Full Reserve Banking in Plain English PDF

FULL-RESERVE
BANKING
(IN PLAIN ENGLISH)
a few simple changes to banking
that could end the debt crisis
Full-Reserve Banking in Plain English | 2
www.positvemoney.org.uk
CONTENTS
INTRODUCTION 4
HOW MUCH MONEY SHOULD WE CREATE? 7
HOW SHOULD WE SPEND NEWLY-CREATED MONEY? 10
HOW CAN WE PAY DOWN THE NATIONAL DEBT? 13
HOW DO WE STOP INFLATION? 17
WHAT ABOUT MY CURRENT ACCOUNT? 20
WHAT ABOUT MY SAVINGS ACCOUNT? 23
HOW SAFE WILL MY SAVINGS BE? 25
THE BANK OF ENGLAND AND THE PAYMENTS SYSTEM 28
HOW WOULD BANKS MAKE LOANS? 31
WILL THERE BE ENOUGH LENDING & CREDIT? 33
WHAT ABOUT OVERDRAFTS? 35
WOULD THIS MAKE BANKS MORE STABLE? 36
INTRODUCTION
T
his proposal for reform of the banking system explains, in plain English,
how we can prevent commercial banks from being able to create money,
and move this power to create money into the hands of a transparent and
accountable body. It builds on the work of Irving Fisher in the 1930s, and
James Robertson and Joseph Huber in 2000.
Removing the power to create money from the
banks would end the instability and boom-and-bust
cycles that are caused when banks create far too
much money in a short period of tme. It would also
ensure that banks could be allowed to fail without
bailouts from taxpayers. It would ensure that newly-
created money is spent into the economy, so that
it can reduce the overall debt-burden of the public,
rather than being lent into existence as happens
currently.
The content in this paper was writen in May 2010,
and has been occasionally updated since then. In
mid-2012 Positve Money will release, as a book, a
much more comprehensive guide to these reforms,
which will also address some of the common objec-
tons and misconceptons about the implicatons of
full-reserve banking.
A QUICK OVERVIEW
Firstly, the rules governing banking are changed so
that banks can no longer create bank deposits (the
numbers in your bank account). Currently these
deposits are considered a liability of the bank to the
customer - afer the reform, they would be classifed
as real money and only the Bank of England would
be able to increase the total quantty of them.
The Bank of England would then take over the
role of creatng the new money that the economy
requires each year to run smoothly, in line with
infaton targets set by the government. In order to
meet these targets, the decision on how much or
litle money needs to be created would be taken
by the Monetary Policy Commitee. To maintain
internatonal credibility and avoid economic elec-
toneering, the MPC would be completely separate
and insulated from any kind of politcal control or
infuence - in other words, the elected government
would not be able to specify the quantty of money
that should be created.
The Monetary Policy Commitee would decide how
much money needs to be created in order to meet
the infaton targets by analysing the economy as a
whole - not the spending needs of the government,
nor the needs of the banking sector. They would
use big picture statstcs to judge whether meetng
the infaton targets requires more or less money
injectng each month. They would also have access
to all the research resources that they require to
make an informed decision.
Upon making a decision to increase the money
supply, the MPC would authorise the Bank of
Englands Issue Department to create the new
money by increasing the balance of the govern-
ments Central Government Account. This
newly-created money would be non-repayable and
therefore debt-free.
The newly-created money would then be added to
tax revenue and distributed according to the elected
governments manifesto and priorites. This could
mean that the newly-created money is used to
increase spending, pay down the natonal debt, or
replace taxaton revenue in order to reduce taxes,
although the exact mix of these optons would
depend entrely on the elected government of the
day.
Consequently, the decision over how newly-created
money is initally spent would be made by the
government, but the government would have
no control or infuence over how much money is
created.
IMPLICATIONS FOR
CUSTOMERS OF BANKS
To the average person, banks will appear to operate
very much as they do now. However, the necessary
behind the scenes changes required to prevent
banks from creatng money will mean that there
would need to be a few subtle changes to the terms
of service on current accounts and savings accounts:
IMPLICATIONS FOR CURRENT
ACCOUNTS (KNOWN AS
TRANSACTION ACCOUNTS
AFTER THE REFORM):
Post-reform, banks will not be permited to lend the
money held in Transacton Accounts (the equivalent
of todays current accounts). Instead, any money
held in these accounts will be held in fduciary
trust by the bank on behalf of the customers, and
in practcal terms will be considered to be held in a
Customers Funds Account at the Bank of England
- the equivalent of putng the money into a safe-
deposit box with the customers name writen on it.
These Transacton Accounts would then be 100%
safe - since the money is technically held at the Bank
of England, the customers are guaranteed to be
repaid, even if their bank was to become insolvent.
This guarantee does not expose either the govern-
ment or the Bank of England to any fnancial risk
whatsoever, and also means that the governments
guarantee on deposits can be withdrawn, since
Transacton Accounts are inherently risk-free for the
customer.
The implicatons of this for the customer are as
follows:
Money in their Transacton Account is 100%
secure and can never be lost
Transacton Accounts will not pay
interest, because the banks are unable to lend
this money. As the rates of interest on current
accounts are rarely higher than 0.5%, this is not
a signifcant loss.
There will probably be monthly or annual fees
for the use of a Transacton Account, since the
bank needs to recoup the cost of providing
payment services. However, competton for
market share between the banks will keep those
fees as low as possible, and many banks are
likely to swallow the costs and waive Transac-
ton Account fees completely in order to atract
customers who are then more likely to take out
mortgages and other products with the bank (a
loss-leader approach to marketng). These fees
will in any case be outweighed by the signifcant
fnancial benefts to every individual that arise
from preventng the privatsed creaton of
money as debt.
IMPLICATIONS FOR SAVINGS
ACCOUNTS (KNOWN AS
INVESTMENT ACCOUNTS
AFTER THE REFORM)
In order to lend money afer the reform is imple-
mented, banks will need to fnd customers who
are willing to give up access to their money for a
certain period of tme. In practce, this means that
the customer will need to invest their money for a
defned tme period (1 month, 6 months, 2 years, for
example) or set a minimum notce period that must
be given before the money can be withdrawn (e.g. 7
days, 30 days, 60 days, 6 months).
Banks will then operate in the way that most people
think they currently do - by taking money from
savers and lending it to borrowers (rather than
creatng new money (deposits) whenever they make
a loan, and walking a tghtrope between maximizing
proft and becoming insolvent).
For customers of the bank, this means they will only
be able to earn a rate of return (interest) if they are
willing to give up access to their money for a certain
period of tme.
Note that this policy completely eliminates the
risk of a bank run and gives the bank much more
stability, as it is able to plan its future outgoings up
to 12 months into the future (a much greater degree
of stability than they have right now).
HOW MUCH MONEY SHOULD WE
CREATE?
W
ouldnt printng new money just push up prices and make everything
more expensive? Only if we print too much. Over the last 30 years,
commercial banks have been creatng new money so quickly that the money
supply has grown by an average of 7.8% every year. Because almost all of this
newly-created money was lent into the economy and was matched by the
same amount of debt, it laid the foundaton for the recent fnancial crisis.
The reforms that we are proposing would make
it impossible for high-street banks to create new
money when they make loans. As a result, they
wont be able to increase the money supply of the
naton every single year.
But that doesnt necessarily mean that the economy
will run smoothly on a fxed amount of money - we
may stll need to increase the amount of money
in the economy in line with rises in populaton,
productvity or other fundamental changes in the
economy.
There are also issues as we make the transiton from
a debt-fuelled economy that requires new money to
avoid collapsing under the weight of the debt, to the
stable, low-debt economy that this reform would
create. Like a junkie coming of heroin, our economy
might need to be weaned of contnual injectons of
new money over a period of tme.
Consequently, once we have stopped money
creaton by commercial banks, we need an alterna-
tve source of new money. The following secton
explains what this source of new money should be,
and how it will work.
WHO DECIDES HOW MUCH
NEW MONEY SHOULD BE
CREATED?
The last few decades show that we cannot trust
proft-seeking banks with the power to create
money. Their incentves stack up frmly on the
side of always lending more money, and therefore
always increasing the money supply, regardless of
the needs of the economy as a whole.
Elected politcians are unlikely to do much beter.
The temptaton the government to increase the
money supply in order to pay for things like high
speed rail and university tuiton fees is likely to be
great, which would result in money being created
without any reference to the needs of the wider
economy.
If the person or organisaton making the decision
to create more money also stands to beneft
personally from the creaton of that money - as do
proft-seeking bankers and vote-seeking politcians
- then decisions over the supply of money to the
economy will be taken on the basis of the beneft to
the decision maker, rather than the beneft to the
economy as whole.
So if we cant trust proft-seeking bankers or vote-
seeking politcians, then we must fnd a neutral,
independent body who have no misaligned incen-
tves and who do not beneft personally from
increasing the money supply.
Under our proposals the Bank of Englands existng
Monetary Policy Commitee will become respon-
sible for making decisions on how much new money
should be injected into the economy in each period
of tme.
They will stop making decisions to raise or lower
the base interest rate and will instead make a
decision to increase or reduce the money supply.
They will likely take a 12-month or 2-year view of
the economy, and then smooth any increase in the
money supply over each month.
The MPC will contnue to be politcally independent
and neutral. This is very important, as it prevents
harmful politcal tnkering with the economy. It
is important that the MPC cannot be overruled
by politcians, whose decisions will be swayed by
politcal maters rather than the long-term health
of the economy. It is also important that the MPC is
sheltered from conficts of interest, and lobbyists for
the fnancial sector.
The Monetary Policy Commitee will also stll be
subject to all the rules regarding transparency of
its decisions, and the amount of the authorised
increase in the money supply will be made publicly
known.
Note that they will not be creatng as much money
as the government needs to fulfl its electon
manifesto promises the needs of the government
will not be considered. As discussed in the secton
Guarding Against Infaton, suggestons that this
reform would cause a Zimbabwe situaton have no
basis in reality.
