If you wanted to follows the Basel risk adverse philosophy your proposal of reserve requirements has some merits in that it allows each banks to set their own reserve requirement based on their own criteria or risk reflected in how high or low interest rates they charge. That part I like, since it does not bound the market to the opinions of some few credit rating agencies. Of course it could not be precisely as you indicate, based on the nominal interest rates, as these will fluctuate independently of risk, but one could think of using the spreads charged over some reference rate like Libor.

That said I am totally opposed to it, just as I am opposed to the current Basel mechanism, because the interest charged to the client already includes the market premium on risk and with this system the regulators imposes an additional cost or tax for risk-taking (a tax on the borrower Min) and in relative terms subsidizes what is perceived to have a lower financial risk, and I do not believe it is the responsibility of banks to pursue high or low risks but the right risks.

This method, just like the current Basel, leverages the mistakes of the market by means of vicious feedback mechanisms like the lower rates you charge you client the lower capital requirements and so the lower rate you can charge him, or, the higher rate you charge the client the higher capital requirements and so the higher rates you have to charge. And this stimulates the whole financial sector to search out the risk free and that to me sounds too much like a world that has decided to lie down and die.

The current system and what you propose, makes life easier for those who presumably already have it easier and harder on those who presumably have it harder and that to me sounds like only exasperating the differences there are in our World. For the development and justice minded technically the Basel Committee directives drives up the Gini coefficient in the world.

Since many of the cognoscenti read this blog, I would appreciate some feedback. Many thanks. :)

The Money Multiplier: Suppose that the reserve requirement for loans is 50%. Say that bank A lends out half its money, which ends up in bank B, which lends out half of that, etc., etc. In the limit the money on loan doubles. That is obvious if we suppose that there is only one bank. When it can no longer lend, half of its money will be equal to the amount of money it started with. In real life, loans are not made to the ultimate extent, but the potential is there.

The inflation of reserves: Suppose that all of the loans are due on the same day. (That sounds like a bad idea, but I have heard that in feudal Japan loans were due on New Year’s Eve. Part of the the New Year’s celebration had to do with being free of debt. Anyway, bear with me for the purpose of illustration.) All of a sudden the money in the bank shrinks back to what it was — almost. What about the interest? Where does it come from? (Remember, we are assuming that this is how we create money. All the money is in the bank.) Well, it does not come from anywhere else. That means that there are going to be loan losses. Some of the money is not going to be paid back. Where is it? In the bank, of course. The amount in the bank will be equal to the original amount plus the loan losses. This is a kind of inflation.

The creation of money via loans is temporary, as that money disappears when the loan is paid back. The inflation of reserves via losses is permanent (without other mechanisms to reduce it). It is hidden by the fact that loans are not due all at once, but are spread out over time. However, the losses are free to be used by the banks to make new loans, so this inflation of reserves is potentially transferred to inflation in the amount of money on loan.

There is a significant issue in the creation of new reserves through loan losses. There are social costs associated with these losses. As a society we have chosen to increase our money supply in part through defaults and bankruptcies. Whether that is a good idea or not I will leave aside for now.

Reserve requirements: Let us say that we have a specific target for the inflation of reserves. What reserve requirements are consistent with that policy? Well, that is underdetermined. Let us add another criterion. Let us maximize the expected return on investment of the loans. The application of Kelly’s theorem pegs reserve requirements to the interest charged. The higher the interest, the greater the reserve requirement. (There is a similarity to Basel II, as less risky loans will be made at lower interest rates, which have smaller reserve requirements.)

Let me illustrate that with a table. I am assuming a target of 5%. (Note that the inflation of reserves in real life will be less, as not all loans that could be made will be.)

Interest % – - – - – Reserve requirement %

06 – - – - – - – - – - 8.7
08 – - – - – - – - – - 20.9
10 – - – - – - – - – - 29.3
15 – - – - – - – - – - 42.3
20 – - – - – - – - – - 50.0
25 – - – - – - – - – - 55.3
30 – - – - – - – - – - 59.2

Note that these requirements have nothing directly to do with payouts of depositors’ money. That is a separate issue. They do have to do with the solvency of the lender. That is because, to maximize the expected return on investment, the lender must not go broke. Since they have nothing to do with depositors, they apply to any person or institution whose business is lending (and hence, creating) money.

There are those who would say that such reserve requirements constitute a tax on the lender. Au contraire. It is just that they maximize the expected return on investment rather than the expected immediate profit. The ability to make loans tomorrow does not figure into expected immediate profit. This difference in viewpoint and, dare I say, definition of rational self-interest, is important, but again, I shall leave it aside for the moment. In any event, if we are going to create money via private lending, it is appropriate to have such reserve requirements. The long term solvency of the system is important.

A couple of comments: While not an anti-usury measure, increasing reserve requirements with the interest rate acts as a check. If your credit card company were to up your rate from 10% to 30%, they would have to double their reserves for your account. They might not want to do that.

The reserve requirements are pegged to interest rates, not credit ratings. Of course, there is a relation between the two. But the interest rate is the key factor. I did not account for possible miscalculations of risk on the part of the lender, but I trust that the overall picture is representative.

I also did not attempt to deal with other factors, such as the bond market. I would appreciate any observations about how such requirements would fit into the economy as a whole.

Many thanks, :)

Min

I voted for Obama, because I felt he was the only viable candidate for the job. He is a good man and I believe he has the best intentions, but he faces very powerful and wealthy opponents, but more than that, a still apathetic American public, who for the most part, went home after the election, thinking problem solved.

What I really meant by my statement is that until people are feeling hit harder by what we have been partially sheltered with in bailouts and stimulus, they will sit on their hands.

I voted for Obama, because I felt he was the only viable candidate for the job. He is a good man and I believe he has the best intentions, but he faces very powerful and wealthy opponents, but more than that, a still apathetic American public, who for the most part, went home after the election, thinking problem solved.

The Franks spoke originally a form of lower Deutch, a form of Dutch. Fact is when Brunehaut was queen the empire was already gigantic. It became more so as it extended soon from Northern Spain to and including Poland, and so on. Snippets are not the big picture. The sack of Constantinople by a Frankish army in 1204, was a spur of the moment thing which is neither here nor there. And Venice was basically a march state of the Imperium Francorum, being under its protection…

I am talking about a particular thread of history as far as finance is concerned, not whether Buddha was a Frank or not. True, the Franks were more tolerant than the Arabs, but that was not the subject here…

Be biased if you please, but I am not… ;-)! It’s not because Bismarck had a big statue pointed at France, that I stayed fixated that way.

So we can manage the domestic economy complete with related Treasury bonds and seperately manage our interface to global trading partners.

Conclusion: The problem is not too hard?
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PS. I definitely warm to the idea of bank leverage being tightly regulated as required. Would 7:1 be a good starting point?
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Now how do we make this happen? well I see the Washington Kool-aid company staff (about 600?) needs to be told by the shareholders,
‘we put you there to fix things so fix them now. No more banker’s kool-aid distribution.’

and are we really ready for that? And, this takes us back to previous discusions on China…

on a coffee break,
mc

I think you’ve nailed the eventual conclusion on all of our minds.

In my experience, though, once you start talking about regulations and interventions on the oligarchies’ affairs, you’re met with boos and hisses and cries of socialsm! from an unignorable sector of the populace. We have a schizophrenic American electorate, who’re dissatisfied whenever you’re hinting at a resistance to unconstrained capitalism and even more dissatisfied at the resultant effects to the economy brought on capitalism. The reasonable people in the middle are dwindling in numbers.

In two years, if we get this wrong, we’ll really be resembling the prototypical oligopolistic economies of Latin America, as Simon has suggested.