Bundesbank Pushes Back Against 100% Reserve Banking Advocates

(Bloomberg) -- Critics calling for the removal of banks’ powers to multiply small deposits into large sums of money are wrong in saying it would improve financial stability.

That’s according to the Bundesbank, which says in its monthly report that the link between deposit accumulation and money creation isn’t as clear as many assume. As an example, it points to the euro area, where banks are hardly flooding the region with new money, even given a surge in central-bank liquidity.

Part of that is related to the fact that the recent rise in banks’ deposits at the European Central Bank is a technical phenomenon -- asset purchases, which began two years ago under the ECB’s quantitative-easing program, increase liquidity in the banking system. That only has a direct impact on money supply when the sellers of those assets are domestic non-banks, as opposed to domestic banks or institutions based outside the euro area.

Money supply itself is determined by a complex interaction between banks, non-banks, and monetary policy, the Bundesbank said, including cost-benefit calculations, regulatory requirements, and credit demand. That suggests any concerns over hyperinflation as a result of QE might be overdone.

The report follows resurgent calls in the wake of the most-recent financial crisis that central banks should be in complete control of money creation, rather than the fractional-reserve banking model -- dominant since the Middle Ages -- that allows commercial banks to multiply money via lending. The argument is that central banks would be able to ensure the real economy has no more than the liquidity it needs, and bank runs could be avoided.

The Bundesbank says the idea that commercial banks should be required to back their loans 100 percent with deposits at the central bank -- first floated in the 1930s by economists such as Irving Fisher under the Chicago Plan of banking reforms. Modern initiatives based on that idea -- one such proposal in Germany is known as Vollgeld -- wouldn’t be more effective than prudent regulation in reining in wayward money supply, it said.

“It would be wrong to assume that restricting money creation for a part of the financial system (the deposits sector) would in itself be sufficient to make the entire financial system resistant. This requires further effective regulation, supervision of the banking sector, and macroprudential policy.”

Implicit in the Chicago-plan logic is the assumption that deposits directly enable or limit credit extension. Given the complex and indirect nature of the link, the Bundesbank says such proposals are “questionable.”

To contact the reporters on this story: Carolynn Look in Frankfurt at clook4@bloomberg.net, Piotr Skolimowski in Frankfurt at pskolimowski@bloomberg.net.

To contact the editors responsible for this story: Paul Gordon at pgordon6@bloomberg.net, Zoe Schneeweiss