Eliminate fractional reserve banking

[rukawa]

I had a debate with a friend yesterday about the monetary system. He believes in Austrian business cycle theory. I believe in the debt deflation theory of Irving Fisher. One thing though we both agreed on was that fractional reserve banking should be ended. In my view it is the primary cause of business cycles. I was surprised to find out that I wasn't the only one with this idea:

 

https://blogs.cfainstitute.org/investor/2016/01/27/is-this-the-end-of-fractional-reserve-banking/

 

 

 

[Tim Eriksen]

The article made no sense to me.  It started off talking about fractional reserve banking and then focused that deposits to loans should be equal.  That is like talking about apples and then oranges. 

[rukawa]

The article made no sense to me.  It started off talking about fractional reserve banking and then focused that deposits to loans should be equal.  That is like talking about apples and then oranges.

 

That article doesn't explain the idea well although it provides information about what is currently being discussed. I've attached the original proposal and provided a link below. Read pages 20-32.

https://web.archive.org/web/20121103110209/http://home.comcast.net/~zthustra/pdf/a_program_for_monetary_reform.pdf

a_program_for_monetary_reform.pdf

[rukawa]

Incidentally this article provides an excellent explanation as to how banks create money in a fractional reserve system:

 

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

[Guest Schwab711]

In aggregate, since 2014 the US banking system has had reserves > deposits, so we already have the situation you described. I believe Hank Paulson was the first to pay > 0% IoER and Bernanke realized the power of moving this rate above or below other benchmark rates. Until the last 5-10 years, the IoER has never exceeded any other benchmark rate. The federal funds rate is pretty antiquated and has very limited trading volume relative to the repo market (more or less the same as federal funds market but any company can participate). Bernanke said in 2012 or 2013 that the Fed intends to use the IoER rate to dictate the federal funds market and banking reserve levels. Other than 1 or 2 temporary occasions, the Fed has never paid interest on excess reserves until 2008. At present, the IoER > fed funds rate > repo rate (any situation where IoER > fed funds and repo rate is uncharted). As long as the Fed continues to create this scenario, we will have a fully-reserved banking system. I'm not fully convinced fully-reserved banking makes sense in the long run but I think it is smart for the time being to maintain confidence in large banking institutions.

 

The most important thing to understand about banking is that it requires trust to work. It's the same reason you'll never hear the FOMC predict bubbles or recessions. The prediction becomes self-fulfilling. I'm always surprised folks criticize Fed presidents when they know that policy makers should always be as optimistic as the market will bare or believe since expectations play a critical role in our economy. Fully-reserved banking (as opposed to fractional-reserved banking) limits the impact of bank runs and thus increases confidence, but I'm not convinced bank runs are as concerning as they were in the 1930's (at least in part because we have a completely different monetary system). I think (pretty much because Bernanke thinks) the real issue is OTC derivatives that aren't centrally cleared. Thus far it has not been an issue but if something went wrong we would see a tremendous level of inflation + a ton of unknown consequences. A voluntary US default would probably be similarly destructive. I think those two issues greatly exceed any other risk to the banking system.

 

If you find IoER policy interesting, you should look at the greatly expanded repo participation by the Fed and the reasoning behind it. The Fed has created numerous monetary policy tools and most of the media has ignored it.

 

Bernanke is a theoretical banking genius and the world would be much different without him.

 

Some articles on the above:

http://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves/

http://libertystreeteconomics.newyorkfed.org/2012/12/why-or-why-not-keep-paying-interest-on-excess-reserves.html

https://www.theclearinghouse.org/eighteen53-blog/2016/june/interest-on-excess-reserves-is-a-critically-important-monetary-policy-tool

 

Interesting article on how complicated general interest rate control is, post-GFC:

https://www.stlouisfed.org/publications/regional-economist/april-2016/interest-rate-control-is-more-complicated-than-you-thought

 

Benchmark rates:

http://online.wsj.com/mdc/public/page/2_3020-moneyrate.html

[rb]

Banking is fractional reserve almost by definition. If you don't have fractional reserve then what would you have?

[Guest Schwab711]

Banking is fractional reserve almost by definition. If you don't have fractional reserve then what would you have?

 

Right now, reserves are just for callable transaction (demand) deposits (primarily checking and NOW accounts). In theory, the only lendable deposits would be 'non-callable' savings deposits and time/brokered deposits.

[Cigarbutt]

I know, we should look for undervalued securities and remain fully invested and all that.

I know, we've been through world wars, depressions etc and most of us are still alive.

What's more, fractional reserve banking may not be the topic of predilection on a first date or during cocktail parties.

And to top it all, some pundits (often dogmatic) have been pounding on the dangers of FRB for years, in the midst of the Great Moderation.

 

BUT

 

I really wonder though because we really live in an exceptional period. Don't we?

 

Fractional reserve banking is the topic and unprecedented central bank back intervention is the source of unease.

 

Why worry? Maybe because my 10 year-old daughter would likely reject this model if basic premises were explained to her.

 

In the 30's, Henry Ford probably said that it was a good thing that most Americans did not know how banking really works, because if they did, "there'd be a revolution before tomorrow morning". Mr. Ford was certainly an exceptional man but his opinions on economic topics have generally not followed him in posterity. He may have had a point though. Connecting to our New Era, I would say that if people had an inkling of the greatest (by far) monetary experiment of ALL times, perhaps we would need something more crushing than financial repression.

 

Schwab, thank you for the explanations and the link. My take on the topic is less technical and more historical. In this context (even if short term in nature), I would not use smart to describe the extent and duration of that experiment. Like you say, for the system to work, you need trust. Long term, the foundations of systems are occasionally re-visited and, when this happens, sometimes you find that the emperor is naked. I would not want to go back to the Gold Standard but, at the end of the day, there has to be some kind of rational quasi-automatic mechanisms against human nature. The whole global financial montage sits now on the confidence that the Federal Board members (and other Quantitative Easers) inspire. I say this is not healthy. My opinion is different and I take into consideration your points. This is just my perspective.

 

I apologize but the following link (cartoon top right) perhaps depicts the great man under a different light.

 

http://www.philstockworld.com/2012/09/13/thursdays-fed-folly-time-for-bernanke-to-put-up-or-shut-up/

 

The money and artificial reserves creation has blurred the reference points essential for the markets to function in a self-sustaining way (yes with recessions and without volatility suppression) and (I believe) has created an unprecedented minefield of unintended consequences: yield seeking speculation, artificial levitation of global asset prices, quasi-equivalent funding to governments to run deficits and accumulate un-sustainable unfunded liabilities and general complacency about debt.

 

Reserves dynamics obviously are highly complex. I tend to wonder at academic banking geniuses with little real world experience who tamper with the foundations of our market-based economy. Who am I to say? Maybe I should ask my ten year-old.

 

What will happen? I simply don't know. I feel though that it may get dirty and may not smell good.

Who will be there to pick up the pieces? Time for NIRP, Helicopter Money, anything else?

The sky is the limit?

 

 

[rukawa]

Fully-reserved banking (as opposed to fractional-reserved banking) limits the impact of bank runs and thus increases confidence, but I'm not convinced bank runs are as concerning as they were in the 1930's (at least in part because we have a completely different monetary system).

 

The concern I have isn't just bank runs. Its the ability of the banks to increase/decrease the money supply arbitrarily.

 

Interesting article on how complicated general interest rate control is, post-GFC:

 

Interest rate control is the wrong paradigm and its why we got into this mess. I am talking about targeting the money supply DIRECTLY. Screw interest rates..banks should be the ones setting them, not the Fed. The FED should be determining the money supply itself.

 

Currently the way things work is that we have fractional reserve banking. In this system its impossible for the FED to directly control the money supply because the banks do. Generally the FED increases reserves in proportion to the demand from banks based on the amount of loans banks issue (growth in demand deposits). The tail wags the dog.

 

Why should money supply increase just because banks decide they would like to give out more loans because everybody is super optimistic about the economy. In what way is this a rational policy? Why should the money supply be decided by animal spirits?

