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A national depository system – radical banking alternative – William F. Hummel

A near melt-down of the global financial system in 2008 sparked renewed inter- est in banking reform as well as alternatives to the current banking system, whose modus operandi is widely believed to be a root cause of the asset price bubbles that can end in debt deflation and deep recessions. The following proposal by William F. Hummel for a national depository as an alternative to the current banking system has been extracted from his website [1]. The original article is set within the frame- work of the U.S. financial system but the principles discussed by him apply more generally, and so the text has been modified accordingly.

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A brief overview

The national depository system that is described here can be regarded as the functional equivalent of a full reserve banking system, but simpler and more efficient. It consolidates the transaction deposits of the many thousands of banks and other depositories into a single depository (the Depository), run as a public service by the central bank (CB). The depository role of banks would no longer exist, but banks would continue to function as profit-seeking financial intermediaries.

The Depository would offer accounts to all who need the payment services of a traditional bank. It would only hold transaction deposits and would pay no interest. The Depository would neither lend nor borrow, but it would execute payment orders and handle the financial accounting.

The deposits themselves would be liabilities of the CB and therefore legal tender. The term reserves (also known as exchange settlement funds) would no longer be relevant and could be dropped from the financial lexicon. The deposits together with the circulating currency would comprise the entire money supply.

One should not confuse the Depository with the CB. The latter would continue to implement monetary policy through open market operations (OMO) and loans to banks. All such transactions would result in credits or debits to the accounts in the Depository and thus affect the private sector money supply.

Transition to the national depository

Transition to the national depository system would begin after a full reserve system had been in operation long enough to settle into steady state. All reserve accounts at the CB would be transferred to the Depository. Bound reserves would become deposits of the respective owners. Free reserves would become deposits of their respective banks. And at their option, banks could exchange their vault cash for deposits at the Depository. The balance sheets of banks would be downsized by the transfers, but the net worth of each would remain unchanged.

The required infrastructure would have to be built and ready for use. It would consist of a secure computer network of the different central bank branches, and an ATM system to withdraw or deposit currency. The ATMs could be located in banks that offer to provide the service as well as in post offices. The Depository itself would not handle currency.

Banking after the transition

Banks could neither create nor accept transaction deposits. However they could accept fixed-term loans of various maturities and pay interest on them.

They could also offer interest-earning savings accounts in the form of indefinite term loans, redeemable on 7-day notice. All loans to banks would be insured by the government. The funds paid by an investor in a loan to a bank would be credited to the bank’s account in the Depository, and immediately available to the bank for its own investments.

Being no longer able to create deposits through lending, banks would operate much like current nonbank intermediaries, borrowing to lend out at a profit.

Differences from those intermediaries include privileges in their relationship with the CB, a fiduciary role with clients, and regulatory constraints. Banks could execute payment orders out of client accounts if authorised; offer loans out of their own Depository accounts; offer insured interest-earning investments; and provide on-line banking services and ATMs for cash management. Fees could be charged but a bank would likely provide such services without charge as long as the client held a term loan to the bank.

The computers used by the Depository would be simply an extension of the CB’s computer system. Payment orders would be accepted by electronic means via plastic cards, the Internet, CB wire, smart phones, or by telephone. Paper cheques would be phased out, after which verifying balances and making payments would all be done in real time. The time delays and nuisance of cheque float would vanish. Payments would be executed by simply transferring funds between accounts. The only exception would be transactions with the CB which would involve a transfer of funds by wire in or out of the Depository.

Managing bank liquidity

Since money in the Depository would earn no interest, banks would normally hold only what is needed in the near- term for operating expenses, making investments, and redeeming maturing liabilities. Money acquired in excess of that would be invested in Treasury securities and in loans to the CB or the money market.

If a bank had to acquire additional funds in order to issue a loan, it would have several options — borrow from the CB, borrow from another bank, borrow from a non-bank, repo securities, or sell securities outright. Borrowing from the CB would increase the total money supply, but the other options would simply move funds between accounts within the Depository.

The CB would offer 7-day loans at its policy interest rate to any bank that can pledge collateral for the amount of the loan while maintaining a capital/asset ratio of at least 10%. Loans could be renewed indefinitely as long as the financial requirements were met. Banks should therefore hold a good supply of Treasury securities to serve as collateral in borrowing from the CB. The CB would also accept 7-day loans from banks at its policy rate. That would provide a secure place to park a bank’s unneeded funds in the near term while earning a return. It would also reduce the amount and cost of interbank lending.

The purchase of securities from the non-bank sector by CB OMO would not directly increase bank liquidity. The proceeds of the sales would all flow to the sellers’ accounts in the Depository. However the sellers would normally reinvest the proceeds to earn a return rather than leaving them idle in the Depository. Banks should therefore actively seek term loans from the sellers by offering competitive interest rates. Such loans would directly increase bank liquidity and require no pledged collateral since they would be insured.

Monetary policy implementation

The control variable for monetary policy would be the interest rate set by the CB in lending to or borrowing from banks. That determines the cost of funds to banks and, after a mark-up, the interest rate banks would charge on loans to private sector borrowers. For any given policy rate, the CB would play a passive role in meeting the liquidity demands of the private sector.

Based on the aggregate amount of lending and borrowing with banks, the CB could determine the approximate amount of money to add or drain by OMO to achieve a balance. It would purchase securities in the open market when its lending exceeded its borrowing by some threshold amount, thereby increasing private sector liquidity and decreasing the demand for bank loans.

Conversely the CB would sell securities in the open market when its borrowing exceeded its lending. By maintaining an approximate balance in its borrowing and lending, the money supply would automatically increase in a growing economy. How well that would meet the liquidity needs of the economy depends on the policy interest rate set by the CB.

Improving Banking System Stability

To improve banking system stability, new operating rules and restrictions for banks should be established. For example, a bank’s book value plus retained earnings should be at least 10% of its risk-weighted assets. A bank should be required to carry on its own balance sheet at least 10% of each loan it issues so as to share in the risk of a default by the borrower.

Permissible investments should exclude those whose basic purpose is to lever- age bets in the financial markets. Since banks could no longer hold demand deposits on their own balance sheets, there is little possibility of a classic bank run in the national depository system.

Each account in the Depository would be labelled to indicate the type of owner, for example: bank; credit union; non-bank financial; non-bank non- financial; non-profit; Eurodollar bank; foreign central bank; or individual.

Without disclosing the account owners or their holdings, the data could be aggregated on a minute by minute basis and made available for economic analysis. That would be particularly useful in times of economic or financial stress.

1. Source: William Hummel’s website, Money: What it is, How it Works (Oct 2016)

William F. Hummel has a longstanding interest in money, banking, post-Keynesian economics, and long-term Investing.

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