SO HOW MUCH SHOULD THEY
CREATE?
The Monetary Policy Commitee (MPC) would
authorise the creaton of as much new money
as they calculate the economy (in other words,
companies and households) needs to functon
healthily, and no more.
The Commitee will contnue to base its decisions
on the basis of infaton targetng - the policy of
trying to ensure that infaton stays within a small
range - such as between 1.5% and 2.5% per annum.
In other words, they should try to ensure that any
change in the money supply is neither infatonary
nor defatonary - neither too much nor too litle.
Note that for this to be efectve, the measure of
infaton used must be redesigned to take account
of asset price infaton (such as a housing price
bubble). It is pointless to atempt to make decisions
afectng the whole economy using a measure of
infaton that ignores infaton of 10% per annum in
house prices when housing is the most expensive
item in anyones basket of goods.
Under this requirement, if infaton starts to rise,
the MPC will need to stop creatng new money
untl infaton has started to fall again. This makes it
impossible for the MPC to create a Zimbabwe-esque
infatonary spiral.
In absolute fgures, the amount of money that
should be created each year will probably start at
around 100billion - less than the banks have been
creatng for the last few years. Over tme, as the
economy stabilises and the overall level of debt falls,
the amount of money that we can create each year
before infaton starts to rise will probably stabilise
at around 50billion a year.
THE MECHANICS OF CREATING
NEW MONEY
When the Monetary Policy Commitee has autho-
rised the creaton of a specifed amount of new
money, it will be created in the following way:
1. The government will hold an account, known
as the Central Government Account with the
Bank of England.
2. The Bank of Englands Issue Department will
simply increase the balance of this account by
the amount authorised by the Monetary Policy
Commitee. They will not simultaneously reduce
the balance of any other account - by making
a credit without making a matching debit, they
are creatng new money.
3. The government can then withdraw the money
from its Central Government Account and add
it to the pool of tax revenue, and then use it in
accordance with the principles discussed in the
secton How Should We Spend Newly-Created
Money?.
In contrast to printng physical cash or coins - which
costs a few pence for every 1 created (According
to the Bank of Englands annual reports, they
spent 38million in 2010 printng physical bank
notes), - a creaton of money electronically is
costless. To create 20bn or 200bn both requires
one authorised ofcial with the right passwords
and a computer connected to the Bank of Englands
central accounts system. Of course, it would also
require witnesses and formalites to be observed,
but all in all, 20bn could be added to the economy
in a litle under 20 minutes, at the admin cost of just
a few hundred pounds.
AN IMPROVEMENT ON THE
EXISTING SYSTEM
In the existng monetary system, the total amount
of money (defned as bank deposits - the numbers
in your bank account) is increased whenever a bank
makes a loan. Consequently, the money supply
increases as a result of the individual decisions of
thousands of loan ofcers and mortgage advisors,
and the lending priorites of bank directors. Each
of these individuals is motvated by a bonus on
each mortgage or loan that is issued, and therefore
their only incentve is to issue as many loans and
mortgages as possible. They have absolutely no
concepton of how their actvites ft into the wider
health of the economy. As revealed in the fnancial
crisis that started in 2007, this tends to lead to
disaster.
Post-reform, the health of the whole economy will
be considered before a decision is made to increase
or decrease the money supply. While there are
always issues when decisions are made by small
commitees of wise men, we believe that it would
be hard for the Monetary Policy Commitee to do a
worse job of managing the money supply than the
banks have done to date. With a holistc view of the
economy, and an incentve to support the economy
rather than to maximise their own bonuses, this
should lead to a beter outcome overall.
HOW SHOULD WE SPEND NEWLY-
CREATED MONEY?
W
hen the Monetary Policy Commitee authorises the creaton of a certain
amount of new money, the Bank of Englands Issue Department will
add that money to the governments Central Government Account. The
government is free to use this money however it chooses in order to achieve
its democratcally-mandated policy objectves. Therefore the government may
choose to:
a) reduce the overall tax burden
b) increase government spending
c) make direct payments to citzens (sometmes
referred to as a citzens dividend)
d) pay down the natonal debt
The exact mix of the above will depend on the
priorites and ideology of the government of the
day. Since the newly created money will simply be
added to tax revenue, there is no need for a special
process to decide how to spend it. If the public have
elected a government that promises to increase
public spending, then the government can justf-
ably use the money for this purpose. Likewise, if
the public elected a government that promised to
reduce the overall tax take, then the government
can use the money to this end (by using this money
to cover existng spending and reducing the overall
tax take).
We will now look at each of the optons above in
more detail.
REDUCTION OF THE OVERALL
TAX BURDEN
Rather than increasing government spending, the
elected government of the day could choose to
reduce the overall tax burden.
The tax burden could be reduced in one of three
ways (or a combinaton of all):
1) through maintaining the current tax regime but
redistributng the newly-created money back to the
public via tax rebates (payments) afer the years
taxes have been received
2) by actually reducing the rates of tax charged on
income, VAT, corporaton tax, Natonal Insurance
etc, therefore collectng less money from taxaton.
They would then make up the shortall with the
newly-created money.
3) by completely cancelling partcular taxes VAT
(the UKs sales tax) would be a strong contender for
eliminaton, being both hugely regressive (hurtng
the poor more than the rich) and a distorton to
markets.
Tax reform is a huge issue, and one that is outside of
our work, but any government using the proceeds of
this reform to reduce taxaton should aim to reduce
or eliminate some of the worst market-distortng or
most regressive taxes.
INCREASING GOVERNMENT
SPENDING
By using the newly-created money to increase
government spending, the government can increase
the provision or quality of public services such as
educaton, health care or public transport, without
increasing the tax burden on the public. Decisions
on exactly how the newly-created money is spent
would fall to the democratcally elected government
of the day.
Although the money has not been raised via
taxaton and therefore doesnt cost anything at this
point, it stll has a massive opportunity cost if the
government chooses to use the money to build a
Millennium Dome, the same money cant be spent
to build 5 large hospitals or a couple of hundred
schools.
Consequently the government has a public duty to
ensure that the newly-created money is spent on
the projects that will bring the greatest beneft to
society as a whole, and to ensure that the money
is not wasted. In reality, the same issues apply to
newly created money as apply to all tax revenue is
it well spent, and do the public get value for money?
DIRECT PAYMENTS TO
CITIZENS
One alternatve to both increasing public spending
and reducing taxes is to make direct payments to
citzens. If the amount of newly-created money in
a partcular year was 100billion, a direct payment
of 2,222 could be made to every eligible voter
(regardless of income). 100bn may sound like a lot,
but it is less than the banks have created in every
year since 2004.
There are some signifcant advantages to this the
most democratc way of spending newly-created
money is to give every single citzen power over how
to spend their share. It would also reduce the risk of
the newly-created money being spent inefciently
by central government.
PAYING DOWN THE NATIONAL
DEBT
We believe that it is in the public interest for the
natonal (i.e. government) debt, to be phased out,
or at least reduced to within a small percentage of
the natons GDP. Over tme, the government would
likely use a proporton of the newly created money
to gradually pay of the debt.
These provisions are discussed more comprehen-
sively in the How Do We Pay Down the Natonal
Debt?.
OUR RECOMMENDATIONS
The current staggering level of household and
corporate debt is a consequence of the debt-based
monetary system that we have had in place for the
last few hundred years. Once we stop issuing all new
money as debt, the frst priority should be to reduce
our overall debt burden (at a household, corporate
and government level) back to a healthy, natural
level.
Consequently, our personal recommendaton is that
in the 5-8 years following the implementaton of
the reform, the newly-created money should not
be used to increase government spending. Instead,
government spending should remain fat, avoiding
the impending cuts to public services but with no
major new spending projects. (Of course the public
sector should contnue to try to reduce waste and
provide maximum value for money).
Any newly-created money should then be used as
much as possible to reduce the overall tax burden,
ideally by 20-25%, by actually reducing tax rates and
allowing the public to keep and spend more of their
income. This will leave people with around 20%
more disposable income, which considering the
highly indebted state of the vast majority of house-
holds right now will most likely be used to pay of
debts, credit cards, personal loans and mortgages,
in the same way that many households are currently
taking advantage of low interest rates to over-pay
on their mortgages.
In short, we would reduce the tax burden to allow
citzens to pay down their own debts. At the same
tme, if part of the tax reducton falls on employers
Natonal Insurance contributons, or on VAT, then
companies will themselves be able to reduce their
debts, which should make it easier for them to
expand and increase employment.
It could be made explicit that this would be a 5-8
year partal tax holiday, with taxes to rise at the
end of it. It is likely that as the economy stabilises
and the debt burden falls, the amount of money
that the Monetary Policy Commitee decided to
create in any year would fall, making it necessary
for the government to collect more revenue via
taxaton.
There is a practcal consideraton involved in this
suggeston too. In the current environment, it is
hard to believe that any UK government will have
the capacity to successfully engage in big infrastruc-
ture projects over the next few years, whilst simul-
taneously batling the afer-shocks of the fnancial
crisis and also implementng this reform. If they
tried to, it is likely that much of the money would
be wasted. As a result, the stmulus from using the
newly-created money to increase spending would
come later, and be less efectve, than a direct
stmulus from reducing taxes. When the economy
has stabilised, the overall level of debt has fallen
signifcantly, and the banking system has adapted
to this new fnancial regime in other words, when
things are less hectc the government could then
look at using the newly-created money for public
infrastructure projects.
HOW CAN WE PAY DOWN THE
NATIONAL DEBT?
HOW WILL THIS REFORM
ALLOW US TO PAY OFF THE
NATIONAL DEBT?
Our proposed reform allows the state to take back
the exclusive power to create new money and to
use any newly-created money to increase public
spending, reduce taxes. The government may
choose to use some of the newly-created money to
pay down the natonal debt. This would not simply
be printng money to pay of the debt (which would
be considered to be an underhand way of defaultng
or reneging on the debt), as the amount of money
created will be restricted to be just enough to keep
infaton low and steady. By giving the govern-
ment an additonal source of revenue (the newly-
created money coming from the Monetary Policy
Commitee), there is more chance that they will be
able to use some of their revenue to make down-
payments on the natonal debt.
At the same tme, because our proposed reforms
would reduce instability in the economy (think of
the credit/debt-fuelled boom-bust cycle), there
would be fewer and less severe recessions, which
should lead to lower unemployment. This would
mean that the government will not need to spend
so much on unemployment benefts, freeing up
more revenue for public services or to reduce the
natonal debt.
HOW DID THE DEBT GROW IN
THE FIRST PLACE?
The natonal debt is the total amount of money
that governments have borrowed over the last
few centuries. However, unlike a debt like your
mortgage, where your payments reduce the total
amount of debt every year, the government typically
does not pay of enough to reduce the total natonal
debt. Instead they just borrow the money they need
to pay the interest on the debt, and typically borrow
a litle bit more for additonal spending. Since 2002,
the government has simply borrowed the money
it needed to pay the interest on the natonal debt.
This is like paying of one credit card with another.
The natonal debt tends to shoot up during wars -
such as World War I (from 650m in 1914 to 7.4bn
in 1919) and World War II (from 7.1bn in (1939) to
24.7bn (1949)). It also shot up signifcantly in 2008
onwards, for two main reasons:
1. The government borrowed 179.8bn to bail out
RBS, Lloyds and Northern Rock.
2. The recession triggered by the banking crisis
led to redundancies and bankruptcies, along
with less spending in the economy. This added
up to mean that less tax was being paid, so the
governments revenue (income) fell.
3. At the same tme, with more people redundant,
there were more people claiming unemploy-
ment beneft, so government expenditures went
up
WHY THE DEBT WILL ONLY GO
UP IF WE KEEP THE CURRENT
SYSTEM
The debt is currently higher (in absolute terms) than
its ever been before. While the government talks
about reducing the defcit, the reality is that the
total natonal debt will keep growing. It is almost
impossible for the government to reduce the debt,
meaning that even if they stop the debt growing,
taxpayers will contnue paying 120 million a day in
interest on the natonal debt for eternity.
To understand why, look at what would have to
happen to actually start paying down the debt:
1. Firstly, the government needs to start paying
the annual interest on the natonal debt each
year out of tax revenue, rather than simply
borrowing more money to pay the interest. As
the interest currently stands at 43bn this
year this means that in order to stop the
natonal debt growing, the government must
raise another 43bn this year in taxes, which
is equivalent to raising VAT (sales tax) to 30%
(from its current level of 20%).
2. However, in the fve years before the crisis,
excluding the efect of the banking crisis, the
government spent an average of 10.6% more
than it took in in taxes every single year. So even
afer the 43bn interest on the natonal debt
is paid, to run a balanced budget right now,
it would need to raise an extra 22bn in taxes,
or cut public services by 22bn - equivalent to
shutng down a ffh of the NHS.
3. So far in this example, the government has
raised VAT by 30% and cut 22bn of public
services and has stll only managed to stop the
debt growing any further. In order to actually
reduce the debt, it needs to raise taxes even
further, or reduce public spending even more.
If we decided that we want to pay of 30bn of
natonal debt every single year, then wed need
to raise another extra 30bn in taxes: equivalent
to doubling council tax. Even at this level, it
would take 30 years to pay down the natonal
debt.
In summary, simply to stop the debt growing,
government would need to raise taxes so high that
it would be thrown out of ofce at the next electon.
As long as we keep the current banking system, the
natonal debt will never go down and tax money
that could have been used to fund public services
will be used to pay interest on the natonal debt.
WHY WE HAVE TO PAY THE
DEBT OFF SLOWLY
If we paid of the natonal debt too quickly it could
destabilise fnancial markets, which would most
likely reduce the value of pensions and therefore
harm pensioners.
REASON 1: Paying it of too quickly could harm
pensioners
The bulk of government debt is not owed to the
banks. Around 40% is owned by foreign investors.
The big concern for us is the 40% of government
debt that is owed to pension funds and insurance
companies.
To see why it is crucial that we do not pay of the
debt too quickly, you need to step into the shoes of
a pension fund manager.
Pension funds like to buy government bonds (i.e.
Government debt) because they know these bonds
will always be repaid (as government can always tax
people to get more money). Bonds are therefore
considered as safe as cash, with the added bonus
that they pay interest. Consequently, pension funds,
especially those with a large number of customers
near retrement age, will use government bonds
to make up a large percentage of their portolios
afer all, bonds are much safer than stocks and the
pension fund will not want stock market volatlity to
wipe out its (and its customers) assets.
The fund manager needs to ensure that the invest-
ment portolio has a range of low-risk, steady return
investments, and higher-risk, higher-return invest-
ments. The lowest-risk investment that stll ofers a
return (i.e. interest) is government bonds, so these
make up the safe part of the portolio.
When we pay of part of the natonal debt, we are
actually reducing the quantty of government bonds
in the market. If we reduce the quantty of bonds in
the market too quickly, we force these pension fund
managers to shif their investments from bonds to
other investments, such as corporate bonds (riskier)
and the stock market (much riskier).
The efect of over 1trillion (the natonal debt)
shifing from the bond market to the stock market
and corporate bond market would be like tpping
a bath of water into a small pond creatng huge
waves in the market. Firstly, prices of stocks would
start to rise, probably creatng a bubble in the stock
market. However, as people started to fear that
the bubble was getng too big, they would start to
pull out of the market by selling shares. This may
trigger another stock market crash as pension funds
rapidly try to move their money into cash. The result
would be, once again, a decimaton of the value of
pensions, which would harm pensioners and those
in middle-age most of all.
To avoid this, we need to gradually remove bonds
from circulaton over a period of tme. Fund
managers would be well aware that government
bonds were being phased out, but would have
around ten to ffeen years in which they could
gradually shif their investments away from the
bond market and into corporate bonds and the
stock market. This would avoid causing any bubbles
in the market, avoid a food of cheap money into
the corporate bond market (which would most likely
lead to some pointless and badly chosen corporate
takeovers if done quickly), and safeguard the value
of pensions.
REASON 2: The Natonal Debt is Cheap While
Personal Debt is Expensive
The overall interest rate on the natonal debt works
out at around 4.3% per annum (from 2000 to 2010).
It is realitvely low because government debt is
assumed to be risk free, so pension funds and other
buyers of government debt are willing to accept low
returns in return for a near-zero risk of default.
In contrast, the interest rate for household debt
ranges between 6% and above for mortgages, right
up to ~17% on credit cards and up to ~29% on store
cards. Overall, the average interest rate is undoubt-
edly higher for households than it is for the govern-
ment.
Lets assume that the interest rate for all household
debt averages out at 8% per annum. Total
household debt is signifcantly greater than total
government debt (1,464billion compared to
slightly over 1 trillion as of March 2012).
A basic principle in debt management is to pay of
the most expensive debt frst. If we acknowledge
that natonal debt is really the debt of the UKs
taxpayers (amountng to approximately 20,555
per eligible voter), then the natonal debt is the
cheapest debt and should be paid of later than
household debt. For this reason, it is beter to divert
more money back to the public (via tax cuts, public
spending or direct payments to citzens) than to
aggressively pay down the natonal debt. The money
directed to the public will then allow them to pay
down their more expensive debts.
That doesnt mean we shouldnt make inroads
into paying down the natonal debt. As a general
principal, we would recommend that the natonal
debt should be paid down by around 30billion per
annum, using government revenue from taxaton
and/or the years newly-created money.
However, using all the newly created money to pay
down the natonal debt as quickly as possible would
be like taking 925+bn from the public in order to
pay of debt at 4.3% interest, when they are stll
paying an average of 8% on their own debts of
1,464 billion.
ONE BENEFICIAL SIDE-EFFECT
OF PAYING OFF THE NATIONAL
DEBT
Besides saving up to 200 million per day on interest
costs (if natonal debt rises as expected up to 2014),
paying of the natonal debt has other benefts for
the economy.
By phasing out government bonds as an investment
opton, we force pension funds and other investors
to look for alternatve investment optons. The next
safest opton afer government debt is the debt of
the blue chip, FTSE 100 corporatons. By investng
in bonds or even new share issues from these
companies, these companies should be able to pay
of more expensive debt, which in theory should
lead to lower costs for customers, or more jobs
being created, or more proft being declared and
therefore more tax being paid.
At the same tme, when large corporatons can
borrow cheaply from pension funds looking for a
safe haven for their money, they will have no need
to borrow from banks. Consequently the banks
will themselves need to look for other investment
opportunites. They will need to shif their focus to
investng in small and medium sized businesses.
The end result of phasing out government bonds is
that small and medium businesses will start to fnd
it much easier to get investment and funding from
banks, which should be benefcial for the economy.
By clearing the natonal debt, we channel more
credit / investment to businesses rather than to
government.
HOW DO WE STOP INFLATION?
When we suggest that the state (or the Bank of
England) should be allowed to create new money,
some people automatcally react with the sugges-
ton that this would cause infaton. Indeed, the
most common misguided critcism of the type of
reform that we are proposing is that it will cause
signifcant infaton, as an irresponsible government
prints as much money as it requires for its own
needs.
There is absolutely no risk of this happening in
the environment created by this reform. For one
thing, decisions on changes in the money supply
will be made not by vote-seeking politcians but
by an independent body (the Monetary Policy
Commitee). Politcians will have no infuence what-
soever in the amount of money that will be created.
The Monetary Policy Commitee will be instructed
to consider the needs of the economy as a whole in
deciding how much new money should be injected
into the economy. The needs or desires of the
elected government do not factor in this decision
at all. In fact, the members of the MPC should
be expressly forbidden from considering politcal
maters or the intentons of the current government
in making the decision.