 

I think bankers should determine interest rates not money supply. And in a fully reserved system they would do so based on the supply/demand of loanable funds. The only way loans in such a system could increase is if investors/savers were willing to part with their money for a certain duration of time to fund the loans. Otherwise the banking system as a whole would find it necessary to increase interest rates to attract more investors/savers.

 

Bernanke is a theoretical banking genius and the world would be much different without him.

 

A system that requires geniuses to function properly is not a great system.

[rukawa]

Let me provide a real world illustration of what I'm talking about. Canada's M1 over the last 10 years from 2005-2015 has doubled.

https://fred.stlouisfed.org/graph/?g=d4Co

 

Why? Did the real economy produce twice as much? Canadian GDP grew 32% over this period. Why such a huge increase? Can anyone explain the necessity of this and does no one think this is linked to what is going on in Canadian housing?

 

The Canadian housing bubble has been greatly enabled by the fact that banks can increase the supply of credit at will without any need whatsoever to attract corresponding loanable funds by increasing interest rates. Banks take no responsibility for interest rates and the B of C takes no responsibility for the money supply. This is how we can arrive at the absurd situation observed in Canada where interest rates managed to decrease even as the demand for mortgage loans grew!

 

I'll ask one question: where did the money come from that Canadian banks used to fund the massive increase in mortgage debt? My claim is that Canadian banks basically created this money out of nothing. This is the problem.

[rukawa]

Banking is fractional reserve almost by definition. If you don't have fractional reserve then what would you have?

 

Here is what I would prefer. You would have two types of institutions to replace todays banks: loan investment funds and custodians. The custodians would hold deposits that would be 100% reserved backed. That means that for every deposit held in the custodian would be backed by an equivalent amount of either physical dollars or dollar reserves accounts at the FED. The custodian would NOT pay any interest to depositors. Instead all depositors would pay annual fees in the same way as people pay for all other services.

 

The other institution would be a loan investment fund. This fund would be funded through investor equity or perhaps a debt like instrument with credit risk. The equity/debt proceeds would be used to issue loans to people that wanted them. You would still have loan officers, credit ratings and all the rest of the things a bank does to make sure loan quality is good. But it would be funded by investors with the understanding that if the debtors defaulted they would lose money.

 

Thus the only way for loan investment funds to increase credit would be to obtain more investors. And the only way to do that would be by increasing interest rates on the loans to increase the interest/dividends going to the investors. Increases in credit WOULD NOT increase M1, the money supply, at all since any increase in loans would be balanced by a decrease in some investors cash holdings.

 

The FED would increase the money supply by buying government bonds from private investors and retiring them. This of course means that any increase in the money supply would directly fund government expenditures. And the FED would increase the money supply at about the rate of the long term GDP growth rate. You could add 2% to that if you want inflation...but I don't think its necessary. That is it.

[KinAlberta]

Let me provide a real world illustration of what I'm talking about. Canada's M1 over the last 10 years from 2005-2015 has doubled.

https://fred.stlouisfed.org/graph/?g=d4Co

 

Why? Did the real economy produce twice as much? Canadian GDP grew 32% over this period. Why such a huge increase? Can anyone explain the necessity of this and does no one think this is linked to what is going on in Canadian housing?

 

The Canadian housing bubble has been greatly enabled by the fact that banks can increase the supply of credit at will without any need whatsoever to attract corresponding loanable funds by increasing interest rates. Banks take no responsibility for interest rates and the B of C takes no responsibility for the money supply. This is how we can arrive at the absurd situation observed in Canada where interest rates managed to decrease even as the demand for mortgage loans grew!

 

I'll ask one question: where did the money come from that Canadian banks used to fund the massive increase in mortgage debt? My claim is that Canadian banks basically created this money out of nothing. This is the problem.

"My claim is that Canadian banks basically created this money out of nothing."

 

 

Don't confuse the banking system with individual banks when it comes to money creation. The old; loans beget deposits which beget loans which beget deposits...  Also, I can't recall what has happened over the years to the reserve ratios in terms of expanding and contracting money supply.

 

However, any buying of banks' crap holdings at a "mark to maturity price" (as was discussed in the depths of the 2008/09 crisis) by the central banks raises a lot of questions in my mind about gifting value to the banks - aka money creation.

