Why any modern banking system is necessarily uncompetitive?

Interesting post by Cameron Murray, a professional economist on Naked Capitalism blog.

He argues why banks are uncompetitive in today’s system.

I want to use this blog post to explain in detail the underlying administrative mechanics of why any modern banking system is necessarily uncompetitive.

The first thing to know is that banks do two things. They make money by extending loans, which expands the money supply; a function that is an essential public service in a growing economy. Second, they settle obligations between parties both within their own bank, and between banks, which is another essential public service.

But letting private entities simply make money is risky. So our central banking system constrains the private banking system by making the banks settle payments between each other with a different currency held in accounts at the central bank. In Australia these are called Exchange Settlement Accounts. Every private bank in the system must have an account at the central bank so that they can perform this second function of settling payments.

By controlling the second function of banks by making them use a currency controlled by the central bank, it indirectly controls the former function of money creation. No one bank can rapidly create new money by writing loans faster than the rest of the banks. If they do, when the borrower deposits the money created into an account at a different bank, like when they use the loan to buy a house from someone who banks with another bank, it will require the originating bank to settle this payment flowing from their bank to a different bank with their central bank money.

This process reduces their net asset position and increases their costs. They can’t continue to do this. What limits their rate of money creation through new loans is how fast other banks are creating money and transferring central bank money to them. Each individual bank is constrained in their money creation function by their settlement function.

This leads to increased concentration:

The Australian bank data shows this process in action. Below are two graphs. On the left is the size of the loan book of Australian banks. There is a clear concentration here and a surprising regularity to the trends at all banks. To show these trends more clearly, on the right is the monthly growth of the loans made by the four major Australian banks. As you can see, there is no sustained deviation by any banks from the core growth trend. All banks are moving lock step, as they should.

The whole point of a central banking system is that the growth rate of loans for all banks in the system will quickly equalise. If you are a small bank, this means you can never grow abnormally fast in order to gain market share by competing for loans with the larger banks.

Any central banking system is therefore, by definition, unable to be competitive.

In Game of Mates, the solution proposed to stop the economic losses from the abnormal profits of the protected private banking cartel is to let the central bank itself offer basic low-risk lending and deposit functions directly to the public. Because it has the ability to create for itself its own central bank money, it is the only entity that can grow faster than the existing banks in the system.


These arguements go into evolution of banking and central banking. Earlier banks ran the show before their powers were curbed by central banks. Free banking guys say this intervention distorted the markets whereas this post argues that banks should be regulated like utilities.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: