If banks do not have a 100% capital ratio, they are subsidised

If government so much as hints that it will rescue banks in trouble, that constitutes a subsidy of banks, and subsidies misallocate resources. Alternatively, if government makes it clear it will never rescue banks, then all of those who fund banks, regardless of whether they are called depositors, bondholders or shareholders, in effect become shareholders. That is shareholder as in “someone who at worst stands to lose everything”. Since subsidies misallocate resources, i.e. reduce GDP, it follows that the GDP maximising option is the latter second one, that is a system where banks are funded just by shareholders or people who are in effect shareholders. And that equals or leads inevitably to full reserve banking. One apparent escape from the latter conclusion for conventional banking might seem to be a system in which banks retain depositors in the conventional sense of the word (i.e. people who are guaranteed all their money back) with that guarantee made good by some sort of self-funding insurance like FDIC. However there are several problems there. One is that FDIC type insurance involves moral hazard in the form of the temptation take excessive risks, keep the profit when all goes well, and have the insurer pay when the risks go wrong. That is a very real cost. Indeed, that sort of moral hazard is widely seen as one of the main causes of the recent crisis, the real costs of which were astronomic. Thus FDIC type insurance costs more than self-insurance, which is what shareholders do. Thus the conclusion is that the GDP maximising arrangement for banks is full reserve. Also the latter point about insurance means that a more accurate title for this paper would be “If banks do not have a 100% capital ratio, they are subsidised, or we have a bank system that does not maximise GDP”. However, that sentence is probably too long for a title. The UK’s Independent Commission on Banking tried to criticise full reserve. Their arguments are examined and shown to be badly flawed. Section 1 sets out the basic argument. Section 2 (p.10) sets out the arguments against self-funding insurance for banks. Section 3 (p.15) considers the arguments against full reserve banking put by the Independent Commission on Banking. The ideas in this paper are ADDITIONAL TO the ideas in Musgrave (2014) rather than a MODIFICATION of the later ideas. I am grateful to Vincent Richardson for reading the draft of this paper. All errors are my responsibility.