for a really level playing field, shouldn’t you get any favours the government provides your bank?
Levelling this playing field has been impractical in the past as it would have required the central bank to open branches around the country to enable you to access its banking services. But the internet changes all that.
If we’re going to talk about a people’s bank, let’s remember that every bank is part of a larger public–private partnership and that at the apex of that system we already have a people’s bank. Right now it might be owned by the people, but it’s captured by the private banks.
The internet enables us to reconfigure this system so that, in addition to sitting at the apex of the banking system dispensing special privileges to banks, the people’s bank also provides the same utility services to the people who own it. Under these arrangements and reflecting its dramatically lower costs, the central bank would capture a dominant market share of the basic or “narrow banking” I’m talking about. Consumers would freely choose it as the cheapest, safest option. That’s competition in a market economy. That’s competitive neutrality.
Has anything like this been done before? Well, yes. In the early 19th century, in Britain, people made payments using banknotes issued by private banks – a practice that was inefficient and overly complex. In theory everyone decided which banks’ notes they’d accept and took the risk on those banks remaining solvent until they spent the notes by passing them on to someone else.
In 1844 the British parliament legislated to allow Britain’s central bank – the Bank of England – to issue notes. Some people objected to central banks competing with ordinary banks. But once allowed to issue notes, the central bank gradually displaced commercial banknotes. Just as it makes no sense to run two telecommunications cables down the same street, involving many banks in note issue simply added complexity and risk to transactions.
Today we need to do on the internet what the British banking system did with analog payments via banknotes in 1844. We need our central bank on a level playing field with the commercial banks it services, by providing us with the same services it already provides our banks.
Not only would the resulting banking system have much lower costs and greater efficiency, not only would it generate tens of billions in revenue to government, but it would be a simpler, safer, more rational system playing much better to the respective strengths of the public and private sectors.
Though it may not obviate the need for further banking reform – for instance, to require banks to hold more capital – on its own these changes would hugely reduce costs and improve the safety of banking, all while reducing the perverse incentives that still lead bankers to take excessive risks with our money secure in the knowledge they’ll be bailed out if things go wrong.
This article was first published in the print edition of The Saturday Paper on Apr 15, 2017 as "Reserve’s a civil answer". Subscribe here.