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Fractional Reserve Banking: The Good, The Bad And The Ugly

Written By ferdy aja on Rabu, 26 Maret 2014 | 01.36

By Wallace Eddington

What can we say about fractional serve banking? It has its pros and cons. Perhaps, though, it also has its con jobs. It certainly has its defenders and detractors. What is the average layperson to make of all this?

This article assumes a basic familiarity with the practices. For those unfamiliar with them, it's suggested that you start with this introductory article instead.

The defenders argue for the virtues of increased liquidity in the financial system: greasing the gears of our complex economy. Fractional reserve banking puts currency into the system, ensuring sufficient funds for entrepreneurs who want to launch new businesses and consumers who want to purchase high-end goods like houses and cars. The loans available through fractional reserve banking makes all this possible, thus contributes to increased demand and production, employment and so on.

Even though if one grants all those claims (which not all critics do), it is the worst failure of economic thinking to ignore the trade-offs. What are the costs of fractional reserve banking?

Three potential costs are considered below: risks 1) to the individual bank; 2) to the overall banking system; and 3) to the monetary system - increasing the vulnerability of the economy and thereby increasing the dangers of the first two costs.

1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.

It is only on the exceptional occasion that some event alerts depositors to the actual fragility of the bank's accounts. On such occasions, many of them simultaneously demand redemption of their deposits. The result is a bank run. And we've learned recently that even the digital banking world is not immune to such runs. (See the recent Mt. Gox run.) Bank runs can put the bank out of business. Minimally, it can be costly for taxpayers forced to bail the bank out of its liquidity crunch.

2) In our heavily interrelated banking world, banks borrow from and deposit with each other. That is banks can be the creditors of other banks, either long or short term. Such banks are of course more sophisticated about the reserve system than are most depositors and appreciate the cascading effects of a bank run.

However, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.

There is though an additional problem to consider. The extremely high level of inter-bank borrowing in the current global banking system means that an explosive chain reaction can be set off by such events. Just such a dynamic was a major contributor to the 2008 financial crash. The entire global financial system becomes vulnerable.

3) It is also important to consider the contributions of fractional reserve banking to destructive inflation. The lead culprits in that story certainly are central banks and governments, who employ their police powers to enforce the fraudulent fiat currency. Fractional reserve banking though also contributes considerably to the mess.

The precise mechanics of how this happens are too involved for discussion here. Suffice it to say that the same money cannot be both in one person's bank account and another person's loan portfolio. Yet, this is precisely what the formal position of accounting presumes.

This bit of fractional reserve voodoo leads directly to distortion in the information feedback system about accurate depiction of saving levels in the economy. The result of this distortion is erroneously suppressed interest rates on borrowing. Unsurprisingly, then, demand for borrowing increases as does incentives for banks to further game the reserves system. All this predictably results in the economically debilitating valleys of the business cycle: recession or depression. Needless to say, such economic downturns lead to more borrowers defaulting on loan repayments. And all this merely heightens the dangers of points 1 and 2, discussed above.

Some of the most vocal critics of fractional reserve banking have concluded, on the basis of such analyses, that the practice is merely criminal fraud and should be banned. I'm not so convinced of this claim. There are other factors to consider. As usual, I'd prefer the market to solve the problem, rather than turn to coercive government intervention.

This is a topic I'll be addressing at greater length soon. Stay tuned!

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