There’s definitely added efficiency. Without fractional reserve banking, you’d have to match each depositor up to a loan of a certain duration and terms so that the duration of the deposit matched the duration of the loan. Or, if the depositor wanted purely on-demand access to his money, then there’d be no loans at all, and banks are just safety deposit boxes. Either scenario means that loans have much higher transaction fees, which slows down economic growth.
I’m totally in favor of the FDIC, but it’s not magic. It’s great at covering the failure of a few bad banks. But if there’s a big enough run, it can’t prevent a systemic collapse. Deposit insurance failed in Iceland a few years ago. What happens if there’s a run on enough banks that the FDIC fails? Well, either the depositors lose their money, or the government steps in (and the taxpayers pay for it). Based on the government’s actions during the recent financial crisis, where they propped up institutions that are not banks and had no explicit insurance, I’d put my money on the latter. The bankers who ran things and drew very high salaries during the good years certainly aren’t going to pay for it.
That’s because the FDIC hasn’t ever run out of money. What happens if there’s a big enough catastrophe that the fund runs out of premiums?
Owning and trading was illegal only in the United States, and only between 1933 and 1975, during most of which period we were under a hybrid regime in which the dollar was fiat currency domestically but redeemable for gold in international settlements. This was not at all typical of historic gold standards. Under most gold standards (including the US between colonial times and 1933) you could trade currency for gold or silver to your heart’s content. Indeed, that was the point of the system.
The nutshell of the story is that the Reagan Admin deregulated the S&L industry while maintaining its FDIC coverage. I recall Libertarian arguments at the time that their mistake was not in removing the FDIC coverage at the same time. Whatever. The point is, of course bankers/lenders are going to gamble and take insane risks, if they think they can lose without losing.
GEORGE BAILEY: Just a minute — just a minute. Now, hold on, Mr. Potter. You’re right when you say my father was no business man. I know that. Why he ever started this cheap, penny-ante Building and Loan, I’ll never know. But neither you nor anybody else can say anything against his character, because his whole life was…Why, in the twenty-five years since he and Uncle Billy started this thing, he never once thought of himself. Isn’t that right, Uncle Billy? He didn’t save enough money to send Harry to school, let alone me. But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? Why…Here, you’re all businessmen here. Doesn’t it make them better citizens? Doesn’t it make them better customers? You…you said…What’d you say just a minute ago?..They had to wait and save their money before they even ought to think of a decent home. Wait! Wait for what? Until their children grow up and leave them? Until they’re so old and broken-down that they…Do you know how long it takes a working man to save five thousand dollars? Just remember this, Mr. Potter, that this rabble you’re talking about…they do most of the working and paying and living and dying in this community. Well, is it too much to have them work and pay and live and die in a couple of decent rooms and a bath? Anyway, my father didn’t think so. People were human beings to him, but to you, a warped frustrated old man, they’re cattle. Well, in my book he died a much richer man than you’ll ever be!
POTTER: I’m not interested in your book. I’m talking about the Building and Loan.
No, government created the FDIC and the Federal Reserve and banking regulations. Fractional-reserve banking emerged, quite independently of government action, in Europe in the late Middle Ages at the latest. (One theory credits the Knights Templar with its invention; certainly they practiced it.)
A few nitpicks. At the time, S&Ls were generally covered by the FSLIC, not the FDIC (same principle, but limited to S&Ls). There were a few things that cause the failure. The Reagan administration deregulated, which led to more risky behavior. They also reduced enforcement, and a lot of flat-out illegal behavior took place, which further destabilized the system. Also, the S&Ls’ business model went upside down when the Volker Fed jacked up interest rates to clamp down on inflation. I think the last one is the major factor, but a lot of people don’t agree.
I got more stuff to add. Deposit insurance (like the FDIC) isn’t supposed to bail out banks. It’s supposed to bail out depositors when banks go insolvent. I don’t really see how deposit insurance encourages unnecessary risk taking by bank executives, because when a bank goes insolvent, the FDIC is supposed to seize the bank, pay off the depositors and stiff the creditors (who include executives, since they’re employees).
