fractional reserve banking :: really a problem?

[Bostwick]

@Anonymous Coward

No new money is being created.

…so long as the depositer doesn’t get paid until the loan is cashed out.

[Anonymous_Coward]

@JonBostwick

@Anonymous Coward

No new money is being created.

…so long as the depositer doesn’t get paid until the loan is cashed out.

…or if you read the rest of my comment for the reason why this doesn’t matter.

[Paul]

@gussosa

In exchange for keeping the money on deposit for the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand, although this may not be the case in an inverted yield curve situation.

It’s perhaps worth nothing here that I believe they do this precisely to maintain the illusion - there’s no fractional reserve money creation going on when they loan out money from term deposits, therefore the income they earn from the interest spread (i.e., between the rate they charge for borrowing money and the amount they pay to their depositors) is far less than the interest income from loans made from demand deposits. E.g., if you assume a single bank with 10% reserve ratio and everyone keeps their money in the bank, you could deposit $1000 and the bank could loan out $9000; if they charge 10% interest on the loan, they get back $900 a year, therefore (ignoring operating expenses, etc.) they could pay depositors up to 90% interest - while only charging 10% to borrowers! So you’d expect them to pay (much) higher interest on demand deposits…

[Paul]

@Anonymous Coward

If for some odd reason 30% of all outstanding accounts showed up at the door at once and they didn’t have enough money to cover them then ‘they usually do’ doesn’t help all the people coming to claim their money that is available ‘on demand’.

And they can’t do “good cash management” anyway - see Mises’ discussion of “class” vs. “case” probability; or Nassim Nicholas Taleb’s “Black Swan”. This article, referenced here a few weeks ago, is good.

[Bostwick]

@Anonymous Coward

@JonBostwick

@Anonymous Coward

No new money is being created.

…so long as the depositer doesn’t get paid until the loan is cashed out.

…or if you read the rest of my comment for the reason why this doesn’t matter.

Looked like a list of ways to cash out.

[gussosa]

@Paul

E.g., if you assume a single bank with 10% reserve ratio and everyone keeps their money in the bank, you could deposit $1000 and the bank could loan out $9000; if they charge 10% interest on the loan, they get back $900 a year, therefore (ignoring operating expenses, etc.) they could pay depositors up to 90% interest - while only charging 10% to borrowers! So you’d expect them to pay (much) higher interest on demand deposits…

I don’t think that example is right (but maybe I am wrong). If someone deposits $1000 in a demand deposit, under 10% FRB, the bank withdraws $900 from the customer’s money and loans it to someone else. They can’t withdraw $9000 because the guy who gets the loan will use it to buy machinery for his factory and his supplier will want to cash the check. At the moment that the Brazilian manufacturer cashes (?) the check at his bank, the Uruguayan bank that received the deposit has to give money to the second bank.

Of course, if there is only one bank in the whole world or if it is the only national bank closed to foreign operations, they can get away with a FRB operation such as you say. It just isn’t the usual situation.

One more reason to oppose bank nationalizations.

[gussosa]

@gussosa

I don’t think that example is right (but maybe I am wrong). If someone deposits $1000 in a demand deposit, under 10% FRB, the bank withdraws $900 from the customer’s money and loans it to someone else. They can’t withdraw $9000 because the guy who gets the loan will use it to buy machinery for his factory and his supplier will want to cash the check. At the moment that the Brazilian manufacturer cashes (?) the check at his bank, the Uruguayan bank that received the deposit has to give money to the second bank.

The inflation occurs because those are $900 that weren’t supposed to be in the hands of someone else. So you have somebody who has those $900 in his accounting records, and somebody else who is spending the same $900. There is the miracle of the multiplication of the money.

[ecoli]

@Paul

It’s the fractional reserve system, not fiat, that’s the problem - in theory, you could have 100% reserve banking with fiat money, and it wouldn’t be a problem.

Are you sure about this? Even if you have complete reserve banking, if a bank wanted to loan more than they had in deposits couldn’t they, in a fiat system, essentially print money (or have the Fed do it for them) to make loans, under the assumption that they’ll be able to get interest on that loan and pay back the central bank.

