Reserve banking

The Vollgeld Initiative and the Future of Fractional Reserve Banking

The 2008 financial crisis took many of us out of our comfort zones, leading to the argument for a complete overhaul of the monetary and banking system. This very concept was recently the subject of a petition in Switzerland. Known as the Vollgeld Initiative, its main purpose is to separate money creation from fractional reserve banking. After receiving the required number of signatures, the initiative will go to a public referendum in 2017 or 2018. If successful, it will be such a profound change that it is worth exploring.

Supporters of the initiative believe it will strengthen the Swiss franc and make the banking system more stable. Their objectives are to separate the systems of cash creation and loan payment; create a stable money supply; reduce the burden of personal and family debt; align risk and reward; and create a structure that allows banks to go bankrupt. These are indeed laudable goals.

Two of the most important changes proposed are deposits guaranteed 100% by foreign currency and the public financing of commercial bank loans. In fact, the money deposited in the banks would never really be a liability of the banks, but rather a singular liability of the federal government. Banks will charge a small fee for storing cash and processing payments. Government loan financing will effectively concentrate its power, allowing it to primarily serve government and political interests, but not necessarily the well-being of the public.

The focus is on the commercial banking system. The loan exists wherever two parties enter into a contract as borrower and lender. For example, insurance companies are constantly entering into contractual relationships to lend money and earn interest in return. Likewise, investment banks use their balance sheets to structure and purchase, for example, mortgage-backed securities. Basically, they fund loans. These are examples of “shadow banking” activities that operate outside the traditional banking system, and these “shadow lenders” each benefit from third party funding. So while the commercial bank itself might be tamed and exploited by the initiative, it says nothing about how the shadow bank might be affected. Human nature being what it is, the lending function is likely to shift more strongly to shadow banking.

In terms of systemic risk, the causes of systemic instability include: leverage, interdependence and buffers. While proponents want leverage in commercial banking to decrease, it is not clear what could result. In order to obtain an adequate return on capital, commercial banks may be forced to resort to third-party sources of funding (and not deposits). The initiative also does not say how leverage might manifest itself in other sectors, such as investment banks and other financial intermediaries.

Either way, commercial banks will each be beholden to a single source of funding (i.e. the Treasury), thus increasing the interdependence of the entire system. The mistakes made by the government will immediately spread throughout the financial network. Finally, the Vollgeld plan is silent on the buffers. It is not known exactly how much capital banks and other financial institutions may hold, nor how much collateral may be required for financial transactions. Therefore, if the Vollgeld effect is negative, then the private and public sectors can reduce the buffers in order to achieve higher growth rates, causing further systemic instability.

Would the end of fractional-reserve banking, overall, be a positive or negative development for capital markets or investors?

It seems like CFA Institute Financial NewsBref readers are concerned about the negative consequences of the Vollgeld Initiative. When asked, “Would the end of fractional reserve banking, overall, be a positive or negative development for capital markets or investors?” our respondents answered overwhelmingly in the negative. Of the 437 participants, nearly 58% said it would be negative, while only 19% suggested it would be positive. The others were undecided. For a more comprehensive review of the Vollgeld Initiative and what it might mean for the future of fractional-reserve banking, Dirk Niepelt, director of the Study Center Gerzensee and professor at the University of Bern, and I debate its merits:

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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics and Alternative Assets at the CFA Institute, where he wrote on economics, monetary policy, currencies, global macroeconomics, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among others). Previously, he was Senior Vice President and Director of Large Cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, customer service specialists and marketing staff. He was also Senior Vice President and Senior Portfolio Manager of Large Cap Equity Products at Mesirow Financial. Rimkus holds a BA in Economics from Brown University and an MBA from the Anderson School of Management at UCLA. Thematic skills: Alternative investments · Economy

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