“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” (Henry Ford)

Basel regulation, in effect, only tinkers with the current system- Martin Webster

Revolution, or at least the potential for it, seemingly goes hand in hand with crises. It may lead to fundamental change, as in the case of the storming of the Bastille and more recently the Arab Spring. It may be suppressed, as in the case of the Eurocrats, Syria’s al-Assad and other unelected despots with an insensitive attitude towards human suffering. At the very least, a society in disarray should lead to introspection as to the viability and integrity of the status quo.

Let us consider the role of the banks. Commercial banks take deposits, and lend money. Investment banks do not take deposits – they operate in the capital markets, both as brokers and by taking proprietary risk. There was a time when investment banks were exposed to unlimited liability, and could not merge with commercial banks. In the name of progress, that divide was removed – in 1986 in the UK, and 1999 in the US. Many attribute the birth of the financial crisis to that momentous decision. That move effectively allowed investment banks to gain access to deposits covered by government-sponsored compensation schemes. These deposits were used in the same way as own funds, to seek a profit – not by lending, but by making bets in the market. When the going was good, the (now composite) bank would benefit. When the going was really bad, the taxpayer would suffer (through bailouts). One would argue that a system which confers rewards to one party but surreptitiously transfers the risks to another is neither viable nor equitable.

Incidentally, I would contend that such a system exists today within Malta’s banking sector.

Note also that, in effect, the capital market was indirectly competing with loan applications. There are a number of reasons why a composite bank might elect to divert capital to the market as opposed to granting loans – liquidity and the chance to crystallise a quick profit, and bonus, for example.

Predictably, there are now calls to reinstate the dividing wall between commercial and investment banking activities. This would appeal on many levels, not least the ability to remove the deposit compensation umbrella from investment banks and cut off their access to unrealistically cheap (relative to the risk profile of its application) funding. It could also remove the ability of banks to prop up governments by buying sovereign debt with ‘excess funds’, and concentrate exclusively on the socially desirable objective of extending credit to the private sector – cheaper credit, to the extent that the crowding out effect is removed. For that activity, and that activity alone, a deposit compensation scheme would be rational.

However, perhaps this might be an opportune time for a more fundamental assessment of what a bank is all about and how money and credit is created. Just as there was a time when commercial and investment banks were kept apart, there was also a time when the creation of money was in the gift of the sovereign and banks were mere custodians.

In the UK, all that changed when the Free Coinage Act of 1666 was passed. This allowed the private sector to create coins, setting the principle that the private sector could create money – and consequently credit. One man’s credit is another man’s debt. It was an extraordinary surrender of sovereign prerogative, and has been called ‘‘the greatest calamity to occur in the whole history of money’’ (Alexander Del Mar). It certainly was, if the subsequent financial crises can be attributed to it.

In that context, it is interesting to read a recent authoritative report from the IMF titled The Chicago Plan Revisited. The authors model what would happen if the Government were to remove the right of the private sector to create money (almost all money is created by the private sector). They corroborate the benefits identified by Irving Fisher: better control of business cycles (driven by bank appetite to lend); complete elimination of bank runs; and dramatic reduction in private and net public debt. They also make their own claims of larger output gains and the possibility of zero long run inflation.

Some might argue that Basel regulation addresses the weaknesses in the banking sector. Basel, in effect, only tinkers with the current system. It changes the degree, but not the principle. Increasing own funds, minimising duration mismatch, and mitigating against the effects of failure is all well and good – but this report eloquently argues that the very risk of failure can be eliminated in the first instance. The authors make the point that this modelling is grounded in reality, and the transition is possible. This is an intriguing proposition – but one which will no doubt not get the attention it deserves.

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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Martin Webster is head of equity research at Curmi and Partners Ltd.