It seems to me, that as long as you have a fiat currency there will be the potential for malinvestment.

[therealjjj77]

@gussosa

So, it’s only transactions deposits that make the problem. Does anyone have a copy of the legislation on FRB? I want to know if the reserves required are a percentage of all transactions deposits or of all deposits (including savings and term deposits)

**

Reserve Requirements and Money Creation**
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

…

Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.

FEDERAL RESERVE BANK of NEW YORK

On-demand deposits are what the reserve requirement are based on. Not savings accounts or time deposits.

The Monetary Control Act (MCA) of 1980 authorizes the Fed’s Board of Governors to impose a reserve requirement of 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties) and of up to 9% on nonpersonal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.

In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank’s transaction accounts, and that the $25-million figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the United States. An adjustment late in 2006 put the amount at $45.8 million. Similarly, the Garn-St. Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bank’s deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. As of December 2006, that level is $8.5 million.

(same link as above)

[Andrew]

Why doesn’t frb ever have a rate like 70 or even 90 percent. You’d think by now someone would lose confidence in 10% or lower reserves. But we are not in a free market so I can see why there would be no competition for higher reserve rates. Wouldn’t frb still be the optimal choice in a free market though, if it existed?

[Juan]

What does optimal mean ? I don’t think that in a free-market any sane person would accept unbacked notes. However, if some people like to mix banking and gambling then maybe FRB would be ‘optimal’ for them.

[Paul]

@gussosa

@Paul

E.g., if you assume a single bank with 10% reserve ratio and everyone keeps their money in the bank, you could deposit $1000 and the bank could loan out $9000; if they charge 10% interest on the loan, they get back $900 a year, therefore (ignoring operating expenses, etc.) they could pay depositors up to 90% interest - while only charging 10% to borrowers! So you’d expect them to pay (much) higher interest on demand deposits…

I don’t think that example is right (but maybe I am wrong). If someone deposits $1000 in a demand deposit, under 10% FRB, the bank withdraws $900 from the customer’s money and loans it to someone else. They can’t withdraw $9000 because the guy who gets the loan will use it to buy machinery for his factory and his supplier will want to cash the check. At the moment that the Brazilian manufacturer cashes (?) the check at his bank, the Uruguayan bank that received the deposit has to give money to the second bank.

Of course, if there is only one bank in the whole world or if it is the only national bank closed to foreign operations, they can get away with a FRB operation such as you say. It just isn’t the usual situation.

One more reason to oppose bank nationalizations.

It’s more or less right given the stated assumption that there’s only one bank - but the entire banking system works out the same way, with a central bank. (Foreign banks don’t matter, because your Brazilian manufacturer wants to get paid in (Brazilian) reals not (Uruguayan) pesos)

[Maxliberty]

@Anonymous Coward

If it says that your money is available ‘on demand’ but they don’t have enough money to fulfill this contract, for whatever reason, then they are engaging in fraudulent activity.

Agreed that you can not lie to people about what you are doing. However, even the current system does not insure your money on demand and in fact there is a waiting period for your money should the bank not have sufficient resources. I don’t think the scenario you are describing actually exists. Nor do I think it would generally exist in a free-market.

@Anonymous Coward

If everyone you wrote a check to understood that there may be a delay up to 60 days in receiving their funds from your bank then they are in effect extending you a line of credit. That’s not the way it works in actual practice, is it? Business are under the impression that if they accept your check or run your debit card they will receive (close to) immediate payment and structure their business activities around this. If they were forced to wait 60 days to redeem your check or have their account credited from your debit card they would have to restructure their ‘good cash management’ which would probably include a premium charged for this extension of credit to you as a customer.

You imply that in a free market system this would be impossible or not desirable. Banking as you envision it working in a free society would have very little practical purpose for daily use of funds. Even slight levels of complication would make a bank unworkable with the arbitrary restrictions your imposing. Why is cash management on principle anti-free market? Do you think businesses don’t manage the cash they have on hand to maximize it’s use?

