Swiss Proposal of Amending Banking Practice as We Know It Essay

Introduction

In the early 1990s, both the US and the EU began wide-ranging reforms aimed at ensuring smooth flow of money in their respective economies. These reforms were built on the idea that a decentralized but integrated banking system encourages the entry of more players into the banking systems thereby enhancing competition and access to credit (Zimmerman, 1996). However, recent evidence suggests that a decentralized banking system may not be transparent enough. For instance, the rot in the US financial system was solely to blame for the 2008 financial crisis that swept through the US and EU markets; banks sought to create too much money from customer deposits which increased the risk of default significantly (Barbaro, 2018; Lattau and Mahdavan, 2018). The opaqueness witnessed in the decentralized modern banking sector motivated the Swiss to change the banks' role in creating money by empowering the central bank to become the single source of money for the economy.

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The US Banking System

The US banking system is composed of several banking institutions which carry out their activities based on the standards and regulations of the Federal Reserve (The Fed). Regarding the creation of money, the Fed adjusts the reserve rate depending on the state of the economy by considering the level of employment, inflation, and access to credit, among other factors. These practices are based on the economic models that represent an improved version of what was proposed by renowned British Economist John Maynard Keynes in 1936 as a response to the Great Depression. During an economic turn-turn/boom, the Fed adjusts interest rate which in turn affects the circulation of money in the economy. For instance, when access to credit shrinks, the Fed lowers its benchmark rate to motivate banks to offer cheaper loans which in turn increases expenditures, stimulating the economy towards the point of equilibrium (Gali, 2018; Gertler & Gilchrist, 2018).

Due to its effectiveness in helping governments to deal with issues related to banking, the Keynesian model remains a dominant economic framework in research, academia and economic policy about America's banking sector (Gali, 2018). For banks, such a model allows them to create new money by lending to the private sector and individual borrowers as a way of creating an enabling business environment for economic stability. However, several criticisms have been advanced against this model. For instance, critics argue that it assumes rational expectations among the market players which are not feasible under practical economic circumstances. Additionally, the model assumes both borrowers and creditors have access to all the information they need to make sound banking and investment decisions (Gali, 2018). Given its inherent weakness, the theory has been blamed for failing to predict the 2008 financial crisis. This can be seen in the lack of transparency on the part of banks regarding their investments and lending activities. The weaknesses of the economic model notwithstanding, the American banking system allows the bank to reserve a small fraction of customer deposits and lend the rest to create more money.

Swiss Banking System

The Swiss banking system is regulated by the Swiss National Bank (SNB) which is the central bank of the country and the chief regulator of banks in Switzerland. Through an elaborate legal framework, a lot of secrecy is observed regarding the banks' activities which often involve dubious transactions involving money that has been laundered or stolen from countries with weak financial regulations. Those who dare challenge this secrecy are often vilified, harassed and even killed not because they challengers are wrong but because their positions contravene those of the political elite and the identity of the society in which they live (Lusardi, 2017). As Rodrik (2014) argues, humans will kill to protect their moral conception of who they are as an identity, and that is what happens to those who challenge the secretive banking system.

However, recent developments have seen the idea of identifying creep into the Swiss public. The lack of stability in the banking sector explains the reason for the emergence of the Vollgeld Initiative. According to Martin (2018), the proposal (though it was overwhelmingly defeated as per the outcome of the referendum) sought to revoke fractional reserve lending as we have known for centuries. Banks create book money by lending customer deposits and mortgage payments and reserve a small fraction with the SNB as a security to their operations. Under this proposal, banks would be required to fund their lending activities through money held in savings accounts and their own borrowings. All deposits from customers would be transferred to the SNB, and the central bank would be responsible for creating money (Martin, 2018; Rojas, 2018). Thus, sovereign money would be the largest source of money in circulation.

If implemented, the proposal could ensure almost 100 percent security of customer deposits in case of the collapse of the system as happened during the 2008 financial crisis. As a consequence, there would be almost nil probability for bank runs to occur, and taxpayers would not be burdened with bail-outs (Rojas, 2018). Although this approach could adequately protect the depositors, its implementation may not be feasible because it does not take care of the interests of the economy due to several negative implications on the parties involved.

One of the negative implications with this proposal is that the role of the SNB bank would no longer be setting interest rates but targeting interest rates. The new obligation is likely to create a considerable challenge for the regulator to control the money supply as it could be forced to control the supply of cash, mortgages, and bank deposits, among others. By performing such a role, the SNB fears could thrust the regulator into politics (Martin, 2018; Thimann, 2015) as the Swiss economy is a political economy with high political stakes.

