National Banking System
This first reform will describe the operation of a national banking system. This system will consist of a single commercial bank for the entire country, with a single reserve. The Federal Reserve will manage the system, with branches existing at the local levels. The Federal Reserve can determine the distribution of lending throughout the country, total lending, qualifications, and various other factors. Investment banks, mutual funds, hedge funds, and other investment funds can still operate in the private sector, but they will have accounts with the national bank to maximize oversight. The national bank may also offer investment banking services.
The benefits of this system include efficiency, security, and stability. In our current banking system there are around 4,000 commercial banks with separate reserves. This division in the banking system creates several issues. When the banking system is divided into multiple banks security and management is less efficient as banks have to work together to keep track of transactions, and regulators have to sort through the separate accounts. With a single bank, there will be a single computer program that keeps track of all transactions in one system. With a single commercial bank, management and administrative positions decrease due to the efficiencies of scale economies when having a single company and eliminating duplicate positions. Stability is also decreased when there are multiple banks, as the banking system is divided into separate reserves, which leads to interbank lending and increased liabilities. This often creates chain reactions. When one bank experiences financial troubles and fails to make payments on its debts, the banks they are indebted to often begin having financial trouble and may fail as well. With a single bank and single reserve, there is no interbank lending, so these debt chains are eliminated. There may be economic downturn if debtors default, as banks have less liquid cash to loan in the short term, but failure would be mitigated and eliminated with the establishment of full reserve banking. Other benefits of a national banking system is better oversight in tax collection, as tax evasion can be more easily detected. Possibly, taxes could be collected automatically by having a computer keep track of certain types of transactions. Commercial banks could be merged in the private over time, to slowly create a single bank before being nationalized.
Full-Reserve Banking
The second major reform is full-reserve banking. Full-reserve banking can help ensure stability of the banking system, as well as increase efficiency due to less accounting. Fractional-reserve banking is the current model of banking. This model allows banks to lend depositors’ money, leaving the bank’s reserve with only a fraction of the money they owe depositors, hence the name fractional-reserve. In a fractional-reserve banking system, deposits are more like debts owed to the depositor rather than an actual deposit that is 100% liquid and always available. Fractional reserve banking is the primary cause of bank failures. When a depositor attempts to use their money, and a bank doesn’t have the money, the bank fails.
The main rule of full-reserve banking is that the reserves must be equal to or greater than the total deposits. If the deposits are equal to reserves, for the bank to make more loans, they would have to sell bonds or have their reserves increased. Full-reserve banking can be implemented in the national banking system described above or the current banking system, where there are multiple commercial banks operating in the private sector. In the national banking system, where there is a single reserve with local branches, if a region or local branch needs more money to lend, the Federal Reserve will simply increase the reserves of those branches as it sees fit. In a privatized system where there are multiple banks, the same process would apply, and the Federal Reserve would just increase the reserves of each individual bank as it sees fit. In a full reserve banking system, only time deposits would be allowed to pay interest, as normal deposits would all be kept in the reserve. Withdrawals would have to be completely restricted on time deposits until maturity to ensure a full reserve. A temporary solution is to have deposit insurance cover 100% of deposits.
Regulating Loan Qualifications
Loan qualifications are what banks use to determine whether a customer is eligible for a loan. The lower the qualifications are, the more at risk the debtor is of defaulting, and the more easily loans are made. The total loans that are made can have several effects on the economy. The main potential effect is an increase in the money supply and inflation. In the current system the central bank often attempts to control lending in the private sector by increasing interest rates, as well as selling bonds and decreasing the monetary base and the reserves of commercial banks. This policy can be dangerous as increasing interest rates on pre-existing debt leads to an increased risk of default. Reserves may also quickly deplete as investors make changes to their investments, creating liquidity risk. High interest rates in high-income countries may put pressure on the global market and cause interest rates in low-income countries to rise as well, which can lead to recessions and financial crises. Controlling loan qualifications rather than increasing interest rates is a better way of controlling lending in the private as it does not create as much risk for debtors. You can also use qualifications to control supply and demand in specific industries, if you want to control prices or control the consumption of those products.
Requiring Guarantees
Bonds are often sold by banks and are paid off with the loans they have made. The bank just transfers money from the debtor to the investor. If the debtor defaults, investors lose their investment temporarily or permanently, depending on if there was collateral. With guarantees, the bank that sells the bond makes payments on the bond even if the debtor defaults. Requiring guarantees has several benefits. Investors are assured that they will be paid, which increases investor confidence and the ease of selling bonds. Guarantees put pressure on banks to make quality loans as they have to take responsibility. The main negative side effect of guarantees is that banks have more liabilities. Another similar regulation could be to restrict the sale of certain types of bonds, and require financial corporate bonds to be used to create funding for certain types of investments. This is essentially the same thing as a guarantee, as now the bank owes the investor instead of the bank’s debtors. Currently, less than 1% of loans in the United States default. Defaults are often referred to as non-performing loans.