[Maxliberty]

@JonBostwick

It would still be fractional reserve because their money can not actually be called in within 60 days. 60 days is just an arbitrary buffer. The time delay on the withdrawal would have to be the same as the legnth of the loan.

Yes, any number would be arbitrary. What you are saying is required is that if I make a time deposit then the bank has to make a loan for that exact amount with that date of maturation. Nonsense, the bank only has to make sure that the funds are available on any day where people will want their cash. Timed deposits are not any different than demand deposits from the banks point of view. The bank still has the same problem to collect on all the money that is loaned out. If the bank loans your money but can’t collect on one car loan, do they not give you your money on the maturation date?

Money in the bank is pooled together, the whole purpose of the bank is cash management.

A demand deposit is simply a loan to the bank where the depositor chooses the date of maturation.

[Juan]

@MaxLiberty

Money in the bank is pooled together, the whole purpose of the bank is cash management.

Wow. Another crank theory : The Cash Management Theory of Banking (CMTB) by MaxLiberty…

[gussosa]

@therealjjj77

On-demand deposits are what the reserve requirement are based on. Not savings accounts or time deposits.

Thank you therealjjj77

Some related questions:

Why doesn’t some bank offer 100% reserves? That would make him way more stable than the other banks and would be a very attractive option.

Is there a maximum reserve limit?

Which are the requirements to start a bank?

[Eduard_Gabriel_Munte]

@gussosa

@therealjjj77

On-demand deposits are what the reserve requirement are based on. Not savings accounts or time deposits.

Thank you therealjjj77

A related questions:

Why doesn’t some bank offer 100% reserves? That would make him way more stable than the other banks and would be a very attractive option.

Is there a maximum reserve limit?

Which are the requirements to start a bank?

The law does not allow full-reserve banking. More specifically, banks have to keep a certain fixed reserve, and this reserve must be kept in the central bank, if I remember correctly.

[Anonymous_Coward]

@Eduard - Gabriel Munteanu

The law does not allow full-reserve banking. More specifically, banks have to keep a certain fixed reserve, and this reserve must be kept in the central bank, if I remember correctly.

There’s nothing stopping a bank from instituting 100% reserve banking it’s just that they have to compete with all the other banks.

[Anonymous_Coward]

@Maxliberty

Agreed that you can not lie to people about what you are doing. However, even the current system does not insure your money on demand and in fact there is a waiting period for your money should the bank not have sufficient resources. I don’t think the scenario you are describing actually exists. Nor do I think it would generally exist in a free-market.

Well, yeah, it doesn’t actually exist because all banks are part of the Fractional Reserve Cartel.

@Maxliberty

You imply that in a free market system this would be impossible or not desirable. Banking as you envision it working in a free society would have very little practical purpose for daily use of funds. Even slight levels of complication would make a bank unworkable with the arbitrary restrictions your imposing. Why is cash management on principle anti-free market? Do you think businesses don’t manage the cash they have on hand to maximize it’s use?

This is the part that always gets me…

If you were to put your chair in a warehouse on the contractual condition that it will be returned when you ask for it you have just opened a ‘demand deposit’ account with that warehouse. What do they do, they charge you money to watch your chair.

Now if you were to go try to pick up your chair and they told you that you have to wait 60 days because they leased it out you would be a little upset and accuse them of fraud, wouldn’t you?

But how is this fraud when all they are doing is practicing ‘asset management’?

Just because money is fungible doesn’t mean that a bailment contract doesn’t apply when you warehouse it contrary to what the current laws say. The only ‘arbitrary restrictions’ being imposed is the application of bailment law to a warehousing operation (bank) the same as every other warehousing operation known to man.

There is nothing inherently wrong about banks loaning out money that they get specific permission from the owner like a CD or savings account where it is understood that the money isn’t part of your current cash holdings and treated as such.

[Juan]

@AC

But how is this fraud when all they are doing is practicing ‘asset management’?

Of course, Max is confusing ‘cash’ or fiat-money with real assets…