The basic flaw in our bank system is simple.

Ralph Musgrave
10 min readSep 27, 2018


The central flaw in the bank system is one of the basic activities carried out by banks, namely “borrow short and lend long” (BSLL), which has long been recognised as being risky. The alleged benefit of BSLL is that it creates money / liquidity. However, that risk is entirely unnecessary because CENTRAL banks can create any amount of money anytime at no cost and at no risk. Worse still, there is a major flaw in a particular form of BSLL, namely depositing your money at a bank with a view to the bank lending on your money so as to earn interest, with taxpayers protecting you against loss via deposit insurance. That insurance flouts a widely accepted principle, namely that it is not the job of taxpayers to subsidise or stand behind commercial transactions, and money lending is clearly a commercial transaction.


On this, the tenth anniversary of the Lehmans fiasco, large numbers of commentators have claimed that we have learned nothing. Well there’s plenty of truth in that claim, and the reason is that the basic flaw in our bank system is so huge and glaringly obvious that no one notices it: a case of not seeing the wood for the trees. The flaw is as follows.

Commercial banks are basically into the business of borrowing short and lending long (BSLL), a process often referred to by economists as “maturity transformation”. In the case of retail banks, bank customers make deposits and banks make long term loans to mortgagors and other borrowers. Many of those deposits are instant access, in which case the borrowing is not so much “short” as “has a duration of about one millisecond” so to speak.

Unfortunately BSLL is risky: if too many people with short term deposits demand their money back, the relevant bank has had it. Much the same goes for investment / merchant banks like Lehmans. The basic difference between investment and retail banks being that investment banks’ customers (both those they accept deposits from and those they lend to) deal in millions of dollars, not thousands.

But rather than be honest with depositors, and tell them their money is not totally safe, banks do the opposite: they tell depositors they are guaranteed to get back $X for every $X deposited (maybe plus interest and maybe less bank charges). That is plain simple fraud.

I.e. one of the basic activities carried out by banks is fraudulent. So why does no one notice the fraud? The answer is that this is a classic example of the Adolf Hitler “big lie”: tell a big enough and glaring enough lie, and no one notices it.

But rather than stamp on that fraud, governments positively encourage it by arranging deposit insurance for bank customers. So, should governments do that?

Well banks (assisted by governments) are actually breaking a very fundamental and widely accepted principle here, which is that it is not the job of taxpayers to come to the rescue of private commercial activities which go wrong. And money lending is clearly a commercial activity.

Indeed, and to add insult to injury, governments do not stand behind a substantial proportion of loans. For example if you lend to corporations by buying their bonds (perhaps via a mutual fund / unit trust which specialises in corporate bonds) you’re on your own, and quite right. But ironically, if you lend to a bank, and the bank lends to exactly the same corporations and it all goes wrong, taxpayers come to your rescue. That is a blatant inconsistency.

A more logical and consistent arrangement would be for government or the central bank to offer totally safe accounts for those who want them (maybe with commercial banks acting as agents for government in the case of small retail accounts), while in contrast, those who want to act in a commercial manner and have their money loaned out are on their own. Indeed, that’s what full reserve banking consists of — a system backed by at least four economics Nobel laureates.

To summarize so far, the basic reason banks fail is that they engage in an activity (BSLL) which is widely seen by economists as acceptable and constructive, but which is in fact a load of nonsense.

The excuse normally given for BSLL is that it creates liquidity, i.e. in effect it creates money. However there’s a flaw in that argument, which is that government and central bank can create infinitely large amounts of money / liquidity whenever they want and at almost zero cost. As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”. (Friedman backed full reserve banking, incidentally. See Ch 3 of his book “A Program for Monetary Stability”)

So what on Earth is the point of creating money in a risky manner — a manner which risks bringing the world economy to its knees — when there is an alternative and entirely safe and costless way of doing the same thing? Darned if I know.

As Messers Diamond and Rajan put it in the abstract of a paper of theirs, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.” (“These functions” being liquidity creation.)

Running the risk of bank runs and crashing the world economy just so as to create money, when money can be created in an entirely risk free manner is a stroke of genius, don’t you think?

An unnoticed bank subsidy.

Moreover, since commercial bank created money is to a significant extent a substitute for central bank create money (base money) it follows that for every dollar commercial bank created money, roughly a dollar of base money has to be confiscated from the population all else equal, otherwise the money supply gets excessive, and excess inflation ensues.

George Selgin (a US economist who specialises in banking) actually illustrates one way in which commercial bank created money can drive base money to near extinction. (See the first few paragraphs of his article. And for more details on how commercial bank created money drives out base money, see my article “The Bank Subsidy No One Mentions”. ).

To put that another way, money creation by private banks drives out publically created money in much the same way as counterfeit $100 bills force the central bank to withdraw an equal number of genuine $100 bills. Indeed, the French economics Nobel laureate Maurice Allias argued that money creation by private banks is counterfeiting pure and simple. David Hume, writing nearly three hundred years ago made the same charge. (For Allais, see the opening sentences of “Credit Markets and Narrow Banking” by Ronnie Phillips.)

Higher interest rates.

A possible argument against forcing all money lenders (including those who deposit money at banks with a view to earning interest) to carry the risks involved in their commercial venture is that it would raise interest rates, which would hit economic growth and make life more difficult for mortgagors.

Well the first flaw in that argument was alluded to above: if the interest rate reducing effect of protecting lenders against risk are so wonderful, why don’t we protect those who buy bonds in corporations? Why not take it a stage further and have taxpayers protect those why buy stock exchange quoted shares against loss?

Re the latter growth point, it is certainly true that all else equal, a cut in interest rates boosts growth. Indeed, interest rate cuts are a standard way of imparting stimulus. But if interest rates rise as a result of abandoning taxpayer funded support for depositors, and demand declines as a result, there is absolutely nothing to stop the authorities making good that fall in demand by simply creating more base money and spending it into the economy. The net result would be a fall in loan based economic activity and a fall in total debts, and a rise in non-loan based activity. Given the incessant complaints we hear about the excessive level of debts, it’s a bit hard to see what the big problem is there.

Indeed, that process is simply the reverse of the above mentioned “Selgin” process via which the creation of money by commercial banks means base money has to be confiscated from the private sector.

As for the idea that lower interest rates benefit those poor deserving mortgagors, the majority of mortgagors are average income people, who can well afford a rise in interest rates. Indeed, the rate of interest that mortgagors in the UK were paying in the 1980s was nearly three times what they pay nowadays. For some strange reason the sky did not fall in in the 1980s. Among other reasons, that was because interest rate changes have a perverse or counter-intuitive effect, which is that it is precisely the fall in interest rates over the last twenty years or so which has enabled people to borrow more and buy larger or more expensive houses, which in turn has boosted the price of houses, especially in the UK (where the author lives).

Thus a rise in interest rates will have much less effect on mortgagors’ ability to afford decent houses than might at first seem.

As to the least well off mortgagors, first time buyers for example, if they need extra help given a rise in interest rates, special measures can be implemented to help them. Indeed in the UK there are already special measures in place for first time buyers. Thus the administration costs of additional help for those home buyers would be minimal.

Government as insurer.

Another possible point in favour of taxpayer backed deposit insurance is that the US deposit insurance system, the FDIC, is run on commercial lines, and arguably there’s not much wrong with anything which is commercially viable.

Well the answer to that is that government or any entity (like the FDIC) which is backed by government is a peculiar insurer: government has an almost infinitely deep pocket in that it can grab any amount of money from taxpayers, plus (in concert with its central bank) it can print as much money as it likes. Thus the likes of the FDIC are not really run on commercial lines. That is, the FDIC provides a Rolls Royce service at a General Motors price.

In addition, there is another form of bank insurance which is blatantly non-commercial: that’s the trillion or so that the Fed loaned to sundry banks at the height of the recent crisis and at a near zero rate of interest. That is a flagrant breach of the principle set out by Walter Bagehot, namely that in a crises, the central bank should lend to commercial banks, but only in exchange for first class collateral and at a “penalty” rate of interest.

And finally if having depositors protected by an insurer with an infinitely deep pocket is a great idea, why don’t we have taxpayer backed insurance for ships and who knows what else? Taxpayer backed insurance for ships would boost the shipping industry, no question. That in turn would cut the costs of almost everything we buy in shops! As you will have gathered by now, the idea that depositors should be protected by taxpayers sounds great until you start to look at the inconsistencies behind the idea.

Would less interest for depositors matter?

The removal of deposit insurance for “mini money lenders” (i.e. depositors) means a significant proportion would flee to totally safe central bank accounts where they’d get little or no interest. But does that matter? Well those depositors are getting almost no interest at the moment (at least on instant access accounts), so not much change there.

Moreover, Milton Friedman and Warren Mosler (founder of Modern Monetary Theory) advocated a permanent zero interest rate. See my article “The arguments for a permanent zero interest rate” for more on that.


The conclusion is that the advocates of full reserve banking are right. That is, there should be two basic types of bank account available for everyone: first, totally safe accounts where money deposited is simply lodged at the central bank with little or no interest being paid on that money. Indeed, several central banks are already actively considering that idea. Second, there should be accounts where money deposited is loaned on, but depositors carry the risk that is inevitably involved in lending.

That way, bank failures are impossible. As to totally safe money at the central bank, that is totally safe, or as safe as is possible in this world. As to “at risk” or “loaned out” money, the organisations or banks which provide that facility cannot fail for the same reason as mutual funds / unit trusts cannot fail: those buying stakes in those funds have not been promised that they’ll get their money back, though if they were to invest in funds that specialised say in granting mortgages to those with a minimum 30% equity stake in their homes for example, the money would be about 99.9% safe.

However, there are numerous different ways of implementing full reserve banking, and it would be easy to write an entire book on the pros and cons of each. Thus no attempt is made here to argue for any particular variation on the basic full reserve theme. The basic point made here is simply that the advocates of full reserve banking have a very good point, while the arguments put by defenders of the existing bank system are feeble in the extreme. (For two of the variations on the full reserve theme, see first the submission to the UK’s Independent Commission on Banking by Ben Dyson and co-authors, and second, “The Economic Consequences of the Vickers Commission” by Laurence Kotlikoff.)

As for investment banks, the extent to which they engage in “economy crashing” BSLL can be easily reduced by upping their capital ratios. And the entirely predictable complaints from them that that will cut down on private bank money creation and will raise interest rates are basically nonsense, and for reasons set out above.

As former head of the Fed, Paul Volker put it, “You know, just about whatever anyone proposes, no matter what it is, the banks will come out and claim that it will restrict credit and harm the economy…It’s all bullshit.”