Fractional Reserve Banking: From First Premises

Currencies, Regulatory 24 Jun 2015

fractbankThree quite recent stories bring forcefully to mind certain basic facts about banks, fractional reserves, and lenders of last resort. I propose looking at these issues from first premises, and I may suggest in due course some conclusions that matter greatly to the world of non-bank financing, including the hedge funds in that world.

Bulletin: Dennis Hastert’s Indictment

The first of these recent stories, jogging my quest for first premises, is the indictment of Dennis Hastert. Hastert is said to have structured bank withdrawals to evade reporting requirements and to have lied to the Federal Bureau of Investigations about why he made these withdrawals when he did.

There are several layers of operating assumptions behind the indictment. One might, at the outmost layer of our box, question why there are banks in the modern (post-Renaissance) sense in the first place, and whether they’re a blessing or a curse. Socialists of many varieties think banks are evil, many Moslems think any institution that charges interest on loans is evil, but I’ll set them both aside. What I’m somewhat more interested in is the argument about the “fractional reserve” nature of banking.

Modern banks hold customer deposits and promise to give the customers this money back on demand.  But of course they aren’t holding it all in the vault. Only a small “fraction” of it is in “reserve.” Most of it is invested. As Jimmy Stewart says to the customers of the Bailey Building & Loan, “It’s in your house, and yours.” It’s out in the world, doing things.

To certain critics, including capitalists like Murray Rothbard, or Irving Fisher, fractional reserve banking in this sense has long seemed like a con game. The use of other people’s money for investment, with the simultaneous promise that it is all available for withdrawal on demand, sounds to them inherently dishonest.

Suppose we dismiss such scruples and accept fractional reserve banking. I personally do so. I believe modern banking has been an engine for growth and prosperity since the time of the Medici, and I’m not going to side with Savonarola (the fellow portrayed at the top of this post) against it all. And yes, modern banking involves fractional reserves. It isn’t just keeping people’s jewelry in safe keeping for them.

Second Bulletin: New Assistance for Greek Banks

I interrupt this explanation of first principles and the post-Renaissance world with another bulletin from 2015. On June 19th , as the banks of Greece struggled with a dangerous speed of withdrawals, the European Central Bank increased the cap on assistance available to those banks of Greece through “emergency liquidity assistance.”

But back to the layering of assumptions: Moving inward from that first layer – the legitimacy of fractional reserve banking – a second assumption is that modern banking may plausibly be thought to require a central bank, a bank-of-banks, also known as a lender of last resort. After all, banks that pull this trick of lending out money while promising it immediately upon demand are subject to bank ‘runs.’

That was the crisis the Bailey family faced in It’s A Wonderful Life.   If a lot of a bank’s customers show up at once to demand their deposits, the demands may exceed the fraction actually held. Then what? Well, then the bankers can appeal for assistance to the central bank, if they’re part of a system that has one.

I personal believe there are ways of resisting the logical move toward centralization, but it is at least historically plausible. And it brings us to the third layer. If there is to be a bank-of-banks: does this institution have to be government chartered or sponsored in some way? In a world full of governments, it will be difficult to keep central bankers on the one hand and government treasury officials apart. They’ll get to know each other, at the very least.

Third Bulletin: Yellen on Normalization Plans

On June 17th, the U.S. Federal Open Market Committee re-affirmed its view “that the current 0 to ¼ percent target range for the federal funds rate remains appropriate.” In a press conference that day, Fed Chair Janet Yellen spoke of the “normalization” of interest rates, and of how she and her colleagues must delay this desirable process of normalization. Beginning it “too early could risk derailing the recovery that we’ve worked for a very long time to try to achieve.”

But back to our program: once we accept (for purposes of discussion) that there will be a central bank responsible for such matters as reacting to panicky bank runs at the member banks of a system, not to mention such more ambitious goals as full employment, and once we accept that this central bank will be chartered by some government, then we come to the fourth layer, one specific to federal systems of government. In the US, we put it this way: which government is to charter banks?  The one in Washington? Or should the states have their different systems, with fifty different central banks?

Well, once there is a common currency in place, there is a powerful pull toward the centralization of responsibility for monetary institutions at the same level at which the currency is issued. This was, after all, Alexander Hamilton’s point. But the matter was not finally settled in the US for a long time after that – not even finally settled by the creation of the Federal Reserve in the Wilson era. The essentially federal/national character of banking in the US seems to have become conventional wisdom only with and since the institution of federal deposit insurance in the 1930s.

All that brings us to the inmost layer of in-the-box thinking. Given this single national system, deposit insurance, etc., the federal government unsurprisingly interests itself in large withdrawals of money.

Combined with this there is the fact that lots of bad guys, operating across state and national lines, need to move large amounts of cash. From drug cartels to Al Qaeda. The nation states trying to restrict their activities will naturally seek to restrict their access to the banking system, making their conspiracies more difficult. From this dynamic arises the regulatory apparatus — the smallest box — in which Hastert may now be trapped.

The most important point, for anyone other than Hastert and his defense team, is that the banking system, as it centralizes, ossifies. Where there was soft tissue, there is now bone.

Banks are in the liquidity transformation business, and that is a critical role. But the ossification by tradition, assumption, and concomitant regulation threatens that very function, and other ways of getting the job done may yet grow up around traditional banking, producing a spontaneous transformation.

 

Be Sociable, Share!

Leave A Reply

← The Core Satellite Model: How to Cut Hedge Fund Fees in Half Part II Headline Factors and Hedge Fund Success →