Now, the Federal Reserve floats temporary loans to banks when they’re in a liquidity crisis. Again, I don’t see how that should encourage risky behavior, since if a bank is in a liquidity crisis, that’s just a temporary blip. The bank still has enough assets to eventually cover deposits, which should mean they haven’t been taking unnecessary risk.
The problem we’re having, in my view, is that in 2008, the Federal Reserve and the US Government treated a solvency crisis like it was a liquidity crisis. And so, instead of seizing the banks, they gave them cheap loans and assumed risk (for free). And if the government is going to give you cheap loans and take over your risk every time you go belly up, that’s certainly going to encourage wildly risky behavior. Additionally, as pointed out earlier, the government essentially provided “deposit insurance” for a number of things (like mutual funds) which weren’t depository instruments, which also is going to encourage risky behavior.
So, I don’t think fractional banking per-se is the problem here. I think we’ve had whole-sale regulatory capture by Wall Street, and they’ve twisted the banking rules so that the taxpayers pick up all their losses, while they keep all the profits.
Private banks would be allowed to issue their own notes, and just as important, be able to back those notes with whatever assets they deemed most appropriate. They’d also be able to freely open branch offices.
The early 19th century US had a faux-free banking system, where private banks would issue their own notes. But early in the century, these were state-chartered banks, so there was no way for them to set up a national system of branches. The result was each state had its own laws, and many of those state charters mandated that the banks back their note issue with state government debt. In this way, the states could borrow extensively knowing that there was a ready buyer, a business which had no other choice. With the debt purchased, the banks could issue notes. This led to an overabundance of state debt, and then an overabundance of notes backed by that debt. When panic came and the states could no longer pay off those bonds, the banks themselves were finished. Their balance sheets, loaded up on those mandatory assets, took a beating, and the wave of bank failures made the panic worse than it otherwise would have been.
During the Civil War, the federal government needed to raise money, and the foundation for a new system of nationally chartered banks was laid down. This would have solved the bank branch problem, but again, this was done to raise money for government debt issuance, so these new national banknotes also had to be backed by debt. The US government has always been more reliable with its borrowing than the states, so there was no problem with the stability of the asset. The problem instead was that the federal government was keen to repay its debt over the war. So in a time when the economy was exploding, the debt was being paid back, and the nationally chartered banks were limited in the amount of banknotes they were allowed to issue. The country strangely saw the paper money supply drop at the same time that demand for more currency was much stronger from what should have been a booming economy. This, along with the gold vs silver problem, arguably led to long periods of stagnation that could have otherwise been avoided.
The general idea of proper “free banking” is that the system is stabilized not with government rules but by giving each bank the competitive opportunity to screw over its competitors. Notes issued by Bank A are vigorously collected by Banks B, C, D, and E and then returned for the proper monetary base (historically this was gold or silver, but it could just as easily be a computerized fiat money). This allows a sort of natural bulwark against unnecessary expansion of the money supply. On top of that, a lot of banks historically (though not all of them) were full-liability institutions. The owners were totally on the hook for everything.
Adam Smith talks a bit about the Scottish system and its admirable features. With that said, it’s pretty obviously a political non-starter. Even the Scottish system was created because of undue political influence. The Bank of England was originally a privately chartered institution, and like many such charters of the time, it had a monopoly, specifically a monopoly on note issuance in England. The BoE wasn’t interested in another powerful institution rising in Scotland to compete with it, so no bank was given the monopoly power north of the border. This allowed a more competitive system, and eventually the Scottish system became widely investigated and even admired. Adam Smith was a Scot himself, one of the most notable members of the Scottish Enlightenment. But later in the 19th century, the law was arbitrarily changed to stop any new banks in Scotland from issuing notes, and the system was irrevocably altered. It’s just not politically stable. The existing note-issuing banks were grandfathered in and allowed to continue, but no new blood could come into the system. Even today, there are a handful of banks in Scotland which can issue notes, but that’s not the same as a free banking system.
