Why not create new banks from QE3?

Banks are unique to an economy. They are the creators of money, via the fractional banking system. How banks use their money greatly affects the way the economy runs.

Currently banks are sitting on $1.6 trillion in excess reserves. Excess reserves have always been a part of the banking system but not in the amounts seen since 2008 Q4. The sheer size of these reserves has hobbled monetary policy - every dollar sat on by banks in excess reserves is a dollar that has effectively been removed from the economy.

Why are the banks sitting on so much money? The answer is that they are suffering from an increasing amount of insolvency. They are Zombie banks, whose net worth is negative but who continue to operate. As Paul Krugman and others have pointed out, monetary policy is only effective in a liquidity crisis, not a solvency crisis.

Obviously these banks need to stop sitting on their reserves and begin lending again. If they lent their money out, the fractional system would gear up, increase money velocity and create enough money for the banks to operate their way out of insolvency. Ironically, the banks' response to the crisis is, in effect, perpetuating the crisis.

But there is a solution - new banks must be formed.

New banks, created without any solvency issues, have no real reason to sit on excess reserves. But new banks are usually created by the market itself. Since the market isn't creating any new banks, then new ones must be created by government: Congress, Obama and the Federal Reserve acting together.

Now it's not as though the government would own these banks long term. The idea would be to create them and privatise them as quickly as is practicable: onto the share market within 12 months of their creation.

But where would this money come from? Are we going to increase government spending and thus taxes? Well if the Fed is going to indulge in QE3, it might as well use the money it creates out of thin air to create something solvent and profitable, rather than prop up institutions that are insolvent and unprofitable.

The Fed's Quantitative easing program involved the Fed creating money out of thin air (by fiat) and then using that money to buy back government securities. Yet this process was hobbled by the Zombie banks because much of the money created in this process ended up in excess reserves. QE2, for example, resulted in excess reserves increasing from $971 billion in November 2010 to nearly $1.6 trillion today: that's around $600 billion in fiat money - the entire QE2 amount - that went nowhere.

But what if that $600 billion was spent capitalising a series of new banks? With no solvency issues to encourage excess reserves, these banks would've used their capital more freely. With QE3 a distinct possibility, why not direct the money at creating new banks?

There is a historical precedent here: The First Bank of the United States, formed in 1791 by congress (see pic above). Although this bank was essentially an 18th century version of a central bank, it did have direct market operations in lending money to the market, borrowing money from the market, and taking deposits. It was also created to be purchased by the market in the form of shares. Moreover, the precedent of creating a bank, coming almost immediately out of the formation of the first congress by the founding fathers, should prevent any complaints by political conservatives that such an action would be unconstitutional.

If we assume that these new banks do get created through the QE process, what of the Zombie banks still out there in the marketplace? My suggestion is that they should be allowed to permanently die - to be declared insolvent and shut down, with deposits (backed by the government) being shifted to newer and/or more solvent banking institutions. While killing off a Zombie bank would have a negative effect upon the market if it was done in isolation, killing them off while new banks are growing and blooming would be more sustainable.

(I wrote about this before in November 2010)