HOW WELL HAS THE CURRENT
SYSTEM PREVENTED
INFLATION?
Over the last 30 years, the banks have been infatng
the money supply by an average of 7.8% per year,
through creatng endless amounts of new debt. This
has led to infaton over that tme of hundreds of
percent, especially in the housing market.
In fact, between 1950 and 2010, total general
infaton was 2,554%, while house price infaton has
been much higher at 8,613%!
From this we know that annual increase in the
money supply of 7-10% will cause infaton, so we
already know our upper-limit on how much new
money should be created. As long as the MPC
keeps the annual increase under 7% per annum
(the average growth rate since 1980) then infaton
should be less than it has been under the old
system.
In other words, infaton is signifcantly less likely
under the reformed system than under the existng
system.
FURTHER SAFEGUARDS
AGAINST INFLATION
If further safeguards are needed to reassure people
that hyper-infaton is not a risk, the following safe-
guards could be put in place (but note that they are
not included in the reform proposal at this stage):
The absolute amount of the increase in any one
month must be no more than x% greater than
the previous month. This prevents any wild fuc-
tuatons in the amount of money created from
month to month, and depending on the level of
x, ensures that it would take decades before
they could create sufcient levels of money to
cause hyperinfaton.
The total annual increase in the money supply
should not exceed x% of the current total
money supply. If you doubled the money supply
in the space of one year, you would cause asset
price bubbles and very high infaton. If you
cut the money supply by 50%, in one year, you
would cause an economic collapse. Common
sense suggests that the safe rate of growth in
the money supply will be somewhere close to
0%, and almost certainly in the single digits.
At no point must the annual increase in the
money supply exceed the average of the last
30 years in which banks issued the money
supply. This would provide a limit of around
7.8% growth in the money supply per annum.
It seems logical that if creatng 7.8% per annum
leads to a 6-fold increase in housing prices, and
the worst fnancial crisis since the 1930s, then
staying below this limit should have a much less
destructve efect.
THE DIFFERENCE BETWEEN
BANK-CREATED DEBT-
MONEY AND STATE-CREATED
POSITIVE MONEY
A 10% rate of growth in money supply is a very
diferent thing when that additonal money comes
from the state, rather than from commercial banks.
When commercial banks increase the money supply,
they do so by creatng an equivalent amount of
debt. The new money acts as a stmulus to the
economy, but the new debt acts as an immediate
drag on the economy. (If you accept and spend a
personal loan in August, you will start repayments
in September. In September you are immediately
poorer than you were before you took the loan
(even though you may have more stuf) as your
disposable income is reduced by the amount of the
repayments. You spend less in the shops and the
real economy loses your regular spending).
Allowing banks to create money is therefore akin
to pressing both the accelerator and the brake at
the same tme and the results are equally painful
to watch! In contrast, the debt-free injecton of
money from the Bank of England is free from the
immediate sedatve of an equivalent amount of
debt. This is akin to pressing the accelerator with
your foot clear of the brake. Which system would
you expect to have the greatest stmulatng efect
on the economy?
For that reason, we can assume that a 10% increase
in the money supply, when created as debt-free
money by the Bank of England, would be far more
of a stmulus to the economy than the same rate of
increase when caused by commercial banks issuing
debt. Whether we should therefore aim for 5%
instead (to avoid any risk of infaton) or stay at 10%
(to pull ourselves out of this recession with a quick
stmulus) needs further analysis.
In short, however, infaton is much less of a threat
under the reformed system, whereby the state
creates all new money, than under the existng
system (whereby new money is created as debt by
private commercial banks).
NOTE: THE MEASURE OF
INFLATION MUST INCLUDE
HOUSE PRICES
For infaton to be efectvely prevented, it is
essental that the measure of infaton used by the
Monetary Policy Commitee includes house prices.
For that reason, the Consumer Price Index (CPI)
currently used by the government is completely
inadequate. It is disingenuous to claim that infaton
is around 2.5% per annum and that the Bank of
England has successfully managed infaton when
the cost of housing which makes up the bulk of
peoples spending is increasing at over 10% per
annum. Consequently, for the Monetary Policy
Commitee to be able to make good decisions about
the money supply, it must use a basket of goods
that really represents how ordinary people spend
their money, including housing costs.
One of the arguments for excluding housing cost
from the existng Consumer Price Index is that,
since mortgage costs are determined by the current
interest rate, under the current regime the MPC
may increase the interest rate to limit infaton, but
then see the CPI rise due to the efect of higher
interest rates on mortgage costs. This argument is
no longer relevant, as under this reform, the MPC
will cease to make a decision on the base interest
rate, and interest rates will be set by markets.
The actual measure of infaton that will be used
afer the reform is very important and requires
further consideraton.
WHAT ABOUT MY CURRENT
ACCOUNT?
Your current account will be replaced by a Transac-
ton Account, which will provide most of the same
services, but will be 100% safe and secure.
Present-day current accounts, are generally used
for payment services (cheques, debit cards, cash
machines, electronic fund transfers), and receiving
money (such as a monthly salary). These current
accounts will be replaced by Transacton Accounts.
To the customer, a transacton account will appear
to be almost exactly the same as a present-day
current account, and members of the public will
probably contnue to call them current accounts.
However, to diferentate between the pre- and
post-reform situatons, well be using the technical
term Transacton Accounts.
WHAT IS STILL THE SAME
1. Transacton Accounts will stll provide cheques,
debit cards, cash machines, electronic fund
transfers etc.
Salaries will stll be paid into Transacton
Accounts.
2. Payments between individuals and businesses
will stll be made from one Transacton Account
to another.
3. Customers will stll have instant access to money
in the Transacton Accounts.
4. These accounts may stll ofer overdrafs. (The
provision of overdrafs is a key, but complex
part of the reform, which is dealt with in a later
chapter).
WHAT IS DIFFERENT
1. A bank will no longer be able to use the money
in Transacton Accounts for making loans or
funding its own investments.
2. These accounts will all be held of the balance
sheet, and not be considered part of the liabili-
tes of the bank.
3. The money paid into Transacton Accounts will
be held in full within an account at the Bank of
England. In other words, the money is in the
bank at all tmes, and could be repaid in full (to
all customers) at any tme, without having any
impact on the banks overall fnancial health.
It is technically impossible for the money to be
lost, and a bankrupt bank would stll be able to
repay all its Transacton Account holders.
4. Because the banks are unable to use the funds
placed in these accounts to invest or lend, they
will be unable to earn a return on these funds.
As they will stll incur the costs of providing
payment services (cheque books, ATM cards,
cash handling etc), they will almost certainly
need to implement account charges to cover
these costs.
BENEFITS OF THE CHANGES
The government and taxpayer would have abso-
lutely no exposure to problems with individual
banks.
It would now be impossible to sufer a run on the
bank. Even if all Transacton Account customers of
one bank were to withdraw their money on a single
day, the bank would be able to pay with no impact
on its fnancial health and no need for emergency
assistance from the Bank of England or government.
We would never see another Northern Rock (or
Washington Mutual in the USA).
Money placed into a Transacton Account would
be 100% safe. There would be no ceiling limit on
the amount that is safe, and the guarantee has no
real or potental cost for the taxpayer (because the
money can not be lost).
Because of the way the clearing system under this
reform would work (see The Payments System),
the tme for payments to show up in the recipi-
ents account could be as litle as 30 seconds (as
compared to 2 hours to 4 days as at the moment).
This would provide a beter service to both individ-
uals and companies and would make the economy
more efcient.
If a bank collapsed, it would only be an administra-
tve procedure to move the Transacton Accounts
over to other banks, and no money would ever be at
risk.
COSTS OF THE CHANGES -
ACCOUNT FEES
As mentoned above, because the banks can not use
these funds any more to make loans, they will want
to recoup the costs of providing payment services
through charging account fees. In additon they will
no longer wish to pay interest on balances in these
accounts.
While no-one likes to start paying for something
that was previously free (although it should be
noted that many banks are already introducing fees
on current accounts), the fee that banks charge
would be more than outweighed by the savings of
between 700 and 6,750 that the average working
adult could expect to make as a result of the reform
(these savings are discussed later).
How much would the fees actually be? The
following is a realistc breakdown of the current
yearly costs of providing a current account, provided
by a consultancy frm that has set up new banks
(Cut Loose):
Checkbook 10 (per book)
Debit Card 2
Branch 5
Call Centre 8
Staf 15
Banking engine 4
CDD 8 (one tme cost at account
opening for Customer Due Diligence)
MC/Visa 2
Link 2
BACS etc. 5
Hostng 2
Total 59
Source: Cut Loose - Making Banks Happen
This equates to a cost of around 5 per month, plus
a litle extra for proft.
Note that even today, these costs are incurred by
the bank, and recouped from customers via 30
unauthorised overdraf charges and other unex-
pected charges.
It is also worth remembering that the interest paid
on current accounts is ofen as low as 0.1% - in
other words, nothing. Someone who had an account
balance of 1000 for a whole year would only earn
1 in interest at the end of the year. The loss of this
interest is therefore insignifcant. In the current
system, many accounts pay no interest at all.
In additon, the post-reform payments system may
be signifcantly cheaper to run than the present-day
clearing system, as there would be no need for a
complex clearing system (transactons would be
instant and fnal). This means that the only signif-
cant costs would be creatng the physical ATM cards
and cheque books, ofering customer service, and
maintaining the banks main computer systems.
In practce, there will be signifcant market pressure
to keep account fees as low as possible.
As the next chapter shows, to be able to make loans,
post-reform banks will need to atract customers
who wish to make investments with them. One
way to atract customers and gain market share is
to run a loss-leader campaign with their Transac-
ton Accounts. They would do this for the same
reason that they currently ofer free overdrafs to
students - someone who banks with you for normal
payment services is far more likely than the average
consumer to save with you and come to you frst for
overdrafs, credit cards and mortgages.