[Guest Schwab711]

I think the current financial system is more or less set up exactly like you have stated you would want it to be, at least in the US. I know very little about Canada's system so maybe there's cause for concern there. I am definitely not saying the Bernanke was perfect or that all of the new tools for the Fed are a good thing. In a perfect world, we wouldn't have needed to conceive new tools to manipulate/control markets. I think the growth in Canadian home values likely has at least some to do with the amount of foreign money transferred into the country.

 

Here's a few other things I disagree with. In short, I'm not really sure how your ideal plan differs from today's financial system and I'm not sure what you are trying to solve. You mention unchecked sovereign printing, but I don't think fully-reserved banking has any meaningful features to prevent that concern. Only the citizens and the discipline of legislators can influence whether a country attempts to print its way out of problems or not. I'd also add that the government is not like a normal business. The Federal Reserve System is not like a normal private bank. They obviously have some similarities but I think one needs to be careful when assuming properties of government or quasi-government entities.

 

* As mentioned, at present in the US, aggregate excess + required reserves > deposits and have for nearly 3 years. Do you think there is a lower chance of recession or general downturn as a result? What consequences should we expect from this unprecedented level of reserves against deposits? It seems like you are concerned with the ratio of sovereign debt to GDP and I don't think that has anything to do with reserves:deposits ratios. Prior to fractional-reserve banking, at least several sovereign nations experienced high levels of inflation from over-zealous minting of coinage and many sovereign nations defaulted on their debt.

 

* I think that if the US or any country really wanted to print itself out of its debt, they are going to do so despite whatever currency controls, incentives, or international agreements are made to the contrary. This has been pretty consistent in history. For that reason, I don't think it makes sense to dampen the regional or global economy in an effort to prevent something that is not preventable.

 

* Central interest rate control is money supply control. They are inseparable. You acknowledge this yourself when you stated that money available for loans would depend on interest rate levels. The Fed can alter the IoER, reserve requirements, and their balance sheet to directly influence the money supply. They can signal their expectations of trends, rate levels, inflation levels, and so on to indirectly influence the money supply.

 

* Individual banks already DO set all of their own interest rates. Almost all banks set their interest rates relative to benchmark rates guided by the Fed because they would go broke if they didn't. Which gets to the reason we centrally set rates in the first place. If we didn't, how would a customer know what to pay on a variable interest loan? If the bank set their own variable rate benchmark then we would almost certainly see banks abuse this power (like in London prior to LIBOR). From my understanding, the Federal Reserve Bank does not literally set rates in some cases. They guide to rates or ranges and carry out market functions at those rates. It is possible in some cases for the market to override the Federal Reserve Bank benchmark rate targets. In recent years, some inter-bank overnight lending transactions occurred at rates outside of the federal funds target rate (the 25 bps range everyone follows).

 

* The Fed has a mandate to "keep prices stable". The money supply varies to meet this mandate (while simultaneously addressing their other mandates). Is it the positive inflation target that you are concerned about? Everything in finance is relative, so I'm not sure why it would matter? There are slight differences between 2% nominal GDP/0% inflation and 4% nominal GDP/2% inflation, but they are practically the same. I think central bankers only care about what maximizes stability and confidence in the system. Prior to the Federal Reserve, banking panics were more or less as common and as severe as we see today. Since the FDIC was established, no depositor has ever lost their insurable deposits.

 

* How do you reconcile the fact that the US banking system is more than 100% reserved at present? Aren't we essentially operating like a fully-reserved system at the moment? What benefit would there be from making this permanent? Are we realizing those benefits today? Fractional-reserve banking has survived for hundreds of years and has organically expanded to nearly every nation around the globe. It has been adopted by every type of government. Why would we switch to an untested system that has historically failed the common man? Personally, I'd rather take my chances with the system that the market voted for with their feet, their dollars, and their labor and have refined over hundreds of years.

 

* As to unchecked 'money printing', there already exist mechanisms to punish the printers through fluctuating exchange rates. The product of a currency's supply and a currency's exchange rate generally equals a constant over small time frames. If a sovereign 'prints', the FX rate will fluctuate to compensate for the new supply. The market provides a check on excessive printing, which affects the ability of the printing nation to import goods and services. I don't see how your plan changes or addresses this sub-system.

