Rethinking Fractional Banking 29 comments
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Bill Gross of PIMCO makes the argument in his most recent "Investment Outlook" that the government needs to support asset prices to stop the hemorrhaging of the global economy. He argues that the TARP funds, while successfully instigating lending among large financial institutions on a limited basis, have not slowed the continued deleveraging by what he calls the "Shadow Banking System", and continues to drag asset prices down. The reason, he says, is because government assistance cannot be diverted to the institutions in this class (hedge funds, investment banks and structured financial conduits) because they are invisible, and therefore such rescues would not pass public scrutiny.
PIMCO is the world's largest bond trader, and so his perspective is derived from a lofty point high up in the financial food chain. As is increasingly evident by the discourse from on high, being too far removed from the economic happenings on the ground precludes the ability to either understand or navigate successfully the uncharted and turbulent waters of the economic landscape.
He furthermore confirms his conviction that capitalism itself is dependent on credit, and that no real recovery will be possible until lending resumes amid stabilized asset prices engendered by the munificence of government support.
Such logic from the leadership of the largest financial institutions, who also advises policymakers in government, assures the depths and duration of the upcoming financial market chaos. The stream of such mindless platitudes emanating from on high is solid evidence that it's the fools at the top who got us here, and that they, for all their impressive accomplishments and credentials, are no more qualified to oversee the evolution of human economy than would be a baboon.
Credit is not essential to commerce. In fact, the requirement for credit to survive by any business is evidence of dubious cash flows which call into question the viability of a business. Credit is an alternative to investment, and depending on market conditions, is either more or less expensive than credit. The reward for putting capital at risk through lending is interest. The reward for doing so through investment is capital gains.
In a perfect world, a financial institution should only be able to lend as much capital as it has on hand in deposits and in marked-to-market real assets (derivatives are not assets, nor are securitized debts, nor are CDO's and other forms of gambling scrip). But our world, as is plainly evident, is quite the opposite of perfect.
Our world is chaos. And that chaos is morphing into a novel type of financial black hole into which assets and liabilities and eventually even countries will be swept, never to be heard from again. The current mainstream media argument swirls around how effective, if at all, the bailouts will be. In ten years time we will look back and marvel at our naïveté.
The banking system became corrupted and now exists as the ground zero for the over-capitalization/deleveraging cycles we have come to refer to as bubbles. They underwrite real economic hyper-growth through the extension of credit that should not exist, and thereby reduce the demand for investment, which is much more efficient at both pricing and realizing risk.
Any financial position that is permitted to leverage itself to 90% or more of Net Asset Value is a juggernaut of financial ruin both for itself, the economies and businesses within which it grows, and ultimately for the populations who permit their existence.
The self-regulating nature of free markets is defeated when excess liquidity is synthesized through the over-extension of credit derived from overleveraged asset bases. Supporting the value of assets through the exploitation of overleveraged financial institutions is a death-spiral of the first order. The toxicity of such fractional banking is now being off-loaded into the government layer, the layer of human hierarchy that is by definition supposed to be the last bastion of protection for citizens against such manifestations of abuse that encumber and render impossible the natural regulating effects of free markets.
Smug pronouncements like that from Bill Gross are testimony to the ineptitude governing global economic policy. Does his conviction stem from the security of his tenure as high priest of bond economics? If so, it is with no small satisfaction that I shall applaud the implosion of PIMCO in the years ahead as the bond market, which is the beard for the destructively rationed fractional banking system, disintegrates in the atmosphere of financial anarchy slowly engulfing the world.
The decadent self-delusion we opt for in favor of a genuine objective analysis of our collective collusion in permitting a banking system so blatantly top-heavy amid such fractional banking ratios will be the just dessert we savor.
If banks and financial institutions and businesses and consumers were permitted no greater leverage than 10% of net worth, (in other words, a reversal of the prevailing ratio), there would be profound effects on future economic cycles.
For one, economic growth would proceed much slower. Resources would be consumed ten times more efficiently, because their availability would be restricted both quantitatively and temporally. The slow growth would defeat asset volatility, as demand and supply would be ten times as predictable.
Instead of living under the ultimately destructive globalist mantra of trying to raise the rest of the world's living standards to the wasteful and decadent levels of G& nations, we might be forced to reduce the standards of living in G-7 nations to something that we could then begin to anoint as "sustainable".
Living on planet Earth right now is like sailing on the Titanic and knowing we're going too fast and we're bound to hit an iceberg. As a mere passenger, the suggestion that we change course and slow down will be met with derision and antagonism. The captains of the boat, who have been sailing for years and have the epaulets to prove it, know far better than we.
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> Aren't you confusing leverage with the fractional reserve system? In the latter, banks are required to hold back 10% of desposits as a reserve against demands. The remaining 90% of deposits can be loaned to borrowers, thus creating money.
Wait a second. Either banks create money out of thin air and loan it out for interest or they limit themselves to loaning out what someone already deposited. If they do the former then it is certainly a leverage situation, would you not agree?
Unfortunately, it is the former. If this were not true then banks could not affect the money supply, but they do. In fact that is why we have deflation - a reduction in the money supply - even though the fed is injecting hundreds of billions. It is happening because banks are removing credit from the money supply faster than the fed can add it. They are calling in loans or writing them down and not creating new ones fast enough to keep up. If fractional reserve banking didn't involve the creation of new money (in the form of credit which cannot be discerned from central bank money by the economy) then you could have a run on a bank, but never a deflationary crash. Get it?
You can understand the mechanics via nice examples on Wiki:
en.wikipedia.org/wiki/...
There it clearly states:
"When combined with the creation of new money, as is typically done, fractional reserve banking affects the total supply of money. Fractionally reserved banks tend to remain fully leveraged and therefore monetary inflation is far more common than monetary deflation. The effect that fractional reserve banking has on the money supply has far-reaching ramifications for monetary inflation, price inflation, interest rates, and the business cycle."
Perhaps you are now starting to see the scam which is fractional reserve banking. Bankers use it to juice up the economy to make massive but unsustainable short term profits. Their money creation activities inflate the money supply with credit. They create a lot more credit than the central bank creates of real money. This does 2 things:
1) chases prices up to the moon temporarily
2) effectively removes control of the money supply from the federal reserve, especially during deflationary times. You can see it in that the fed is pounding on the banks to loan but the banks are refusing to make bad loans like they did before because they are insolvent and need to hoard cash.
Banker CEOs make massive short term Ponzi Profits and then stick the rest of us with a stinking mess that will take years to work through and which will ruin countless lives, wipe out countless retirements, etc. This time it is bad enough that the EU might not survive and there is even talk that the USA could break apart. Think that is ridiculous? Google around for states reaffirming their 10th amendment rights. They are not doing this at this particular time for their health. The survival of the union will be a question if CA and NY and FL and AZ, etc. need bailouts and ask TX and WA and other places which have strong economies to bail them out. Ron Paul's Campaign For Liberty is a thinly veiled secessionist movement for TX and other states IMO.
Assuming 10% reserve requirements, when I deposit $100 with my bank, they don't lend out $90, they lend out $900.
--- kjj
On Feb 17 08:21 AM tom steep wrote:
> Aren't you confusing leverage with the fractional reserve system?
> In the latter, banks are required to hold back 10% of desposits as
> a reserve against demands. The remaining 90% of deposits can be loaned
> to borrowers, thus creating money.
This is in fact leverage when viewed from the banks side. It is making money on loans of $200, based on assets of $100, or a 2X leverage. In this case it is paying for $100 of the $200 lent, through interest to the depositors, while it costs nothing for the remaining $100 of the $200 lent.
However, from the overall Banking system perspective, a deposit is a loan to the bank and a liability, and the bank loan is an asset to the bank since it must be repaid with interest (like an annuity). So when viewed this way the Bank system has $200 in assets (loans outstanding), based on $100 of debt (deposits) that it pays interest for, so the Bank system leverage (assets/debts) = $200/$100 = 50% for this example. So the effective leverage for the Bank system is the inverse of the required asset reserves backing of the banks loans. A typical 10% asset backing, results in a 90% leverage, creating $9 for every $1 deposit, increasing money supply with a nominal velocity.
If banks were required to "borrow" the "extra" money they lent from the US Treasury, then the US governmet would have direct control of the total money supply, and bank's would have an economic reason to minimize thier leverage since they have to pay for all of the money lent. This could be accomplished by requiring 100% reserves composed of depositor's "loans" to the bank, and loans from either the Fed, or the US treasury. In this case, no bank run would be possible since there would alway's be funding to cover all of the depositor's withdrawal demands from either the reserves held back, or the loans from the Fed/Treasury.
A commenter wrote: "banks are required to hold back 10% of deposits as a reserve against demands. The remaining 90% of deposits can be loaned to borrowers, thus creating money."
No! Any banker who followed this rule would be fired for incompetence. You hold back 10% and pass 90% in the first account. In the SECOND ACCOUNT you hold back 10% and pass 90%. You keep repeating this process, which asymptotically approaches a multiplier of 10X, until the numbers are too small to bother. Loans are 10X of deposits in this case, but we are not let off so easy...
"banks are required to hold back 10% of deposits"
No again. Another firing offense for a banker. Over the years since the 1930's, the percentage of reserves has been relaxed over and over. You can confirm this in documents available from the Fed website. The current fractional limit for the vast majority of deposits is 0%, all told. In other words, there is no real limit to fractional loaning save what the market will absorb.
Incidentally, this process means that most of the money in the system was not created by the Fed, but by private banks making loans. There is much more to say, but this is not my soda shop.
You honestly believe that economic expansion should slow as a nation's population and wealth increase?
But in fact deposits are not capital, they are borrowings. Surely you will agree it is the basic prupose of banks to intermediate between lenders and borrowers, for example by passing on deposits (minus the fractional reserve) to worthwhile borrowers.
It's all gone horribly wrong because too many bankers forgot about the requirement that borrowers be worthy. Further they were allowed to become too leveraged (and the comparison here is to equity, not deposits) and were therefore ill-equipped to to withstand credit losses.
The very process of intermediation creates money, because while the depositor still has a claim to 100% of his deposit, when the borrower spends the money he's borrowed, the recipient also has a claim to the same money.
Thanks for the wiki ,link, but I've studied fractional reserve in some depth
On Feb 17 01:07 PM Did U Think The Ponzi Scheme Would Last? wrote:
> On Feb 1 08:21 AM tom steep wrote:
I think we're applying lessons in banking that, while still taught, have not been applicable for a while.
Which brings me to another point. Banking shouldn't be so dang mysterious. Or thrifts, or whatever else.
On Feb 17 03:25 PM Latrare wrote:
> Good article. Thank you for calling it like it is. I will amplify
> what some other commenters have already picked up on.
>
> A commenter wrote: "banks are required to hold back 10% of deposits
> as a reserve against demands. The remaining 90% of deposits can be
> loaned to borrowers, thus creating money."
>
> No! Any banker who followed this rule would be fired for incompetence.
> You hold back 10% and pass 90% in the first account. In the SECOND
> ACCOUNT you hold back 10% and pass 90%. You keep repeating this process,
> which asymptotically approaches a multiplier of 10X, until the numbers
> are too small to bother. Loans are 10X of deposits in this case,
> but we are not let off so easy...
>
> "banks are required to hold back 10% of deposits"
> No again. Another firing offense for a banker. Over the years since
> the 1930's, the percentage of reserves has been relaxed over and
> over. You can confirm this in documents available from the Fed website.
> The current fractional limit for the vast majority of deposits is
> 0%, all told. In other words, there is no real limit to fractional
> loaning save what the market will absorb.
>
> Incidentally, this process means that most of the money in the system
> was not created by the Fed, but by private banks making loans. There
> is much more to say, but this is not my soda shop.
I'm going to clarify something here, because it looks to me like you're the one making the mistake. Here's a quick look why.
You make a deposit in A Bank of $100. A Bank lends $90 ($100*(1-10% reserve requirement R) to I.Borrower to buy a car. The car dealer deposits the $90 into B Bank, which then lends $81 ($90*(1-R)) to II.Borrower, to buy a car. The car dealer deposits the $81 into C Bank, which then lends out $72.9 to III.Borrower to buy a car. Et cetera, et cetera, and so forth.
As the number of iterations approaches infinity, the total amount lent from the initial deposit approaches 1/R times the initial deposit.
Now, your statement is somewhat dependent on what "they" means. If "they" is the same as "my bank," then you're wrong, unless all subsequent deposits are made in the same bank. If, however, by "they" you mean "the entire banking system," then you're close to right. But in either case, it's a theoretical maximum that depends on an unlimited number of lending iterations.
This mechanism, which is described quite adequately in Wikipedia in the "reserve banking" page, is quite often transmogrified into a single bank lending out more than it has on deposit, which is simply not the case.
Don't bother with the nice little cartoons somebody put on youtube trying to explain it the other way. They're wrong, plain and simple.
Finally, it seems our tax money will be put to good use, like rebuilding bridges and schools. Reversing the years of neo conservative (vice conservatives like Ron Paul) trashing of our nation and our kids education. Yet, sure, the package may not be perfect. But, it does get money flowing, something the TARP family of legislation failed to do.
No, conservatives, I am afraid tax cuts are too little too late and are not the save all, as one might hear argued. They're fine as a part of a larger spending bill. If the private sector doesn't spend, someone has to. And who might that be? China? No, our own government...which unfortunately has to borrow money from the very folks who put us in this mess.
But, thank goodness Obama got elected. I was conservative, but just got tired of my own party standing in the way when these are such times we need to speak and act with one voice. But, that's politics, I guess...and not economics, so much. In closing, I for one am now hopeful of a bottom by year's end. I said, hopeful...
Derivatives and the like need to die a horrible death, or at least be tightly restrained from creating paper wealth. Let the banking system do banking and get out of the insurance business. Want a CDS, go to an insurance company. What's that? They don't offer them? WHy? Too risky, riskier than a teenage pot head with a learner's permit and daddy's hot rod on a date with the prom queen. Ah, but what does post industrial economy mean?
Actually, what kjj wrote is spot on. Any bank in the federal reserve system is only required to keep in "reserve" $100 for every $900 they loan out. Just google fractional reserve banking and you'll locate thousands of articles that will spell it out in detail, wikipedia, not so much.
On Feb 17 06:20 PM BS Detector wrote:
> kjj wrote: "Sorry, I really hate seeing this mistake, but it is pervasive
> in discussions of fractional reserve systems. Assuming 10% reserve
> requirements, when I deposit $100 with my bank, THEY don't lend out
> $90, THEY lend out $900." [emphasis added]
>
> I'm going to clarify something here, because it looks to me like
> you're the one making the mistake. Here's a quick look why.
>
> You make a deposit in A Bank of $100. A Bank lends $90 ($100*(1-10%
> reserve requirement R) to I.Borrower to buy a car. The car dealer
> deposits the $90 into B Bank, which then lends $81 ($90*(1-R)) to
> II.Borrower, to buy a car. The car dealer deposits the $81 into
> C Bank, which then lends out $72.9 to III.Borrower to buy a car.
> Et cetera, et cetera, and so forth.
>
> As the number of iterations approaches infinity, the total amount
> lent from the initial deposit approaches 1/R times the initial deposit.
>
>
> Now, your statement is somewhat dependent on what "they" means.
> If "they" is the same as "my bank," then you're wrong, unless all
> subsequent deposits are made in the same bank. If, however, by "they"
> you mean "the entire banking system," then you're close to right.
> But in either case, it's a theoretical maximum that depends on an
> unlimited number of lending iterations.
>
> This mechanism, which is described quite adequately in Wikipedia
> in the "reserve banking" page, is quite often transmogrified into
> a single bank lending out more than it has on deposit, which is simply
> not the case.
>
> Don't bother with the nice little cartoons somebody put on youtube
> trying to explain it the other way. They're wrong, plain and simple.
Fred Banks: Panic is exactly what is needed. Panic on the Democratic side, that their Backloaded stimulus package catering to the 2010 elections will Backfire.
Read what I wrote more carefully, and read what kjj wrote: "Assuming 10% reserve requirements, when I deposit $100 with my bank, they don't lend out $90, they lend out $900."
Of the $100 deposit, I stated that the first bank holds $10 in reserve, lending the other $90 (based on a 10% reserve requirement). Kjj might mean that the bank lends $900 that didn't exist until the $100 deposit was made. If you think the latter is accurate, you might want to give wikipedia a chance, here: en.wikipedia.org/wiki/.... Further, if you do actually believe the latter, would you do me a favor and just one single document on the Fed's website that supports this notion?
A bank that takes in 1 from a depositor is allowed to loan 10 to a borrower. That 10 costs the bank interest because they borrow it at a different rate than they loan it. The difference between rates minus the rate they pay the depositor is profit. This convention has kept banks independent and solvent. As long as there is not a run on the bank and the default rate on loans is small, all is well. A loan for a house can be held or sold to Freddie or Fannie as long as it is conforming. There is little risk. Even if there was a run on the bank and the 1 proved insufficient, the government would back it, up to a point (FDIC insurance).
The securitizers had no such convention. They borrowed enormous sums at very low short term interest, the Greenspan Gift. They constructed long term mortgages based on shaky assumptions and sold them to investors as money good. that money was recycled into more mortgages with the short term loan outstanding. When the investors stopped buying overnight, the banks were stuck with all the mortgages based on short term borrowing, which they did not have the ability to honor. They were not equipped to have money come in over the next 30 years. Their worth is tied up in assets they can't sell, can't value, and are deteriorating. Of course they decided to make things complicated with derivatives. Investors could buy chunks of MBS without getting their hands dirty collecting mortgage payments and evicting defaulters. Investors could buy chunks of chunks of chunks all protected by some company like AIG. The more products they created, the more fees to collect. A fund of funds of funds nets three management fees. Plus you get to throw some risky junk in the mix called "insurance like products" thereby passing the risk off to investors of stuff that is beginning to smell bad or is providing enough return to justify high management fees.
As far as money velocity, James Tobin was interested in that, I don't know if Keyes was. The thought was to slow money down so the market could absorb the effect or rather money moving at the speed of light could destabilize the market and create unfair advantages. We have proof with Enron and their unregulated electronic trading causing the rolling blackouts and high energy costs in California. Credit allows money to move at the speed of light. You don't need the money to make the move. You can buy 50,000 barrels of oil as long as you sell it To be forced to actually buy it would stabilize prices and ruin everyone's fun.