Money Supply Creation
There are two ways money can enter the economy when money is created. One way is through loans and the second way is through spending. Most central banks currently inject money into the economy through loans. Loans are made generally by purchasing government bonds and sometimes purchasing bonds in the private. Commercial banks can further increase the money supply when they make loans. Injecting money through loans has benefits and costs. The main benefit is that there is a debt attached to the money, which can then be sold as a bond if the money supply needs to be decreased. When someone buys the bond, money leaves the economy and returns to the central bank or commercial bank. The only other way to decrease the money supply is if the government runs a budget surplus and decreases the money supply through taxation. The main cost of injecting money through loans is that debt begins to add up which can then be a burden on the economy. Debt to GDP ratios is the main way debt burden is measured, although there are some flaws to this measure. Some debt is long-term vs short-term term so the yearly payments may differ. Monthly or yearly payments owed is a better way of measuring debt burden. As the debt burden increases, it becomes more difficult to make payments and defaults become more likely. Governments often deal with this by increasing the money supply in order to devalue the debt. The increase in money supply leads to higher prices, income and revenue, enabling debtors to more easily repay their debts. This increase in money supply also increases the debt, but the ratios between debt and GDP change in the short term.
If money is injected into the economy through spending, there are also benefits and costs. If the injection occurs through government spending, this means there will be no government debt, the central bank simply transfers the money to the government, which then spends it. If it is done in the private sector by increasing a bank’s reserves, it eliminates unnecessary debt burden on banks, increasing economic stability. The main cost is that if it is not done strictly, it can lead to an increased likelihood of inflation. This would mainly occur if the government runs budget deficits that are then funded by the central bank transferring money to the government rather than loaning the money. Budget deficits would have to be kept at a minimal level to prevent inflation. Ideally, the money supply should only increase if the population increases, with the money supply per person always being kept at a stable level. If the money supply is increased through spending, the central bank doesn’t have bonds to sell, so the money supply could only be decreased through taxes or commercial banks selling bonds.
Collateral Protection
Mortgage collateral often has protection in what is known as a homestead exemption. This essentially protects the property, or a portion of the property, from being used as collateral. However, this protection is often limited, varying depending on the state.14 When a debtor defaults, lenders will seize the property collateral, and only pay the debtor for a fraction of the value of the collateral, or none at all, depending on the exemption, even when the debt owed is only a fraction of the value of the collateral. For example, a property might be worth $500,000, with the debtor owing $100,000, and a homestead exemption covering $50,000. In this situation, the debtor will lose $350,000, as their $100,000 debt will be cancelled, and they will be repaid $50,000 for the exemption. In order to better protect debtors, the exemption will be expanded to protect the equivalent of the portion of the property that has been paid for, only leaving what is equivalent to what is left of the debt unprotected. When the collateral is liquidated, the portion that the debtor owes to the lender will be repaid, while the debtor will retain what is left. Normal real estate fees will also be taken out of the debtor’s portion of the sale. During the time the house goes unsold, monthly interest payments and principal will still be owed to the lender by the debtor, this can be taken out of the debtor’s portion of the sale. The normal foreclosure period will stay in effect, requiring debtors to vacate the house after 4 months. The sale of the property will be controlled by the debtor. The reason for this is that the lender may try to underprice the property, knowing their portion is guaranteed, in order to make a quick sale. These laws can be potentially applied to home mortgages, commercial mortgages, and potentially car loans and other types of business loans where there is collateral as well.
CD Regulations
CDs can be regulated in order to make them easier for customers to use and encourage investment. CDs can be regulated so they have settings that customers can adjust online. Customers will be able to set whether they want the CD to automatically renew or automatically be deposited in a bank account. Customers will be able to adjust the term length at which they want the CD to be renewed at. CDs will always be renewed at the highest rate offered for that term length. Customers will be able to adjust these settings as much as they want until the time of maturity. Commercial banks could offer other direct investment opportunities online as well, such as selling bonds, stocks etc.
Profit Sharing Loans
Profit-sharing loans are loans where the debtor repays the principal and pays a share of the profits to the lender, instead of interest, during the period of repayment. The main benefit of these types of contracts is that they give debtors a little more flexibility in repayment. For lenders, it is not as straightforward as an interest rate, as profits must be kept track of. However, with modern banks and computers, it is easier to do this. These types of contracts were historically used more extensively during the medieval period. In Christian Europe these contracts were generally referred to as commendas, and in Islamic regions, qirads, and to the Jews, isqas. Muslims still use these types of contracts as laws banning interest are still common in Islamic regions. In Europe, they fell out of use during the 1600s as stocks and interest-bearing loans replaced them. Their use could be most beneficial for small start-up companies that have a higher risk of default. These types of contracts could be offered as an option by banks. Some banks already offer these contracts through what are known as Islamic windows. The feasibility of their use and how it affects a bank’s solvency, and their effect on preventing bankruptcy for small businesses, could be investigated.