 

* The banking system did not and does not require Bernanke-like folks to function successfully. Just because he was good at his job does not imply that the system requires someone like him.

 

* Canada's real GDP grew by 32%.

 

* It seems like more and more folks are coming to agreement that one of the leading causes of international housing bubbles over the past 20-30 years is the Basel Committee on Banking (BASEL) standards. BASEL agreements set (non-binding) banking standards for all developed and/or trading nations. Part of BASEL is the introduction of risk capital and how to weight various classes of assets to come to a general determination of acceptable levels of reserves/provisions that should be held against those assets. Since home ownership is a goal of most governments (and these assets were/are historically safe on a relative basis), the weightings for residential mortgages are low and relatively low. This incentivizes banks to provide mortgages above and beyond what they might otherwise do because it's the easiest way for a bank to maximize its earnings. It has happened in almost every country that conforms to BASEL. It took hundreds of years to get to our current system. I think it's pretty reasonable to expect some bubbles or under-lending in specific asset classes while we fine-tune asset class weightings or devise better methods to broadly regulate risk.

 

I would be very much against a fully-reserved banking system (if you couldn't tell). I think it is useful to consider that fractional-reserve banking system helped pull Europe out of the Dark Ages and has been in almost continual use since the mid-1600's. It's interesting reading more about a fully-reserved system but to be blunt I think it would be a terrible idea to implement it. I think people over-hype the threat of the US's national debt and the Federal Reserve System.

 

http://www.cobdencentre.org/2016/10/a-history-of-fractional-reserve-banking-or-why-interest-rates-are-the-most-important-influence-on-stock-market-valuations-part-1/

 

-----

 

I agree with KinAlberta that the way the Fed and other central banks purchased distressed assets certainly did not inspire confidence in the system. Maybe it was necessary. I am not knowledgeable enough to have an opinoin. But it definitely looked bad and distorted whatever outcomes should have occurred.

[SharperDingaan]

The fractional reserve is supposed to be the $ on hand to meet demand deposit withdrawals – UNDER NORMAL CONDITIONS. The; if customers have $1000 on demand deposit with us, & on any given day we expect to have to return no more than $100 - we can have a 10% LIQUID RESERVE, and $9,000 out on loans at various terms to maturity.

 

The central bank is supposed to be the ‘go to’ when conditions are not normal. Their function is to temporarily absorb the entire ABNORMAL market risk, until such time as normality can be restored; and it is you and I, Joe citizen, who absorbs the risk.

 

We know the division works very well, and that it puts the everyday risks of lending on the bankers making those decisions. The poor lender goes bankrupt if they make bad decisions, & is instantly replaced by a more competent lender.

 

Our issue today is that we don’t let big banks fail, & reward them for incompetency.

We ‘bend’ the interpretation of ‘reserve liquidity’ to essentially lower the fraction, and increase total loan making capacity; the if we only have $40 when we need it, & not the $100 required – the central bank will spot us the difference. Moral hazard.

 

It has been almost 10 years since Lehman Brothers.

We don’t need to end fractional banking, we just need another Lehman Brothers and a central bank exit from everyday banking. No more liquidity injections, no more bowing to threats of mass layoff, end of moral hazard.

 

Obviously, not a popular view.

 

SD

 

[Guest Schwab711]

Our issue today is that we don’t let big banks fail, & reward them for incompetency.

 

.

.

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It has been almost 10 years since Lehman Brothers.

We don’t need to end fractional banking, we just need another Lehman Brothers and a central bank exit from everyday banking. No more liquidity injections, no more bowing to threats of mass layoff, end of moral hazard.

 

I couldn't agree more.

[Cigarbutt]

I'm with SharperDingaan on this one but thank you Schwab for the thoughtful and measured response. Yes, the "over-hype" has to be put in perspective.

I also think that there is now a pervasive and embedded moral hazard.

There are "checks" but I submit that this may not be effective going forward especially during periods of stress.