As a result, competton between banks for market
share means that the costs of payment services may
be absorbed by the banks as a cost of acquiring
market share, and recouped from their investment
earnings. In short, the cost passed on to customers
is likely to be minimal.
WHAT ABOUT MY SAVINGS
ACCOUNT?
INVESTMENT ACCOUNTS
REPLACE SAVINGS ACCOUNTS
Your savings account would be replaced by an
Investment Account. We call them Investment
Accounts, for the sake of clarity and because it more
accurately describes the purpose of these accounts
- as a risk-bearing investment rather than as a safe
place to save your money.
Afer the reform, the bank would need to atract
the funds that it wants to use for any investment
purpose (whether it is for loans, credit cards,
mortgages, long term investng in stocks or short-
term proprietary trading). These funds would
be provided by customers, via their Investment
Accounts.
WHAT IS STILL THE SAME:
1. Investment accounts will stll be used by
customers who wish to put money aside or
earn interest on their spare money (savings).
2. These accounts would stll pay varying rates of
interest.
3. They would stll be provided by normal high-
street banks.
WHAT IS DIFFERENT:
1. At the point of investment, customers lose
access to their money for a pre-agreed period
of tme. There would no longer be any form of
Instant Access Savings Accounts. This would be
a legal requirement .
2. Customers would agree to either a maturity
date or a notce period that would apply to
the account. The maturity date is a specifc date
on which the customer wishes to be repaid
the full amount of the investment, plus any
interest/bonuses. The notce period refers to
an agreed number of days or weeks notce
that the customer will give to the bank before
demanding repayment.
3. The Investment Account will never actually
hold any money. Any money placed in an
Investment Account by a customer will actually
be immediately transferred to a central Invest-
ment Pool held by the bank, and then be used
for making various investments. At this point,
the money will belong to the bank, rather than
the Investment Account holder, and the bank
will note that it owes the Investment Account
holder the amount of money that they invested.
4. At the point of opening an account, the bank
should be required to inform the customer of
the intended uses for the money that will be
invested, along with the expected risk level.
The broad categories of investment, and a
consumer-friendly ratng system for the risk of
those investments, will be set by the authori-
tes.
5. The risk of the investment now stays with the
bank and the investor, rather than falling on a
third party (i.e. the taxpayer). In some accounts,
the risk will fall entrely upon the bank, while
on others a large proporton of the risk will fall
on the investor. Any investor opening an Invest-
ment Account will be fully aware of the risks at
the tme of the investment, and those who do
not wish to take any risk will be able to opt for
an (almost) no-risk (and consequently low-
return) account. See the later secton on Invest-
ment Account guarantees for further details.
KEY ADVANTAGES OF THE
CHANGES:
1. Banks will be beter able to manage their cash
fow. Since all the investment funds that will
be used by the bank come from Investment
Accounts, and every Investment Account has a
defned repayment date (or a maturity date),
the amounts that the bank will need to repay
on any one day will be statstcally far more
predictable than under the current system.
For Investment Accounts with Maturity Dates,
they will know the exact amount that must be
repaid on any partcular date - they will also
know, from experience, what percentage of
customers with maturing accounts will ask for
the investment to be rolled over for another
period (in other words, what percentage of
accounts will not need to be repaid on the
maturity date). With regards to minimum notce
periods, they will know the statstcal likelihood
of an account being redeemed within the next
x days, and so be able to plan the payments
that will come due on any partcular day for
up to 6 months into the future. In additon,
because they have, on their loans-made side, a
collecton of contracts with specifed monthly
repayment dates and amount, they know
almost exactly how much money they will
receive on any partcular date up to 24 months
in the future (allowing for a small degree of
variance due to defaults and late payments).
Consequently the banks computer systems
will easily be able to forecast cash fow (money
coming in and out) over the next 6 months or
so, with a much greater degree of certainty than
under the present-day banking system, and
identfy any future shortalls that need to be
prepared for (for example, by scaling back loan
making actvity and building up a bufer). At the
same tme, it will be able to identfy periods
when the money coming in will be greater
than the repayments due to customers, and
therefore increase loan making actvity to soak
up the surplus.
2. The government and taxpayers will be neither
implicitly nor explicitly responsible for losses of
banks. Because the customer making an invest-
ment has explicitly agreed to accept the risks of
the investment, there is no need (nor a justf-
able case) for the government to guarantee any
investments. If a bank makes bad decisions and
loses money, the customers who provided the
money for those investments will lose money.
See further discussion of this under Risks to
Consumers below.
3. By retaining the strong similarites with present-
day savings accounts, we minimise confusion
for the public. There are already many savings
accounts with minimum notce periods or fxed
term savings accounts of up to 5 years, so it
is not a big leap to apply this to every type of
savings account. We consider this to be easier
for members of the public to understand than
asking them to invest in mutual funds, or asking
them to buy some form of investment certf-
cate or investment bond from the bank.
HOW SAFE WILL MY SAVINGS BE?
Under our reform proposals you have two optons:
Keep your money in a Transacton Account and
ensure that it is 100% secure (regardless of how
much money you keep in that account, there will be
no cap on the amount that is guaranteed)
Put your money into an Investment Account and
accept some risk in exchange for a return (i.e.
interest)
PROBLEMS WITH THE
CURRENT SYSTEM
Under the existng system, if a bank fails due to
bad investments, a third party (the taxpayer) will
reimburse the savers who have money invested with
that bank. (This scheme is called deposit insurance,
or the Financial Services Compensaton Scheme
in the UK. In the USA a similar scheme is run by the
FDIC - Federal Deposit Insurance Corporaton).
This creates a few serious faws or distortons in
the economic system:
1. It means that the banks can gamble with their
customers money in the knowledge that the
government will step in to cover any serious
losses. This creates moral hazard and encour-
ages the banks to take greater risks in their
investments.
2. It means that one group stands to beneft if
the bank is successful in its investments, while
another group (taxpayers) stands to lose if the
bank is unsuccessful. The government-backed
guarantee on funds in any UK bank accounts
means that bank account customers do not
need to pay any atenton to the actvites of
the bank that they choose to invest with. If
customers bear at least some of the risk of
the investment, it should encourage them to
be more vocal in how the banks invests their
customers money - maybe expressing concern
that large sums of money go in to risky propri-
etary trading, or requestng accounts where the
money is ring-fenced for certain types of invest-
ment.
Our proposal contains a few simple rules that
collectvely fx these fundamental problems in the
current design of the banking system. Practcally, it
works as follows:
1. An insttuton has the opton of ofering Invest-
ment Account holders a guarantee that they
will be repaid a minimum percentage of their
original investment. For example, the bank
may say that a partcular Investment Account
product guarantees to repay the investor at
least 100%, or 80%, or 60%, of the amount
originally invested.
2. The insttuton may also ofer a guarantee on
the rate of interest that will be paid on the
Investment Account product, for example,
guaranteeing to pay 2%, 4% or 5% interest.
A WORKED EXAMPLE:
Lets look at a worked example. Imagine that a
bank wants to atract funds to fund conservatve
housing market loans to middle-income families.
It charges an interest rate of 8% on the mortgages,
and it knows that only a tny percentage of the loans
that it makes to these middle-income families will
actually default. Consequently, allowing for defaults,
the normal case rate-of-return will probably be
around 7.8% overall (over all the funds invested in
this type of mortgage), and in the very worst case
scenario, with a high rate of defaults, the rate of
return might drop to 2% (with the losses of the
defaults being canceled out by the interest paid by
those who dont default).
Because the bank knows that, in the very worst case
scenario it is stll likely to make a return of 2%, then
it knows that investng in this market is efectvely
risk free, in that it is highly unlikely to lose more
than the bank originally invests.
Consequently, in order to atract more funds into
its Investment Accounts in order to fund more
lending in this partcular market (i.e. mortgages for
middle-income families), it may ofer to guarantee
the original sum invested, and guarantee a rate of
return of 2%. This makes this a risk-free investment
for the Investment Account holders, and provides
a good investment vehicle for savers/investors who
dont want to take much risk and dont need a very
high return.
In this situaton, the bank holds all the risk of the
investment. If the investments were made badly and
the bank actually lost 20% of everything it invested,
it would stll need to repay the entre original sum to
each Investment Account holders, plus 2% interest.
It would then need to cover its losses with its own
profts - in other words, bad investments by the
banks would wipe out their profts for the year (or
the next few years, if they really miscalculated their
investments).
Lets look at another scenario. Imagine that the
bank wants to raise funds for investng in a risky,
emerging market. The possible return here is much
higher, but the risk of loss is much greater too. The
bank wants to limit its own risk by sharing some of
the risk with customers. The potental interest rate
that it will ofer if its investments are successful is
8%. However, if it is unsuccessful, and the market
turns out to be a bubble about to burst, it could end
up losing up to 50% of the funds invested.
In this case, the bank may opt to ofer no guarantee
on the rate of return, and to ofer a guarantee of
60% of the principal invested. This would atract
funds but would force the investors to share the risk
with the bank. If the investments failed badly, the
investors would lose 40% of the principal, and the
bank would need to make up the other 10% of the
losses from its own profts.
Some of us may read the fgures above and say that
it is not fair that the bank only risks 10% while the
investors risk 40% of their investment. However, in
every case, each investor would have been made
aware of the guarantees, and therefore made their
own decision to invest in a partcular Investment
Account, knowing the risk to them and the potental
upside.
These two guarantees set up the conditons in
which competton between the banks will lead
them to ofer a full range of products for every type
of investor. Investors who want a high rate of return
will need to take on some of the risk themselves,
and investors who are happy with a low rate of
return will be able to invest efectvely risk-free.