The world is much different. I’m not convinced it would work today, but it is one of those interesting historical episodes. I’d be thrilled to see a new experiment with it but that ain’t ever gonna happen.
Ah, that’s a good point.
The idea that deposit insurance encourages reckless behavior on the part of executives is based on the change of incentives for depositors.
In a system without deposit insurance, depositors are balancing the desire for a return with the integrity of the institution. It’s a two-dimensional problem with a clear trade-off, and obviously many many people are going to choose a reliable institution with an enormous focus on responsibility and security rather than the up-start with three weeks history which is trying to compete by offering an extra half point on savings accounts. When we add deposit insurance, depositor behavior collapses to just the one dimension: the return on the account. They lose nearly all concern for security, at least up to the insurance limit, and start demanding higher rates on their accounts.
And that means competition among executives becomes much more tightly bundled with delivering competitive rates on accounts instead of creating an aura of invincibility. They’re going to take relatively more risks in order to be competitive.
Of course fractional reserve banking could exist without government, the difference is government creates the problem by insuring deposits and creating greater instability. Then they try to fix this problem they created by regulation.
Hellestal gave a good summary of the supposed free banking era in the US. I will only add that, during this period when a panic was on, governments would invariably allow banks to break contract and suspend specie payments. So banks knew they would have this crutch to fall back on in the event depositors tried to redeem their notes. This could only be an incentive for instability.
The whole process seems archaic if not contrived. Leave in place the Federal Reserve but allow (or “force” it if need be) it to act as a Bank to the People instead of just corporations. It is absurd to me that the Fed gives JPMorganChase a $1,000,000 loan at 0.25% interest and Chase turns around and charges me 4 to 5% on a car or auto loan or 30% on a credit card. That’s a markup of over 1000%. Moreover, when the banks get caught doing something wrong, they use this money obtained at a low interest rate to pay for whatever fines they get for breaking the law. Why can’t we all get that deal? What’s good for the goose ought to be good for the gander. Moreover, why doesn’t the bank pass on that savings to the consumer? God knows the Fed interest rate has been a flat 0.25% for years yet interest rates have been stagnant or getting higher while savings rates have been falling to record lows. Where’s my trickle-down savings from Federal monetary policy?
On its face, our Banking system is set up to allow the financial services industry to skim money off the top. Why would the Fed only make loans to private corporations? It’s the most stupidest I’ve ever heard. The financial services industry, for the most part, is just nothing but a cumbersome middle-man that drives up the cost and stalls the economy (by hoarding cash and not making loans to the People). If we allow the Fed to open its doors to the public, real capital will flow from the People to the People without meddling and interference from private corporate interests (who’d rather gamble on the stock market and have no interest in loaning to businesses and start-ups).
Investment banks also have large wealth management businesses. Large investors frequently invest in their merchant banking operations.
With full reserve banking you don’t have any loans, which means your deposits don’t earn any interset either.
You realize that bankers pay a fee for that insurance, right? I don’t think the FDIC ran out of money during the most recent financial crisis, and thats saying something.
The FDIC regulates the risk that banks can take and obviously they had gotten too lax on their regulations. For example, the FDIC started to treat all federal debt as treasuries (Ginnie Mae securities), then they started to give favorable treatment to Fannie Mae and Freddie mac debt securities, then they gave favorable treatment to freddie mac and fannie mae preferred stock. If the reserve rate was higher than 3% and they didn’t allow fannie Mae/freddie mac preferred stock and debt to have preferable treatment, this financial crisis would have been only a bit worse than the S&L crisis. The real estate market would still have crashed, etc but only the real bad actors would have had problems in the banking industry and we could have let THEM go under without risking the entire global financial system.
