Friday, March 20, 2009

Does fractional reserve banking have to be a scam?

“To some extent, commercial bankers lend out their own capital and money acquired by CDs (certificates of deposit). But most commercial banking is "deposit banking" based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time. If Jim has a checking account of $1,000 at a local bank, Jim knows that this is a "demand deposit," that is, that the bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to "get his money out." Naturally, the Jims of this world are convinced that their money is safely there, in the bank, for them to take out at any time.” Murray N Rothbard, ‘Fractional Reserve Banking’.

When my friend Jim asked my reaction to this quote, I said that I didn’t know that he knew Murray Rothbard. Jim replied: “I didn’t know that he knew me, but I think he is making a good point.”

I asked Jim whether he thought most people really believed that banks were like warehouses that kept the money deposited with them until people wanted to withdraw it. Jim said: “Most people know that banks lend the funds deposited with them to other people, but the point is that banks do promise to repay deposits on demand. They know that they can’t keep this promise if everyone wants their money back at the same time. Banks shouldn’t be allowed to make promises they can’t keep.”

I tried to argue that the financial system generally works well even though exceptional circumstances can arise where financial intermediaries make promises that they cannot keep. I suggested that it is very rare for situations to arise when a high proportion of borrowers do not meet their commitments and the value of the security held by banks falls below the value of loans outstanding.

Jim said: “Look, you can’t pretend that these situations where banks can’t keep their promises occur so infrequently that they should be ignored. Democratic governments don’t just look the other way when banks go bust. Do you think that the best solution for this problem is for governments to get involved by offering deposit insurance, guarantees that banks will not be allowed to fail and close supervision and regulation to ensure that such guarantee do not result in irresponsible behaviour? Don’t you see that this government intervention has arisen because banks are allowed to make promises that they can’t keep.”

I asked Jim whether he was suggesting that instead of promising to repay deposits on demand, banks should convert themselves into unit trusts. That would mean that the amount that investors could get back on demand would vary according to the market value of the financial institution’s loan portfolio.

Jim replied: “I don’t think many people would view that system as a good substitute for conventional bank deposits that are repayable on demand. What I have in mind is that a bank would specify in its agreement with depositors that in the event that it could not meet its promise to repay deposits in full within, say, a month of the request being made, then equity holdings in the bank would immediately be cancelled and re-issued to depositors in proportion to the nominal value of their deposits. The former depositors could decide whether they wanted to liquidate these equity holdings immediately by selling them on the stock market, or to hold on in the hope that the bank’s financial situation would improve.”

I have been thinking about Jim’s proposal. I do not imagine that the conversion of deposits in a troubled bank into equity holdings would be as quick and simple as Jim envisages. Nevertheless his proposal seems to me to be preferable to the current shambles that has arisen as government regulators have sought to substitute their assurances for dodgy promises that financial institutions are not able to keep.


Sam Rothrock said...

Converting deposits into equity would be, probably, a long process where much money would be lost in the process (in expenses). another issue to look at would be the Federal backing of funds up to one hundred thousand. This allows banks to make careless decisions and the money, if needed from the Fed, would only cause higher inflation rather than protect a deposit.

Winton Bates said...

JS: You might be right that conversion of deposits into equity would be a long process, but I don't see why it should be. As I see it the main issues that would need to be addressed are: clearly defining the event(s) that would trigger the conversion; and defining the equity entitlements of individual depositors. To do this all we would need to know would be the amount of an individual's deposit as a percentage of the total debts of the institution. Complications could arise with such things as hybrid securities, but it seems to me that it is just a matter of making a ruling at the outset as to whether this stuff is equity or debt.

I share some of your concerns about deposit insurance. I see this proposal as an alternative to such things as deposit insurance and guarantees to banks that they will not be allowed to fail.

As I see it what we need to avoid a financial shambles like we are experiencing at present is a process that will (1) require financial institutions to make up-front commitments to depositors as to what will happen if the institution is unable to meet its promise of repayment on demand, and (2)a way to enable the market to deal with the assets of troubled banks (that doesn't leave the banks in Zombie land or require taxpayers to pick up the tab for restructuring).

Being and Quirkiness said...

Quite an interestibng proposition Winton. Seems feasible. Of course, the worm is in the debt based money system apple.

Winton Bates said...

B&Q: I think the worm in the apple metaphor is appropriate. We need to think about how a natural evolutionary process would make the apple resistant to worms.

Anonymous said...

Looking at the debt based money system and fractional reserves there is more debt than equity & it is in the hands of private banks that seem to have stretched the debt leverage too far to be ever paid back.
One solution for this is for government to nationalise private banks, so that securities used to provide deposits to private banks can be used directly for the taxpayer benifit without the over expansion, profit motive, & unsustainable leverage.
As the vast majority of deposits purchased by private banks are from government securities or directly from the depositing taxpayer,one must ask why should they pay a premium for thier wealth to be managed by private concerns who make profits from other people's money & assetts,that eventually end up in a profit frenzy ponzi scheme asking for bailouts from the victims of this scam.
If one reviews the reforms made by prime minister Ben Chiffley just after the last depression you will see he knew about this solution his comments in the Royal commision into banking state this plus his 1948 bank act set out how this can be done this act was passed by all sides of parliament here only to be knocked back by Englands Privy council on state issue grounds that could be rectified.
Avery good example of how fractional reserves work is given by the federal reserve bank of chicago explainging the source,& the expansion of deposits upon which interest is charged on all expansion of real deposit including money from nowhere

Winton Bates said...

Excessive leverage can be a problem, but not because debt is greater than equity. Banks get into trouble when debt outstanding is greater than asset values of borrowers and/or debt servicing obligations are greater than income available to service debt.

It is confusing to view the banks as creating money from nowhere. The Reserve Bank has the capacity to do that, but the other banks are just financial intermediaries - providing a mechanism for funds to flow from savers to borrowers.

The question of whether there has been excessive or insufficient money creation by central banks is quite distinct from the question of whether the legal framework in which financial intermediaries operate tends to encourage them to take excessive risks.