NO GOVERNMENT
GUARANTEE ON INVESTMENT
ACCOUNTS
The Treasury and government do not back the guar-
antees made by the banks. If a bank went bankrupt,
Investment Account holders would become
creditors of the bank and would have to wait for
normal liquidaton procedures to take place to see
if they will get back part of their investment. While
this is likely to be unpopular with savers who have,
to date, been able to save without taking any risk at
all (thanks to the taxpayer-funded guarantee) there
is no morally or economically justfable reason
why savers/investors should have their investments
efectvely insured by UK taxpayers.
THE FSA OR BANK OF
ENGLAND MAY FORBID
SPECIFIC GUARANTEES
We have allowed whichever insttuton that is
charged with supervising the UK banking system
to forbid an insttuton from ofering a partcular
rate of return on a partcular Investment Account
product. This provision is necessary to prevent
banks from ofering unrealistc guarantees.
We know from history that professionals in the
fnancial sector are not very good at identfying
bubbles while they are in one. When a bubble
takes of in say, hotel constructon, a bank has an
incentve to ofer a beter guarantee than all its
compettors in a partcular Investment Account
product in order to atract the maximum amount of
funds for investment in the bubble. The guarantee
they ofer may be one that is based on the best
case scenario.
If the bank tries to ofer an Investment Account
product with a guaranteed rate of return of 8%, the
FSA may judge that it is highly likely that the invest-
ments themselves will not generate a return of 8%,
and therefore the bank will end up with a shortall,
which will increase the likelihood of the bank going
bankrupt or appealing to the Bank of England for
emergency funding. In short, ofering a guarantee
(on either the rate of return or the principal) which
bears no relaton to the real risks of the invest-
ment makes it more likely that the bank will run
into fnancial difcultes, and therefore the FSA or
Bank of England should be allowed to disallow any
guarantee in order to maintain the stability of the
banking system.
THE BANK OF ENGLAND AND THE
PAYMENTS SYSTEM
We now look at the bigger picture and explain how
the payments system works in the post-reform
economy. Understanding the payments system is a
pre-requisite for understanding how loan making
and investment will take place in the post-reform
banking system.
It is important to understand that money - at least,
97% of it - now has no physical form. It is merely
numbers in computer systems. With that in mind, it
should be remembered that unless you are referring
to physical cash, money is never actually kept
or stored anywhere. It is only recorded in one
computer system or another.
This is important because our reform requires some
subtle changes to the computer systems used in
the banking network, and these changes are easily
misunderstood if the nature of money itself is
misunderstood.
BANK OF ENGLAND HOLDS
ALL DIGITAL MONEY
Firstly, all digital money (other than cash and coin)
would be held in a central computer system
under control of the Bank of England. The Bank of
England already has a computer system, known as
the RTGS (Real-Time Gross Setlement) Processor,
which records the amount of central bank money
or reserves in the reserve account of each bank in
the UK. This computer system handles millions of
transactons every day, and with a few small tweaks
can be used to handle full-reserve banking under
the Positve Money proposals.
EACH BANK WOULD BANK
WITH THE BANK OF ENGLAND
In the same way that you or I might hold personal
bank accounts with HSBC or Natonwide, HSBC and
Natonwide (and every other bank) would in turn
hold accounts with the Bank of England. Each indi-
vidual bank would have three main accounts (stored
in the Bank of Englands RTGS Processor):
1. THE CUSTOMER FUNDS
ACCOUNT
This is the account in which all of each banks Trans-
acton Account funds are held. When a payment is
made to a Transacton Account holder by someone
at another bank, the balance of this account will
increase. When a Transacton Account holder makes
a payment to someone who uses a diferent bank,
the balance of this account will decrease.
2. THE INVESTMENT POOL
ACCOUNT
This is the account that the bank uses to receive
investments from customers, receive repayments
from borrowers, make payments back to Investment
Account holders and make loans to borrowers.
3. THE BANKS OPERATIONAL
ACCOUNTS
This is the account where the bank can hold funds
for its own purposes - retained profts, own capital,
money to pay staf wages etc.
Each of these accounts may be split into sub-
accounts to help the bank manage and segment its
own funds.
INDIVIDUAL BANKS MANAGE
INDIVIDUAL CUSTOMER
ACCOUNTS
While the Bank of England would hold the real
money (in digital form), it would not hold any
informaton on individual customers or customer
accounts. This would be the responsibility of the
individual banks.
The three accounts at the Bank of England would
be huge pots of money. Legally, the money would
belong to the banks (with the excepton of the
Customer Funds Account, where it would belong to
the individual customers).
For its Customer Funds Account, each bank would
record the amount of this money that is owned by
each and every one of its individual customers, and
the transactons made in and out of each customers
account. As a simplistc example, a banks database
may look something like this:
Mrs K Smith: balance 546.21
Mr W Riley: balance 1942.52
Mr J Heath: balance 26.78
The Investment Pool Account is money that techni-
cally belongs to the bank, so the bank would not
have corresponding records to divide this pool up
between customers.
However, each bank would need to keep records of
all its contracts and agreements, both to Invest-
ment Account holders and to borrowers.
For borrowers, it needs to know:
the amount lent
the agreed interest rate
the date of monthly repayments
the quantty of repayments to be taken,
and so on.
For each Investment Account, the bank will need to
have a record of:
the amount invested
the date the investment was made
the maturity date or minimum notce period
whether the minimum notce period has been
exercised
the interest rate agreed
MAKING TRANSACTIONS
BETWEEN ACCOUNTS
Understanding the following is not essental to
understanding the wider reform. However, an
understanding of the following will dispel a few
misconceptons and misunderstandings about how
the reform works.
In the present day, money is simply informaton.
Consequently, we need to look at computer systems
to understand how the monetary system will work.
The frst thing that must be understood is that,
under the new system, a commercial bank will not
have the power to create money electronically,
just as you do not have the ability to log into your
internet banking and change your own account
balance. Since all real digital money will be held in
the Bank of England computer systems, the Bank
of England gets to determine how the commercial
banks can interact with this money. As a result, they
can ensure with 100% certainty that it is impossible
for money to be created by anyone other than the
Bank of Englands Issue department, even in digital
form.
A WORKED EXAMPLE:
PAYMENT BETWEEN TWO
ACCOUNTS
Imagine that a customer, Jack, banks with HSBC and
pays using internet banking to transfer 400 in rent
to his landlord.
Jack logs in to his internet banking and flls in the
landlords account number and sort code, the
amount he wants to pay, and clicks Make Payment.
If the landlord banks with HSBC, then HSBC will
simply adjust its internal records to reduce the
balance of Jacks Transacton Account by 400,
and increase the balance of the landlords Transac-
ton Account by 400. The payment has now been
completed and cleared within fractons of a second.
The balance of HSBCs Customer Funds Account at
the Bank of England remains unchanged, since this
was an internal transfer within HSBC.
However, if the recipient (the landlord) is at another
bank, say Barclays, then HSBC must:
1. Reduce the balance of Jacks Transacton
Account by 400.
2. Send a message (via the computer system) to
the Bank of England. The message, in plain
English, will read something like this:
Transfer 400 from our Customer Funds
Account (CFA) to Barclays CFA. Tell Barclays that
the payment is for account number 295283742,
on behalf of account 192384192 (Jack Smith),
with the senders reference Heres the rent...
3. The Bank of England will then decrease the
balance of HSBCs Customer Funds Account by
400, and simultaneously increase the balance
of Barclays Customer Funds Account by 400
(in other words, it will transfer 400 from HSBC
to Barclays).
4. The Bank of Englands computer system will
then send a message to Barclays that will
read, in plain English, something like the
following: You have received a payment of 400
for Customer Account No. 295283742. The
payment was sent from HSBC Account number
192384192 (Jack Smith), with the senders
reference Heres the rent...
5. The computer systems at Barclays would then
update their own customer account record by
increasing the balance of the landlords Transac-
ton Account by 400.
The entre process outlined above could be done
in less than 30 seconds, and the funds would have
cleared instantly and be immediately available
to the landlord for making payments to other
accounts.
(For those with litle experience of computer
programming, the above may sound complicated,
but in reality the technology behind this process
is actually much simpler than the technology that
allows you to order a book at Amazon.co.uk - just a
litle more heavy-duty to handle billions of transac-
tons a day!)
With an understanding of the post-reform payments
system, we can now look at how loans will be made
afer the reform.
HOW WOULD BANKS MAKE
LOANS?
Unlike the current system, the process of making
loans afer the reform is very mechanical. The
process would move money from A to B, rather than
creatng new money (unlike the current system).
In the post-reform banking system, a bank will only
be able to make loans using money from one of the
following sources:
a) the money that bank customers have given
to the bank for the purposes of investment
(specifcally, the money that bank customers
have used to open Investment Accounts)
b) the banks own funds, for example from share-
holders or retained profts
c) any borrowings from the Bank of England (when
permited).
In contrast with the current system, all money in
Transacton Accounts (which would currently be
held in current accounts) is of limits to the banks
loan-making side of the business.
THE INVESTMENT POOL:
Each bank will hold an account at the Bank of
England, known as the Investment Pool. This
account will be held at the Bank of England. All
loans will be made from this account, and all loan
repayments will be paid back into this account.
FILLING UP THE POOL:
When a customer opens an Investment Account, the
behind-the-scenes transacton will actually involve
money being taken from the customers Transacton
Account and transferred into the banks own Invest-
ment Pool.
(Recall that the customers Investment Account is
really just a customer-friendly way of representng
the investment contract made between the bank
and the customer).
HOW BANKS WOULD MAKE
LOANS:
When the bank wishes to make a loan, it will
efectvely transfer the amount of the loan from
its Investment Pool into the borrowers Transac-
ton Account. To do this, it will need to instruct the
Bank of Englands computer system to transfer the
amount of the loan from the banks Investment
Pool into the banks Customer Funds Account,
and update its internal records for the borrowers
Transacton Account.
HOW CUSTOMERS WOULD
REPAY LOANS
When a customer wishes to make a repayment
on the whole or part of a loan (or when the bank
regularly takes its deposit), money will be trans-
ferred from the customers Transacton Account
back into the banks Investment Pool.