Is there something wrong with your math?
AFAICT, fractional banking doesn’t allow banks to lend out more money than they have received in deposits (or borrowed from others). Fractional reserve banking allows is the lending out of money that I have effectively borrowed from others. I don’t magically create new money where none existed before.
I have run into some people who are under the impression that a 10% fractional reserve banking system allows me to take 1000 dollars in deposits and lend out $1000 on the strength of that $100. This is not fractional reserve banking.
My broker lends out my shares and frequently doesn’t even pay me interest on the loan.
In what world do you think that a bank could pay interest on your deposits without being able to lend you money out to others.
It permits the vast majority of financing (prior to about 10 years ago) to occur.
You realize that most banks can’t make loans without fractional reserve banking right?
Banking is a way for a middle man to borrow money from a lot of people who don’t have an immediate use for their money (in the form of deposits) and lend it out to people who do (in the form of bank loans) and to earn a spread on the difference between the borrowing and lending rate.
To some extent the solvency crisis was a liquidity crisis in the sense that banks earn money so reliably and consistently that for many banks, it was just a matter of time before they became solvent again.
True dat.
So you don’t mind a government middleman but you don’t want a private aprty to act as middleman? I suppose we have the expertise to make credit decision and we could convert all our post offices into bank branches but we would need to make our post offices a lot bigger. We also wouldn’t be lending money out at the discount window rate.
Yes, the money supply is increased through iteration over multiple incidences of deposits and loans.
But with a 10% reserve requirement, a bank does not take in $100 in deposits and make $1000 worth of loans. Instead they take in $100 in deposits and make $90 worth of loans. Of course, the person they loan the money to goes and spends it on widgets, and that money gets deposited back into a bank. So another bank gets $90 of deposits and from that makes $81 worth of loans. Keep doing this, and in a perfect world with no financial friction and yes, $100 in original money gets turned into $1000 worth of “money”. And $900 worth of that money exists only as bank ledgers and is not represented in any other way.
This sort of creation of money happens every time a store sells something on credit, or you buy something with a credit card, or you lend your buddy $10 to buy a sandwich and take an IOU in return, or company A ships 50,000 widgets to company B and then sends company B a bill.
Empirically, looking back over the history of the United States, was the banking system more stable before the adoption of deposit insurance or after? I don’t see how one can look at this question and conclude that deposit insurance is destabilizing.
Bankers are not middle-men. They’re the originators in the process. All money is made (created) by banks. Either commercial banks (Wells Fargo) or by central banks (the Fed) there is no other place (other than counterfeiting) that money can come from.
All bank deposits - checking, savings, etc. - are all created by commercial banks through the process of making loans. A bank makes a loan, say $100,000, and simultaneously creates a liability on itself for the same amount. That $100,000 is a credit to somebody (initially the person who borrowed the money) and it appears out of nowhere - poof! - thin air. Suddenly there’s a bank account (money) that didn’t exist before.
All other money - besides commercial bank accounts - are created by the Fed. All the currency in your wallet - take a look at it - it says “Federal Reserve Note”. All that currency is a liability on the Fed. There’s about a trillion dollars of it. It’s created by the same process. The Fed lends it into existence - usually lending it to the Treasury, which then spends it into the economy. In addition, the Fed acts as the banker to regular bankers, and the Treasury and foreign governments. It creates money the same way any bank creates money - by lending it into existence. Quantitative easing - it’s just the Fed lending money. Usually, it lends money to the Treasury, by buying bonds.
Which is a strange concept when you think about it: since both the Fed and the Treasury are part of the Federal government, it’s really just a case of the government lending to itself. Since it’s the government lending money to itself, it’s really not debt in the ordinary sense. (If you lend $10 to yourself, how much have you gained or lost?) but it’s counted as part of the debt, anyway, for political reasons.
Anyway, the point is, banks make money. They’re not just middlemen. Without banks there would be no money.
