As we recently pointed out, the current ACCC inquiry into bank deposits reflects a fundamental misunderstanding of banking – and deposits.
The inquiry, therefore, is not off to a good start. If the ACCC continues on its current course, the inquiry findings will not be well-founded and the recommendations will be unduly constrained. In particular, the erroneous starting point will cut off large and fertile new frontiers in banking and finance.
For example, by incorrectly presenting banks as converting deposits into loans, the ACCC has ruled out the promising world of lending-only banks (LOBs) and deposit-only banks (DOBs).
The ACCC has also inadvertently ruled out an important sub-species of DOB: a publicly owned one that, by virtue of its ownership, is free of credit risk.
By ignoring that new world, the ACCC has excluded reforms that should offer greater competition, lower lending costs, a more vibrant market for business loans and venture capital, big reductions in deposit risks, and even more important reductions in system-wide financial risks.
How would such a world work? And how would those benefits be achieved?
In a world of LOBs and DOBs, the commercial success of LOBs would depend on their ability to make loans that, together as a portfolio, yielded a positive net return over their life. LOBs that were unable to do this would fail. Crucially, they would fail without causing systemic consequences for the industry or the economy as a whole.
When a LOB created a loan, the resulting deposit account balance would immediately be placed with a DOB.
How might that work in practice? Let’s consider an example with a single privately or publicly owned LOB and a single publicly owned (and credit-risk-free) DOB. The LOB and the DOB are licensed, respectively, to make loans and hold deposits. (And let’s remind ourselves that, for banks, deposits are liabilities.)
Our current regime of inter-bank payments depends on a system of Exchange Settlement Account (ESA) balances with the Reserve Bank. With just a small number of exceptions, only banks can hold ESAs, and they function as inter-bank transfer units. The financial systems of most developed countries have comparable units.
These benign-sounding balances are extremely important: they are central to the overall systems of banking and payments. Today, all other things equal, a bank should not need to fail merely by running short of ordinary deposits; but it certainly can fail if it runs short of ESAs. This is because, with a shortage of ESAs, a bank cannot handle a net outflow of deposits from itself to other banks.
A new regime of LOBs and DOBs would likely require the government and the RBA to usher in a new type of ESA unit. Why?
An LOB that wrote a loan and created a deposit balance would only be able to transfer the deposit balance to the DOB if the LOB had sufficient ESAs to cover the transfer. But the loan-creating LOB would not have enough ESAs, as there is no inflow of ESA-bearing deposits at the time of loan creation. (Only later, via loan and interest repayments, or, more likely, by way of its own account with the DOB, would the LOB accumulate ESAs. This paragraph shows that things quickly get complicated even with a simple two-bank example!)
How could the ESA system be changed to permit LOBs and DOBs? Under one scenario, the federal government could lend a new type of ESA unit (‘ESA 2.0’) to the LOB automatically at the time of loan creation. The LOB would then transfer to the DOB both the deposit amount and the ESA 2.0 funds.
This example begs important questions. On what basis should the government provide the ESA 2.0 loan to the LOB? How would the LOB be likely to price its loans? How might the government, and thus taxpayers, financially benefit from such a regime? And how might the regime alter the overall social costs and benefits of banking?
Ideally, the government would provide its ESA 2.0 loan to the LOB on the basis that those ESA funds would be extinguished immediately upon their receipt by the DOB. For its part, the DOB would have to borrow ESAs in the interbank market or from the RBA, to ensure the DOB always had enough ESA funds to cover immediate outflows of a proportion of its deposits to other banks.
The LOB would price its loans within an identifiable band. The loans would be cheaper than comparable loans offered by the rest of the banking industry; and the LOB’s lending rates would be high enough to cover any associated costs, such as government charges for the ESA 2.0 funds loan, and any clawing back of profits in the interests of taxpayers.
Banking industry competition should increase substantially through the entry of this new category of lenders. As a result, the cost of loans would fall market-wide, and the pattern of lending would likely change.
Lower-cost, longer-term, fixed-rate loans could be expected to constitute a much larger proportion of total bank lending. The government could also use the LOB-DOB regime to encourage pro-social lending, such as for new industry creation (for example, green hydrogen), small businesses and social housing.
The overall level of risk in the financial system would fall, because LOBs would be able to fail without endangering the integrity of the banking and payments system.
Other significant risk-related benefits would also be realised. A credit-risk-free DOB would, for the first time, give all Australian customers a place where they could maintain and continually access their deposit funds at no risk.
In turn, the prospect of wide access to risk-free funds would open up all sorts of other possibilities, including the establishment of an open, safe and transparent market in various different types of insurance contracts – including ones that insured customers against interest rate risk.
A DOB would also complement a government-underwritten ‘stable coins’ regime, which could enable real-time, cross-border currency exchanges.
The LOB-DOB regime we have described here would be assembled largely within the current financial system architecture. But another, yet more radical, frontier would see the LOBs and DOBs operating as a separate financial ecosystem, independent of existing private banks.
We will consider that frontier in a future article.
