Why would banks exist if it wasn’t for the concept of Fractional Reserve Banking? Isn’t this the way banks make money? Why else would I want to be a bank unless I thought I could “invest” funds from depositors? This is how banks make money and pay an interest rate to those that have accounts, right? Am I missing something here?
I read further into our reading, I imagine Rothbard will get into the idea that banks can’t always cover their funding due customers or daily reserve requirements. To cover these balances, banks use “overnight loans” i.e. Federal funds, or fed funds. These are unsecured loans of reserve balances at Federal Reserve Banks that depository institutions make to one another. The rate at which these transactions occur is called the fed funds rate. This fed funds rate is the primary tool the Fed uses for monetary policy. If the economy is growing too rapidly and a bubble is forming, the fed will raise the fed funds rate. The effect is banks will have a tendency to “loan” less money. The inverse creates the opposite effect.
When in doubt, use a T-Account. As an accountant, I liked Roth’s use of T-Accounts to detail banking works. Visually this helped think through the balance sheet. I don’t like how he is analyzing the banks financial position. You can look at any publicly traded bank and you’ll see they do not hold much excess cash. ( http://finance.yahoo.com/q/bs?s=ZION+Balance+Sheet&annual )Banks tend to have a high amount of long-term receivables (other assets) - loans /etc. Banks’s have a high amount of current liabilities. Banks hold amounts due depositors as liabilities, classified as short or long term (pending the deposit terms). Thinking through the accounting of Fractional Reserve Banking, this is the banking business, right? A public banks will disclose its financial position to investors, anyone can see how leveraged a public bank is. You run a poor banking business.
In summary of the above, yes, we increase reserve requirements or let’s regulate the type or ratio (based on risk) of securities public banks hold. However, to argue the concept of fractional reserve banking, the very root of why a bank would exist - for profit, is garbage.
Through all this discussion and through what I’ve read thus far, its not so much that I question what makes the economy work (a central banks role in the economy, including the tools and methods used). My questions more concern how it has been working. Let’s question how the Fed 's monetary has worked and is working. How about the tech and housing bubble’s of the 2000’s?
Critics have long urged the Fed to intervene in bubbles - an argument that seems even stronger given the financial crisis. Had the Fed raised the fed funds rate more aggressively, it is possible that banks would not have made so many questionable loans. We can't know for sure, but we do know what did happen. From 2001 to 2003, the Fed lowered short-term interest rates 13 times. They rates stayed low for another year, and then rose at a sharp pace. With credit so cheap 2001-2003, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years. This brings me to a comment I made in my first post “too much government interference does hurt capital markets. Capital markets do find balance naturally through supply and demand”
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"Why would banks exist without fractional reserve banking?" Matt asks. Perhaps they would not exist, and perhaps we would be better off for it. I would love to see an end to banks as we now know them. As Scott mentioned earlier, lending club and many other websites that the internet has helped innovate, have created much simpler ways to make and receive loans.
ReplyDeleteI am all for getting rid of the middle-man (rent seeking bankers)
I would even support the existence of 100% reserve banks that make money off fees that they charge for their services. They do provide some very convenient services that we take for granted because they are being subsidized by the fractional reserve lending practices such as the ability to withdraw money anywhere in the world and the ability to pay bills online. I would pay for those services if banks could no longer make money through counterfeiting, but again, the internet creates opportunity for more innovative ways of providing those same conveniences (paypal, etc), so perhaps there really is no need for banks at some point in our lives (at least not for personal use, commercial is a different story) Any thoughts??
I think that is an interesting idea and one worth discussing and thinking about. However, it is also an idea that will never come to pass. Since there is so much money in banking, the invested parties will fight with their lives to keep them.
ReplyDeleteNevertheless, it is interesting. I can imagine a world where everyone had a card that recorded every person's financial movements and banks were substituted for an arbiter (digital or human) who did nothing but keep the ledger. However, there are a couple obvious problems with this. First, banks don't just store money, they are the main supplier of credit. So how do we solve the problem of intertemporal allocation (some people want more money now and others would like to invest). An online auction type system could be employed where people could post money available to borrow/lend and a price at which they would be willing to do so (interest rate). The problem then becomes how to manage the risk of lending to a person you don't know. We do this anyway but we just don't generally think about it because the bank where we store our money evaluates the credit worthiness of the borrowers and generally assumes the risk (though as recent events have shown, large amounts of incorrectly evaluated risk can lead to large systemic shocks which affect everyone). Now the libertarian inside me says that this is okay because each person should be allowed to evaluate the riskiness of their investments using credit history etc and accordingly set their price, but another part of me knows there are a lot of stupid people in the world who would be taken advantage of. Now, people being taken advantage of is not inherently a problem because you'd think that after being fooled once the person would wise up and make better decisions but it seems to me that there are some people who just aren't capable of being financially savvy regardless of how many times they've been duped. So the non-libertarian inside me thinks that this system would lead to the exploitation of the non-savvy. And that is assuming that the current credit system could be improved enough such that credit scores and histories accurately reflect the riskiness of the person (something which currently, I don't think they do).
The other problem with my idea is the arbiter. If it is a person, who is it and how do we design an incentive scheme such that the control and knowledge inherent to the position are not abused? There could be multiple arbiters and intense oversight but I'm still not sure that eliminates the problem. And if it is done digitally we now have a lot of potential for hacking. A large part of why online/digital banking is secure is because the banks have a lot of financial incentive to be secure in regards to both their reputation and the money they make off deposits.
There are probably boatloads of other ideas out there we can discuss but if anyone sees around the problems with this idea I would love to hear about it. Its kind of fun to think about how you would reorganize the world.
The system you described already exists. Check out lendingclub. There are 1000's of loans that you can sort through by riskiness, past history, loan amount, debt to income...etc. Each investor chooses where they want to put their money and how risk is compensated with higher rates.
ReplyDeleteI agree that banks will try to stop this from developing further, but it is already moving along nicely. If the banks lobbied for such systems to be shut down, it would be the first time I would feel obligated to march on Washington.
I don't understand exactly the need for the arbiter. Currently, they use numerous metrics to value the riskiness of the loan and the computer systems ensure that everyone gets paid properly. Where I do agree is that these startups could be more vulnerable to piracy due to their lack of resources when compared to established banks. I bet when the banks begin to lobby, that will be the first worry they try to sell to the media. The swing in stocks today show the current vulnerability of the system, so it is a problem for everyone.
Well, the loan system does exist but the other functions of banks are not covered by lendingclub. And that is why I think you need an arbiter - keeping track of how much money you have because currently this is done by banks. The arbiter doesn't have anything to do with lending and borrowing, just bookkeeping. And even though lendingclub seems to be doing fine it doesn't address the problem of unsophisticated investors and borrowers because without a doubt the only people currently using lendingclub are sophisticated. If I hadn't heard of it till now there's no way that the less educated an less financially savvy have (and I'm not the most educated or savvy).
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