Proposals

#9 Restrict money creation by banks

The immense power of private commercial banks to create money and determine where it goes and at what price, contributes to a fragile and unstable financial system, because banks tend to lend more in certain sectors than others.

To make the system more safe, some have proposed a radical  proposal (often called “narrow banking” or “full-reserve banking” or “sovereign money”) under which banks would be restricted in their ability to create money when making loans.

In these alternative models, to make loans to customers, banks would be required to use pre-existing money, instead of creating it. Banks have two options: either they would mobilize money from a pool of customers’ savings (known as loanable funds), or by borrowing central bank money from the European Central Bank (ECB) in the first place, as they already do currently under refinancing operations (such as Targeted Longer-Term Refinancing Operations (TLTROs).

From a consumer perspective, this would mean that our current bank accounts would become totally risk-free, as this money would be kept strictly separate from the banks’ lending activities. The establishment of a digital euro would create a step in this direction, as people could choose to put their money outside of banks’ deposits. But if everyone was to put all their money in those digital euro accounts, it would become more difficult for banks to lend to businesses as no money would be available in loanable funds.

The money in our savings accounts would be remunerated, but it would be less easy to withdraw money from it, because borrowers would have to repay the bank first.

Under a less radical proposal, known as “bank separation”, banks’ most speculative activities (such as investing in big firms and speculative market trading) would be separated from “daily” retail bank activities (managing deposits and loans for customers). The two types of activities would be run in separate entities so that the risk on investment activities does not jeopardize deposits. However credit creation by banks would still involve creation of money.

This reform proposal requires a rather fundamental rethink of the way the current system is designed, and it is not yet clear whether the ECB could decide such transformation alone or if other political decisions would be needed.

➕ Pros

• The banking system would no longer face “systemic risk” where the failure of one bank escalades in the failure of the whole system. Banks would no longer be “too big to fail”.
• Our savings would be better protected, thus reducing the risk of a “bank run” (i.e. when everyone rushes to withdraw their money from the bank for fear of losing their savings).
• Deposit guarantee schemes would become redundant.

➖ Cons

• There is a risk of slowing down the economy if banks do not have enough loanable funds to offer credit to businesses.
• This would make the ECB even more central and powerful in the financial system, as banks would rely a lot more on ECB funding to make loans.
• The system would become more complex for consumers.
• The transition to this new system would be complex and uncertain.