Another adverse implication of this proposal is that the transition would be costly for both banks and the SNB. It could take some time for banks to transfer the customer deposits to the SNB and also for the regulator to adjust for the new role (Martin, 2018). Such transfers could disrupt the economy as banks prepare for a life without customer deposits. However, the implementation of this proposal may not be as radical as projected by stakeholders. As widely argued by Rodrik (2014), the arguments of economists often take political considerations because political power is critical in determining whose interests that matter. Interests of power players in the economy are framed as those belonging to the larger public create legitimacy.

The Swiss Proposal and the American Banking System

One of the drawbacks of the decentralized American system it promotes the interests of the rich. As pointed out previously, the Vollgeld Initiative to seeks to centralize money distribution. It means that the SNB would be forced to regulate supply money directly instead of using the benchmark lending rate. This is in contrast with the US's banking system where the Fed only regulates bank reserves. Following the 2007/08 crisis, the Fed responded by lowering the reserve to zero benchmark rate. According to Barbaro (2018), Fed's gesture built a considerable amount of money reserves that allowed banks to lend handsomely once again in late 2009 mostly to the rich while the poor's incomes in the form of savings were reduced, destroying the home ownership dreams of middle-income and low-income Americans. This has, in turn, led to increased income inequalities as many lower-income people live beyond their means.

Information asymmetry is one of the major issues that caused the 2008 crisis. A boom in the housing sector saw banks extend significantly 'irrational' amount of credit to borrowers as a strategy of taking advantage of the favorable economic conditions at the time to create more money from the boom. Banks recalled products, repackaged them and sold them as mortgagees with little security for customer deposits, as in the case of Lehman Brothers (Barbaro, 2018). According to studies done regarding the causes of the recession, imperfect market conditions such as inadequate information, irrational expectations, lack of transparency, and fraudulent dealings among banks played a crucial role in precipitating the country into the crisis (Gertler & Gilchrist, 2018). The lack of information on the part of borrowers played enabled the banks to manipulate lending. This means that adoption of the Swiss proposal could eliminate the central bank would handle cases of banks basing their lending activities on short-term deposits as such source of funds. Hence, the interests of the depositors would be protected to avoid scenarios such as the case of the 2008 crisis.

Despite the potential benefits of the Swiss Initiative, an introduction of such a policy in the United States could pose various challenges not only to the banking sector but also across the entire economic system. According to Martin (2018), the Swiss proposal means that sovereign money would not be created through SNB induced market operations but debt-free transfer to the public and the government. Such a scenario may undermine the operations of a free market economy. In a decentralized money supply system such as that of the United States, several advantages may accrue, including sound financial practices, competition and overall vibrancy of the economy (Zimmerman, 1996) as demonstrated in the robustness of the US's financial system after the 2008 crisis.

Another merit of fractional reserve lending practice is that the Fed plays a prominent role in regulating the interest rates. Under the Swiss proposed system, banks would have to reorganize themselves and look for alternative sources of funding (Martin, 2018). Obviously, the other sources of funds would be expensive. In other words, bank interests are likely to exponentially increase as banks would strive to factor the risk premium of the borrowed funds, locking out most borrowers. In contrast, the current American system allows banks to fix the interest rate which creates a healthy market economy as money circulation is determined by demand and supply.

The GDP of any country depends on credit access avenues available to individual borrowers and corporate institutions. Under the US model where the Fed only regulates the reserves of banks, banks are at liberty to price their loans in such manner that recognizes the benchmark lending rate of the Fed. This means that loose monetary policy would spur increased lending, unlike the centralized system where banks lack the headroom to lend at friendly rates due to the high cost of funds. Although this model has been blamed for preventing small borrowers from accessing credit, it has contributed, significantly to the creation employment of employment and improved wages across the economy (Barbaro, 2018). The creation of more jobs translated into more output in terms of GDP and increased the health of the economy.

Conclusion

In conclusion, the Swiss proposal may play a crucial part in keeping the effects of market imperfections at bay. Adopting such a proposal has the potential to reduce the risk of customer deposits as well as deal with the lack of transparency in the financial sector. However, the American system has demonstrated robustness during the crisis as it allows the Federal Reserve to inject stimulus packages through major economic agents such as banks. Evidence from the operation of this system shows that it increases access to credit and strengthens the country's GDP through job creation. Overall, neither the...