HOW BANKS WOULD REPAY
CUSTOMERS INVESTMENT
ACCOUNTS:
When an Investment Account reaches its maturity
date or notce period, the bank transfers the money
that it owes to its customer from its Investment Pool
into the customers Transacton Account.
WORKED EXAMPLE: MAKING
A LOAN:
Lets look at a worked example, startng with a
customer who wishes to invest some money.
1. The customer decides to invest 1000 in an
Investment Account with the same bank that he
normally uses for his Transacton Account. He
chooses the account type and agrees to accept
the terms and conditons of the account.
2. The bank then transfers 1000 from this
customers Transacton Account into the banks
Investment Pool. At the same tme, it creates
a record of an Investment Account of 1000,
belonging to the customer, and records details
of the maturity date, interest rate paid and
so on. The Investment Account does not hold
any money it is simply a user-friendly way of
representng this investment.
3. The bank now has 1000 in its Investment Pool
Account at the Bank of England, which it can use
to fund new loans.
4. A diferent customer applies for a loan of
1000. The bank makes this loan by transfer-
ring 1000 from the Investment Pool into the
banks Customer Funds Account and increasing
the borrowers Transacton Account balance by
1000 in its internal records.
(Note that in the example above, the fgure of
1000 is used for simplicity. There is no need for
the amount of a loan to match the amount of an
individual investment the 1000 loan could just as
well have been funded by 5 people investng 200
each. On a bigger scale, there would be thousands
of investors and thousands of loans, with parts of
each investment going into each loan.)
NOTE THE MAJOR CHANGE:
Note that in all these transactons, every tme the
balance of one account is increased, the balance of
another account is decreased by an equal amount.
In other words, money can only be moved from one
account to another.
This is in direct contrast to the current loan making
process, whereby the borrowers account is credited
with the amount of the loan but the original deposi-
tors are never told that their money is on loan. It
is impossible under this reformed system for new
money, purchasing power or credit to be created
within the banking system as a result of the loan-
making process (or indeed any other process).
INTER-BANK LENDING
Interbank lending in the post-reform system is very
simple. If Bank A wishes to lend 1bn to Bank B,
it simply instructs the Bank of Englands clearing
system to transfer 1bn from its own Operatonal
Account to the Operatonal Account or Investment
Pool of Bank B. The legal contract or agreement
dictatng how and when the loan will be repaid is a
mater for Bank A and Bank B to arrange between
themselves. The Bank of England will have no
interest in, or record of, which bank owes what to
who. It will only record the amount of money in
each of the banks accounts at any one tme.
As with loans to the general public, a bank may only
make a loan to another bank using:
a) Funds in the banks Investment Pool
b) The banks own capital (retained profts, share-
holders funds etc)
c) Banks should not make interbank loans with
funds that they have borrowed from the Bank of
England.
Consequently, with interbank lending, it is impos-
sible for both banks to use the same money at the
same tme. If the money is with Bank A, it cant be
used by Bank B. Clearing between the two banks
would be instantaneous and fnal, and no money
creaton would take place at any point in the
process.

WILL THERE BE ENOUGH
LENDING & CREDIT?
This reform will reduce the amount of credit or
more accurately, lending available in the economy,
from around 100% of the existng money supply
to around 50-60%. Considering that the authori-
tes focused on the credit squeeze as the biggest
problem in the recent fnancial crisis, the idea of
signifcantly reducing the amount of available credit
(lending) raises alarm bells for many people.
However, most of these concerns stem from an
incomplete understanding of how the monetary
system works. The reality is that our dependence on
credit is not a natural aspect of the economy it is a
direct result of allowing banks to create the natons
money as debt. When 97.5% of the existng money
supply was created as debt, and is therefore earning
interest, it creates infaton (especially in housing)
that necessitates people borrowing more simply to
survive.
Before we explain why a reducton in credit
(lending) will not be a problem afer the reform,
we need to clear up a few misconceptons about
credit, debt and lending.
CREDIT = DEBT
The term credit is used misleadingly. Credit has
positve associatons everyone wants a good
credit ratng, and your salary appears in your bank
account under the credit column. But in this case,
bank credit means debt. If we say that businesses
depend on access to credit, we are saying that
their fnancial situaton is poor enough that they
urgently need to go into debt. Of course, very new
businesses and businesses which are expanding
rapidly will need access to credit/debt, but the fact
that many businesses will go bankrupt as soon as
banks stop ofering them further debt points to the
poor fnancial health of most businesses. This poor
fnancial health is not the natural state of afairs it
is a symptom of a monetary system where all new
money is created by the banks.
WE ARE DEPENDENT ON
CREDIT/DEBT BECAUSE OUR
MONEY SUPPLY IS DEBT
The absolute dependence on credit, and the
fact that the economy grinds to a halt whenever
credit dries up, is used to point to the importance
of credit in a modern economy. In reality, it points
to a chronic shortage of debt-free money in the
economy. By defniton, if the economy needs
credit to contnue functoning, we are dependent
on debt.
Under the existng fractonal reserve banking
system, the only way the public can get money is to
borrow it from banks. Consequently, if banks dont
lend, the economy doesnt have a money supply.
This is the main cause of our dependence on debt/
credit.
Over the last few decades we have all become
accustomed to having total debts equal to 5 or 6
tmes our annual salary, and businesses having
debts as much as their annual turnover. However,
this is not a natural state of afairs it is a product
of a system where almost all money only comes into
existence when someone takes out a loan.
This means that, while economists argue that easy
access to credit is essental to a well-functoning
economy, in reality, dependence on credit is a
symptom of a malfunctoning economy and a
malfunctoning money supply. The debt-based
monetary system actually creates the need for
companies and households to access credit (debt).
In other words, we are all so far in debt because we
allow our money to be created as debt.
The answer to our debt-dependency is not more
debt (despite politcal leaders shoutng We must
get banks lending again!) but newly created,
debt-free money, which can help to cancel out the
debt and reduce our debt-dependency.
AS DEBT-FREE MONEY
CANCELS OUT THE DEBT, WE
WILL HAVE LESS NEED FOR
CREDIT
As we create and inject debt-free money into the
economy, this will allow individuals and companies
to gradually pay down their own debts and start to
increase their savings. With greater savings, people
have less dependence on debt, and therefore access
to credit (debt) becomes less critcal to the health of
the economy.
AS THE AMOUNT OF CREDIT
FALLS AFTER THE REFORM,
DEMAND FOR LENDING WILL
ALSO BE FALLING
The amount of credit/lending available afer the
reform may gradually fall to around 50% of the
current level. At the same tme, newly-created
money will be injected into the economy, not as a
debt into the housing market, but as tax cuts, tax
rebates and government spending.
This newly created debt-free money provides a
stronger stmulus than debt-based money created
by the banks, since there is no need to pay an
interest charge on the money as soon as it is
created. As a result, the economy should improve,
and people will be beter able to pay of their
existng debts, pay down mortgages, and improve
their fnancial positon. With lower taxes and a
more buoyant economy, the need to go into debt
will fall and apply to fewer people. In other words,
the demand for credit will fall in tandem with the
availability of credit.
If there are any shortalls in the amount of credit
available during the transiton phase between
the two systems, these can be met by the MPC
choosing to create more money (if all the other
economic indicators also point to the need for more
money), or by lending money directly to banks on
the conditon that this money goes into productve
lending funding businesses rather than consumer
credit cards, for example.
THE CURRENT SYSTEM
SUPPLIES TOO MUCH CREDIT/
DEBT
Bank assets (loans) and liabilites (bank deposits,
the money in your account) have increased by a
staggering amount in the last 30 years (by a factor of
ten, relatve to GDP). This has brought with it some
lending which has been clearly irresponsible and
on a massive scale, e.g. NINJA mortgages. Thus the
idea that there is something inherently wrong with
a reduced amount of lending is clearly nonsense (if
not positvely hilarious). A system that provides less
credit than fractonal reserve banking is much more
likely to lead to a steady and stable economy, rather
than the stop-go economy that weve had for the
last few decades.
WHAT ABOUT OVERDRAFTS?
Overdrafs on Transacton Accounts can play a key
part in the post-reform banking system. Firstly, they
will provide a short-term liquidity bufer to house-
holds and businesses. Secondly, they will provide a
very useful indicator on the need for more (or less)
new money to be injected into the economy.
THE LIQUIDITY BUFFER
Overdrafs provide short-term liquidity and allow
businesses and individuals to smooth out temporary
mismatches between their incoming and outgoing
cash fows (for example, if an individuals bills need
to be paid just a few days before their salary is paid
into the account). There would be no advantage to
the bank, to the customer, and to the economy as a
whole of removing the overdraf functonality from
Transacton Accounts.
INDICATING CHANGES IN THE
NEED FOR MONEY IN THE
ECONOMY
The balance of one overdraf may fuctuate wildly
through the month and at diferent tmes in the
year. However, averaged over millions of Transac-
ton Account holders, the average balance will
be fairly stable. This means that changes in this
average balance will indicate signifcant changes in
the economy. If this average balance is increasing
(i.e. people on average are going further into their
overdrafs) then it indicates that people do not have
enough money to meet their regular expenses, and
could therefore mean that the economy needs a
greater injecton of new money. On the other hand,
if average overdraf balances are falling (people are
on average paying of their overdrafs) it could
mean that there is spare money in the economy
and point to the possibility of infaton in the near
future.
HOW OVERDRAFTS WILL BE
FUNDED
Overdrafs will be funded like any other loan, from
money that the bank has borrowed from customers
(who will have put the money into investment
accounts).
WOULD THIS MAKE BANKS MORE
STABLE?
These reforms would make banks signifcantly more
stable. There are some major sources of instability
in the current system that can be removed with
a few simple changes to the way that banks do
business.
SOURCES OF INSTABILITY
UNDER THE CURRENT
BANKING SYSTEM
Instability under the current banking system comes
from a variety of sources:
1. Every loan that the banking system makes
creates more deposits (the numbers in your
account), and consequently funds more loans.
As a result, as peoples fnancial situaton gets
worse and they take on more debt, the overall
availability of loans increases. This creates a
positve feedback loop as we get further and
further into debt, banks become increasingly
willing to ofer us more debt. This develops into
high levels of personal and household debt,
which eventually become impossible to repay.
This in turn triggers a wave of defaults, such
as seen in the sub-prime mortgage market in
America, which in turn triggers a domino efect
throughout the economy. This means that the
loans that banks originally expected to be repaid
are no longer likely to be repaid, creatng a huge
shortall in their income and potentally bank-
ruptng them. In short, the design of the current
banking system makes it fundamentally prone
to collapse.
2. The majority of the banks customers can
demand repayment at any tme from any
accounts that do not have maturity dates or
notce periods. This could result in the bank
being required to pay back huge sums of
money in a short period of tme, making the
bank illiquid (unable to make payments). If this
contnues, the bank becomes ofcially insolvent
and would therefore be bankrupt. This is what
happened to Northern Rock in 2007. The banks
try to guard against this by keeping back enough
reserves at the Bank of England to meet any
likely payments, but they contnually walk a
knife-edge between keeping reserves high
enough to cover the maximum likely net with-
drawals, and keeping them as low as possible in
order to free money up for making further loans
(to maximise profts).
STABILITY IN THE POST-
REFORM BANKING SYSTEM
The post-reform situaton is much more stable. The
stability arises from the fact that the funds a bank
uses to make loans are now locked in customers
can no longer demand them back whenever they
choose. As a result, the bank knows:
What it will need to repay to customers who
have made investments, and when.
What it will receive from borrowers making
repayments on their loans, and when.
Money withdrawn from Transacton Accounts
doesnt afect the bank in any way, as the money is
stored in full at the Bank of England, and therefore
doesnt need to be found from anywhere when it
has to be repaid.
Since all the investment funds that will be used
by the bank come from Investment Accounts, and
every Investment Account has a defned repayment
date (or a maturity date), the amounts that the bank
will need to repay on any one day will be statst-
cally many tmes more predictable than under the
current system.
For Investment Accounts with Maturity Dates, a
bank will know the exact amount that must be
repaid on any partcular date, and will also know,
from experience, what percentage of customers
with maturing accounts will ask for the investment
to be rolled over for another period (in other words,
what percentage of accounts will not need to be
repaid on the maturity date).
With regards to minimum notce periods, a bank will
know the statstcal likelihood of an account being
redeemed within the next x days, and so will be
able to forecast the payments that will come due
on any partcular day for up to 6-12 months into
the future. In additon, because a bank has, on its
loans-made side, a collecton of contracts with
specifed monthly repayment dates and amount,
it knows almost exactly how much money it will
receive on any partcular date up to 6 months in the
future (allowing for a small degree of variaton due
to defaults and late payments).
Consequently, the banks computer systems will be
able to easily calculate how much money should
be required on any partcular day up to 2 years into
the future. If it identfes any potental cashfow
problems (such as a large number of Investment
Accounts maturing in a short period of tme and
insufcient income from loan repayments to cover
them all) the bank can rein back loan making actvity
untl it has built up a bufer to cover the upcoming
shortall. On the other hand, if the cashfow
forecasts identfy a period when repayments from
existng borrowers are in excess of the amounts
required to repay Investment Account holders, it can
increase loan making actvity to ensure that it does
not end up with a swelling Investment Pool Account
full of idle funds.
SOURCES OF UNCERTAINTY IN
THE POST-REFORM BANKING
SYSTEM
There are three sources of uncertainty in the post-
reform banking system. The frst source relates to
the banks in-comings, and the other two relate to
the banks potental outgoings:
1. The risk of default by borrowers. However, it
should be remembered that the risk of defaults
will be signifcantly lower throughout the entre
fnancial system afer the reform
2. Uncertainty about the likely use of minimum
notce periods. At any one point in tme, there
may be billions of pounds of liabilites subject
to short-term minimum notce periods. For
example, imagine that a partcular bank has
10bn in Investment Accounts that are subject
to a 30-day minimum notce period. In an
extreme case, if a rumour spread that that bank
had made some bad investments, and all these
account holders exercised their minimum notce
period, the bank may be required to repay
10bn in 30 days from now. Again, while this is
stll a source of instability, it is both less likely to
occur than under the current system, and if it
does occur, the total impact on the bank would
be far less.
3. Uncertainty about the proporton of customers
who will (or wont) roll over their investment
accounts as they mature.
THE LOWER LEVEL OF
SYSTEMIC RISK:
We believe that the risk of any bank or all banks
sufering a cashfow crisis is signifcantly lower
post-reform than under the existng banking system,
for the following reasons:
1. Unlike the present day banking system, the
post-reform banking system is counter-cyclical,
rather than pro-cyclical. This means that the
banking system will not create debt-fuelled
booms that soon turn into economic crashes,
causing a wave of defaults. Consequently, each
banks loan portolio is likely to be far safer than
under the current system.
2. The economy will be generally more benign.
Without regular banking-fuelled boom and bust
cycles, recessions will be less frequent and less
severe. If a million people are no longer thrown
out of employment every few years, then fewer
people will run into fnancial difcultes, and
therefore fewer borrowers will be forced to
default.
3. Because the bank has limited funds for making
loans (and because each loan does not create
new deposits), the incentve for loan-making
departments shifs from lending as much as
possible, to fnding good quality borrowers to
lend to. As a result, the banks are less likely to
lend to bad-risk borrowers, and consequently
the overall quality of a banks loan portolio
should be higher, making defaults less likely.
PROVISION FOR
EMERGENCIES
We have made provisions for the situaton where
a bank does not have sufcient funds in the invest-
ment pool to re-pay maturing Investment Accounts.
In this situaton, the Bank of England has the discre-
ton to make an emergency loan to the bank in
queston. This loan must always be used to re-credit
the maturing Investment Account it can not be
used to fund new loans.
This may sound a litle like the taxpayer-funded
bailouts that we have seen over the last few years.
In reality, it is completely diferent the emergency
loan will consist of nothing more than numbers
added to a computer system; in other words, it
will be newly-created money, and will not cost the
taxpayers anything. The borrowing bank will need
to repay the loan in full, out of its future income. If
the bank needs to borrow signifcant amounts, then
it is unlikely to earn a proft for a number of years.
However, as the bank repays the loan, this newly
created money will be destroyed again, ensuring
that the emergency loan has no long-term efect on
the money supply. This emergency loan will merely
provide some liquidity for the individual bank in
unusual cash-fow circumstances.
Note that this emergency loan should only be
provided to meet a short-term liquidity problem
for example, if a recession had caused a larger
withdrawal from short-term Investment Accounts
than normal. In deciding whether to support the
bank with such an emergency loan, the Bank of
England should look closely at the banks loan
portolio and future income. If this is purely a short-
term cash-fow problem (i.e. loan repayments are
out of synch with maturing Investment Accounts),
the loan portolio is healthy, and its clear that the
bank will soon be able to repay the emergency loan,
then the emergency loan should be made. However,
if the cash-fow problem arises because the banks
loan portolio is toxic and a large proporton of
borrowers are defaultng, it may be unlikely the
Bank of Englands emergency loan will be repaid.
In this case, the Bank of England would probably
choose to initate wind-down procedures for the
bank in queston.
PENALISING BANKS FOR POOR
CASH-FLOW MANAGEMENT
The Bank of England or the banking regulator can
and should penalise banks that have to seek
emergency funding. There are a number of ways
that they could atempt to do this:
By charging a punitve rate of interest on the
emergency loan (reducing the banks future
profts)
By charging a monetary fne
By launching an in-depth investgaton into the
bank by the banking regulator
By any other method that the banking regulator
believes will prevent further transgressions by
the bank in queston or any other bank in the
industry.
Rather than a bank in trouble representng a
huge fnancial burden on the taxpayer, under
our proposed reform it could actually be an
opportunity for the state to proft in real and
absolute terms.
NO BAILOUTS OF BAD BANKS
The provisions above mean that the Bank of England
would have the power to lend money to a bank in
order to prevent it sufering a temporary cash-fow
crisis, and that doing so would have absolutely no
fnancial cost to the taxpayer.
However, we are keen that this should not be seen
as state support for banks that are fundamen-
tally unsound. We should not see governments
supportng toxic banks in the way that we have
seen over the last three years.
If a bank is judged to be badly managed or have
made bad investments across the board, meaning
that all holders of Investment Accounts are likely
to lose money, then the bank in queston should
be wound down, broken up and sold of to either
healthier banks or debt collecton frms. (Note
that by debt collecton frms, we are referring to
companies that would buy at a discount the legal
contracts between the bank and its borrowers, and
collect repayments over a period of tme, according
to the payment terms in the individual contracts.
No borrower would be requested to repay the loan
earlier than originally agreed).
In the post-reform system, winding down a bank
would be far easier and cheaper than under the
existng system, for the following reasons:
The funds placed in Transacton Accounts are 100%
safe, held separately from the banks investments in
the banks Customer Funds Account at the Bank of
England.
The taxpayer and government has no exposure or
responsibility whatsoever for the funds owed to
holders of Investment Accounts. The Investment
Account holders would become creditors of the
liquidated bank, and insolvency law would govern
whether and by how much they are repaid their
original investment.
Writen By: Ben Dyson
Positve Money
205 Davina House
137-149 Goswell Road
London
EC1V 7ET
Tel: +44 (0) 207 253 3235
Email: info@positvemoney.org.uk
This work is licensed under the Creatve Commons Atributon-NonCommercial-
NoDerivs 3.0 Unported License. To view a copy of this license, visit
htp://creatvecommons.org/licenses/by-nc-nd/3.0/
February 2012 Positive Money
(Version 1)

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