Given this context of equilibrium, how do you explain the Japan experience (not exactly conservative in its money creation predisposition during the last few years) and the evolution of its currency exchange rate curve?

Thank you for the historical link.

A few months ago, I read a book about John Law who has contributed greatly to the application of fractional reserve banking (good thing and a cornerstone of capitalism). Perhaps then (like today?), this foundational concept was contaminated by money printing gone too far. I plan to start a new thread with a commented review of that book or perhaps will include it later in this thread if it continues to have life.

[rukawa]

Our issue today is that we don’t let big banks fail, & reward them for incompetency.

 

You have no choice but to bail out banks in a fractional reserve system because if you don't the money supply contracts and you get a recession/depression. Its as if the banks are holding a match to the money supply and saying to you: Let us fail and we will burn it.

 

For instance in 1995, M1 was 1200 billion and the monetary base was 400 billion. If every single bank throughout the whole US failed simultaneously, M1 would shrink from 1200 to 400 and you would have a Depression that would make the Great Depression look like a fun picnic. This is why central banks MUST intervene!! Because the dynamics that play out when this happens: Massive unemployment, bankruptcies are too painful.

 

However in a fully reserved system, it doesn't matter if every single loan throughout the entire country defaults at precisely the same time. You won't get a Great Depression. Employment won't be affected. So there is absolutely no need for any bailouts or central bank intervention.

[Cigarbutt]

Interesting take rukawa.

You may be interested in a course given by Andrew Metrick and Timothy Geithner (yes him) called the Global Financial Crisis (Coursera).

I enjoyed it. I will tell you that I feel for the main actors when Financial Pearl Harbor hit.

The course actually does a good job (balanced) at describing conflicting priorities that have to be dealt with urgently, with incomplete information and an un-written script.

I see your point but perhaps one does not need to modify profoundly a system that has worked fairly well over the last centuries (reference to schwab's post).

Perhaps, to prevent moral hazard and unintended deleterious consequences, strict and focal application of the Bagehot rule should prevent short term liquidity crisis management from morphing into a nightmare of historical proportions.

For completeness sake:

Bagehot rule:Walter Bagehot, a 19th century economist and editor of The Economist, designed the solution that remains as relevant today as it was then. The Bagehot rule is that the central bank ought to lend freely to a failing bank, against high-quality collateral and at a punitive rate.

[TwoCitiesCapital]

Our issue today is that we don’t let big banks fail, & reward them for incompetency.

 

You have no choice but to bail out banks in a fractional reserve system because if you don't the money supply contracts and you get a recession/depression. Its as if the banks are holding a match to the money supply and saying to you: Let us fail and we will burn it.

 

For instance in 1995, M1 was 1200 billion and the monetary base was 400 billion. If every single bank throughout the whole US failed simultaneously, M1 would shrink from 1200 to 400 and you would have a Depression that would make the Great Depression look like a fun picnic. This is why central banks MUST intervene!! Because the dynamics that play out when this happens: Massive unemployment, bankruptcies are too painful.

 

However in a fully reserved system, it doesn't matter if every single loan throughout the entire country defaults at precisely the same time. You won't get a Great Depression. Employment won't be affected. So there is absolutely no need for any bailouts or central bank intervention.

 

I don't know if I buy this argument. If every single bank failed in a single reserve system, you're still going from 400 to 0. You'd have massive disruptions in spending patterns (hits to top and bottom lines) and asset ownership (as collateral is transferred to debt holders) which would have significant implications for further declines in inflation, wages, asset values, etc. etc. etc.

 

I'm pretty sure in ANY system, the bankruptcy of all banks is disastrous. But how much below 0 can you go as a country? Or can you only hit 0 and the drop from 400 to 0 is the same as a drop from 1200 to 0?

 

 

[SharperDingaan]

The reality is that all bail-outs eventually end, and fear has a limited shelf life.

 

Even if you think exit is a Russian Roulette decision; there is still a 5 in 6 chance that pulling the trigger is going to result in a successful exit - and if it fails, its no different to what we already have. 'Radical change' is also the underlying mandate of the tens of millions who voted for Brexit, and Trump; because for them - there is little to lose.

 

SD