The price of safety

Image Credit: marcokolmann (Flickr: Creative Commons)

Switzerland is turning its back on the modern banking system. Well… maybe. We will find out soon just how far the Swiss people will go to eliminate risk in the banking sector and make their economy just a little safer. But what’s the price of this safety? The answer has bankers panicking.

After acquiring over 100,000 signatures, the supporters of the Vollgeld Initiative have secured a plebiscite today, 10 June 2018, on the future of Swiss banking. But what is it? How does it involve banking? And why should you care? If the pundits are to believed, this one vote could save or ruin the country.

At the heart of this debate lies two issues. One, is the safety of using the fractional-reserve banking system (FRBS) where banks are only required to hold in reserve (in M0 & M1: base money) a fraction of the money they loan out to customers as credit (M4: broad money). If banks need to cover losses from defaulted loans collectively exceeding the value of their reserve (and shareholder equity), it means the bank is insolvent. This was a problem during the Global Financial Crisis when the mortgage-backed assets some banks held in reserve turned out to be almost worthless. The Vollgeld Initiative aims to reduce this danger by increasing the ratio beyond the 4.5% reserve currently mandated by the Basel III rules.

The second issue is the role of the Swiss National Bank (SNB). Traditionally, the SNB has restricted its activities to being the lender of last resort and having the exclusive right to issue the base money (M0) banks need to create the reserves in the FRBS. The Vollgeld Initiative would increase the SNB’s role of creating money in circulation (M0-M4) beyond its current 10% and expand the power of the SNB to control Swiss bank loans.

In short, the Vollgeld Initiative has several objectives, namely to dampen business cycle fluctuations by controlling banks’ supply of M4 money, and to eliminate bank runs.

These are lofty goals indeed and are based on initiatives previously proposed in the United States and Iceland. They intend to achieve these goals by changing the landscape of Swiss banking. Instead of being able to create broad money, banks will now have to have a money/credit ratio of 1:1. They won’t be able to issue loans that exceed the value of their SNB issued M0 assets. Any attempt to expand their pool of loans will require either the sale of assets and allocating that profit to their reserves, or asking SNB for a below market rate M0 loan. This means eliminating the risk of insolvency from bank runs.

As you may imagine, this proposed change is not without its opponents. The Swiss Federal Council, the Swiss Parliament, the Swiss National Bank, the Swiss Federation of Trade Unions, members of academia, and financial pundits are all saying the same thing: there’s nothing to fix and any proponents of the Vollgeld Initiative don’t understand the issues.

They go further and claim its adoption would not only be ineffectual, but would also have serious negative ramifications. These include causing uncertainty in the market, undermining the independent ability of banks to respond to market conditions, intolerably increase the power of an unwilling and ill-equipped SNB, and raise the risk of political interference in the SNB. And all this could mean an annual cost to the economy of 0.8% GDP, a weakening of the CHF and lead to an unwise relaxation of banking regulations due to a false sense of security.

But the trouble with the arguments advocated by both sides is that they all come from people with entrenched interests. That’s not to say they’re wrong, only that they should be examined.

A main goal of proponents is to protect bank deposits. But there is an existing national deposit guarantee scheme that covers a maximum of CHF 100,000 per customer in the case of bank failure. Couldn’t that just be amended? Or perhaps they could marginally strengthen the reserve rate beyond the Basel III rules?

Antagonists are concerned the requirements the SNB may place on banks for M0 loans may not allow them to continue their existing loan practices, and thus goes Switzerland as a global banking giant. But all the Doomsday theories are exactly that: theories. We do not know the terms of the loans. We can actually be optimistic. The institutions that would draft and apply the terms are openly against the Vollgeld Initiative, and therefore would attempt to mitigate negative economic ramifications.

For all the pundits claiming salvation or disaster, none know what will happen if Switzerland says “yes.” The only certainty is that we find out whether Switzerland believes the risk of the modern banking system is too high a price for their economic safety.

Nicholas Filer is a Brisbane based writer with honours degrees in law and international relations.