The 2008 financial crisis jolted many of us out of our comfort zones, leading to the argument for a complete overhaul of the monetary and banking system. This very concept has recently been petitioned in Switzerland.
Switzerland, that scion of banking, may vote to end the bedrock philosophy underlying modern finance. More than 100,000 Swiss citizens signed a petition to hold a constitutional referendum to end fractional reserve banking. That petition was certified on 24 December 2015 and a vote will be held on 10 June 2018.
The movement is known as Vollgeld and is inspired by the torch-lighting work of Nobel Prize-winning economist Irving Fisher in the 1930s and the torch-bearing work of the International Monetary Fund (IMF). Though it draws on these antecedents, the Vollgeld Initiative features its own distinct provisions.
After receiving the requisite number of signatures, the initiative will be up for a public referendum in 2017 or 2018. If successful, it will be such a profound change that it is worthy of exploration.
Supporters of the initiative believe that it will strengthen the Swiss franc and make the banking system more stable. Their objectives are to separate cash creation and payment systems from lending; create a stable money supply; reduce the burden of personal and household debt; align risk and reward; and create a structure allowing banks to fail. These are, indeed, laudable goals.
Two of the most important proposed changes are 100 per cent currency-backed deposits and government funding for commercial bank loans. In fact, the currency deposited at banks would never actually be a liability of the banks, but rather a singular liability of the federal government. Banks will earn a small fee for storing the cash and processing payments. Funding loans through the government will effectively concentrate its power, enabling it to serve primarily government and political interests, but not necessarily the well-being of the public.
The focus is on the commercial banking system. Lending exists wherever two parties come into a contract as borrower and lender. For example, insurance companies enter into contractual relationships all the time to lend money and earn interest in return. Likewise, investment banks use their balance sheets to structure and purchase, for example, mortgage-backed securities. In essence, they are funding loans. These are examples of “shadow banking” activities that work outside the traditional banking system, and these “shadow lenders” each have third-party funding. So, while commercial banking itself could be tamed and harnessed by the initiative, it is silent on how shadow banking might be affected. Human nature being what it is, the lending function is likely to shift more heavily into the shadow banking sector.
In terms of systemic risk, the causes of systemic instability include: leverage, interdependence and buffers. While proponents want leverage in the commercial banking sector to diminish, it is not clear what might happen as a result. In order to get an adequate return on capital, commercial banks may be forced to lever up through third-party funding sources (not deposits). The initiative is also silent as to how leverage might manifest itself in other sectors, such as investment banks and other financial intermediaries.
Regardless, commercial banks will each be beholden to a singular funding source (i.e., the treasury), thus elevating the interdependence of the entire system. Mistakes made by the government will immediately be propagated throughout the financial network. Finally, the Vollgeld plan is silent on buffers. It is unclear how much capital banks and other financial institutions may hold, or how much collateral may be required for financial transactions. Consequently, if the effect of Vollgeld is negative, both the private and public sector may then reduce buffers to achieve higher growth rates, causing further systemic instability.
Watch the debate between Prof. Dirk Niepelt (Uni Bern) in Zürich and Ron Rimkus CFA (CFA Institute) in the US on the potential impacts of the Swiss Vollgeld initiative and other instances of the Chicago plan on banking and finance.
Additional information provided by Jason Voss, CFA.