Calling the big banks’ bluff

By Frank Schäffler and Norbert F. Tofall

Eliminate the financial system’s rapidly growing debt to create a new monetary order of free-enterprise

The G-20’s decision in November 2008 not to let any systemically relevant bank perish may have seemed wise at the time, given the threat of a global financial meltdown. But that decision, and bad policies by central banks and governments since then, has given over-indebted major banks the power to blackmail their rescuers – a power that they have used to create a financial system in which they are effectively exempt from liability.

Big banks’ ability to extort such an arrangement stems from an implicit threat: the financial sector – and with it the economy’s payment system – would collapse if a systemically important bank were ever pushed into insolvency. But it is time to call the bankers’ bluff: maintaining the payment system can and should be separated from the problem of bank insolvency.

Above all, the G-20’s decision to prop up systemically relevant banks must be revisited. And governments must respond to the banks’ threats by declaring their willingness to let insolvent banks be judged accordingly. A market economy must rest on the economic principle of profit and loss. An economy with neither bankruptcies nor a rule of law that applies equally to all is no market economy. The law that is valid for all other companies should apply to banks as well.

Moreover, governments should guarantee insolvent banks’ loans to non-financial companies, as well as private customers’ current, fixed-term, and savings deposits, by reforming insolvency laws. Certainly, governments should not guarantee interbank liabilities that do not affect customer deposits. An insolvency administrator would manage the bank and ensure that all payments for which a state guarantee is given are carried out properly, with refinancing of these payments continuing to take place via the central bank.

After taking these steps, the payments system would be safe. In case of insolvency, a bank’s computers would not be turned off, its employees would not instantly be dismissed, and payment transactions would not collapse. Nor would a run on savings deposits occur, given the official guarantees that they remain unaffected by a bank’s insolvency. After all, even a simple banknote is money only because the government says so, and thus is no different from savings deposits, which means that no saver has an advantage from holding cash. So there would be no need for bank  Of course, the deliberate restriction of the effects of bankruptcy to accounts other than private current, savings, and fixed-term deposits means that the insolvency of bank A could lead to the insolvency of bank B. For bank B, too, the same liquidation scenario would apply: savings deposits would be safe, payments could be made from its customers’ current deposits, and loans that it granted to non-financial companies would not be revoked.

Obviously, the domino effect need not stop there: the insolvency of banks A and B could get a bank C – and additional banks – into trouble. Indeed, the entire over-indebted fractional reserve-banking subsystem might have to be liquidated. But the payment system would survive.

This might trigger a positive domino effect as well, as other states – on grounds of international financial integration – adopt similar procedures for controlled liquidation of their own insolvent banks. Zombie assets would be destroyed. A large part of the money and credit that was created out of nothing from former interbank transactions, now excluded from official guarantees, would return to nothing. Afterwards, the liquidated, formerly over-indebted banks could be sold.

We have it in our power to eliminate the financial system’s rapidly growing debt and to create a new monetary order that corresponds to free-enterprise principles and the rule of law, without risking a breakdown of the entire payment system. All that is required to revive effective bank regulation – in Europe and elsewhere – is the will to resist blackmail by the banks themselves.

Frank Schäffler, a member of Germany’s Bundestag for the Free Democratic Party, is on its finance committee. Norbert F. Tofall is a member of the Friedrich A. von Hayek Society.