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Chapter 6: How Liquidity Ratio has ceased to act as a restraint on bank lending.

At the time that Backhouse was saving his bank in Darlington from the malevolent Duke of Cleveland, banks had to keep, on average, about 60% of liquid assets as a proportion of total deposits, an extremely high ratio explained by the frequency of liquidity crises around that time. 

Shortly after the 1866 Overend and Gurney bank crisis, the Bank of England accepted a role as lender of last resort, leading banks to relax their extremely conservative (and inefficient) approach to an average liquidity ratio of around 30% of total deposits.

The first formal agreement on liquidity between the Bank of England and private banks occurred in 1947 at a minimum ratio of 32%, when the bank was nationalised.  This was reduced to 28% in 1961, then 12.5% in 1971 and was finally replaced with a cash ratio deposit regime in 1981 which in 1996 was calibrated to ensure that a bank had enough highly liquid assets to meet its outflows for the first week of a liquidity crisis without recourse to the inter-bank market, in order to allow the authorities time to explore options for an orderly resolution.

This meant that there was virtually no restraint on the quantity of money banks could create apart from the demand for loans at the going rate of interest and some lingering residual caution on the part of bank management.  During the next ten years the banking community lost all caution and the government and regulators demonstrated a complete inability to understand what was happening. 

The above figures for liquidity ratio are taken from a speech by Nigel Jenkinson, Executive Director for financial stability at the Bank of England, on the 24th April 2008.
 
The liquidity ratio of a bank is the only physical restraint on the amount of new money it can lend, whether the money has been deposited or created out of nothing, i.e. forged.  When the ratio was reduced to 12.5% in 1971 at the same time as America left the gold standard it was an open invitation to inflation and we got inflation with a vengeance.  We were immediately hit by a house price bubble.

The 1970’s were the scene of ever more desperate attempts not only to control wages but also to control the banks.  During the 1960’s we had used direct controls over hire purchase with highly adverse effects on manufacturing, summarised as “Stop Go” policies.  Manufacturers were encouraged to expand by these polices only to be practically bankrupted when they were reversed.  A full account of the methods used as we tried (unsuccessfully) to control the money supply during the 1970’s is given in “Controlling the Money Supply” by David Gowland, 2nd edition 1984.

“A History of Money” by Professor Glyn Davies is a very good read for any serious student of the subject and gives a useful account of what happened in recent times as well as the history of money from barter to credit cards.  

Professor Davies blames the influence of Keynes for much of the UK inflation between 1951 and the late 1970s when the government at last understood how difficult it was to control the money supply and began to control the demand for money by its price, - interest.

In all of this frantic activity it was never suggested that the banks should not be allowed to create money at all.