“Money is a public good; as such, it lends itself to private exploitation.” ― Manias, Panics, and Crashes: A History of Financial Crises by Charles P. Kindleberger
This weekend the people of Switzerland vote on the Swiss sovereign-money referendum – a radical bank reform plan otherwise known as the Vollgeld proposal. The proposal for the referendum was initiated by Hansruedi Weber, a former schoolteacher turned financial reformer who founded the Monetary Modernisation Association (MMA) – a Swiss, not-for-profit, non-governmental, non-politically affiliated organization. Mr Weber and other proponents of the reforms argue that the reforms within the Vollgeld proposal will make the financial system safer while the Swiss National Bank dismisses them as a “dangerous experiment”.
So which is it? The short answer, it is a bit of both.
Taking a step back, the Vollgeld proposal consists of two key elements:
- Imposing a 100 per cent reserve requirement on demand deposits i.e. putting an end to the long-standing system of fractional reserve banking; and
- Transferring the right to “create” money to the central bank (without the need to finance debt).
By requiring banks to back demand deposits fully with reserves, the Vollgeld proposal effectively necessitates the conversion of Swiss banks from lenders to depository institutions. In simple terms, under the terms of the Vollgeld proposal, Swiss banks will not be permitted to use demand deposits to extend financing. Thus making hundred per cent of demand deposits available on demand and in turn fully mitigating the risk of a bank run.
Since money is created by commercial banks by extending financing, commercial banks would, as a consequence, no longer be able to create money. Banks wishing to continue their lending activities would instead have to obtain funds through alternative sources and in all likelihood offer higher interest rates to attract time deposits. From this perspective, if the reforms were to pass it would be a victory for savers. And given that capital is fungible, capital would flow from the negative and zero interest rate regimes across the developed world into Switzerland.
The losers from the reforms passing, we think, would be Swiss banks and banks across the Eurozone. While we suspect the Swiss banks shares would be the first to be hit, the forward earnings expectations of European banks operating under zero and negative interest regimes would be most severely impacted. European banks we think would suffer from marginal capital fleeing from the environment interest repression in Europe to benefit from interest rate liberalisation in Switzerland.
For the Swiss economy at large, a hundred per cent reserve requirement may well turn out to be positive. There would no longer be the waxing and waning in the demand for, or supply of, credit that could cause wild swings in money supply. A stable money supply in turn would reduce both the risk of credit led excesses building up in the economy and the volatility in business cycles.
Unfortunately the Vollgeld proposal is not limited to simply ending fractional reserve banking.
For all its soundness with respect to putting an end to fractional reserve banking, the proposal is equally flawed as the current system by allowing the central bank to continue to lend directly to the banking system. The provisions within the proposal allow the Swiss National Bank: (1) to support any banks suffering from declining net interest margins or shrinking loans and (2) to control interest rates by offering funds to banks at low interest rates.
Moreover, the Vollgeld proposal enables the central bank to create money and inject it into the system simply by giving it away. In contrast, today, the Swiss National Bank is only able to create money either by lending to commercial banks or by selling Swiss francs in exchange for other assets such as euros or US equities. In either case, the central bank can only create money today by financing debt .
The reforms would free the Swiss National Bank to undertake Milton Friedman’s famous ‘helicopter drop’ of money at any time should they wish to do so as money creation will be unhinged from the requirement to buy debt. The only limitation on the central bank would be that money can only be given out either to the government or to the Swiss population.
The MMA insists this loophole will be used prudently. There are no checks and balances on the central bank to ensure conservatism, however. And history has taught as us that when push comes to shove central banks when placed under political pressure can abandon conservatism without hesitation.
For this reason, in the unlikely event the Vollgeld plan does get approved this weekend, it is not clear that in the short term it should be either bullish or bearish for the Swiss franc. The Swiss National would still have all the tools to manipulate the Swiss franc in any way it wishes.
While would be somewhat surprised if the reforms pass, we think the Vollgeld proposal is the start of trend that will result in many such banking reforms being put to vote across the developed world. For this reason and until the dust settles, we would avoid investing in Swiss and European banks.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein