Jeremy
06-04-2008, 08:25 PM
http://blog.lawsonforcongress.com/2008/06/04/whats-the-problem-with-banks/
I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.
Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.
What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.
Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.
In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:
* Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
* Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.
From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.
You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.
Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.
The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.
From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.
You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:
If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)
This verse is talking about the prohibition of interest in loans to poor fellow believers. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, the collateral offered by the borrower is important. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.
As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.
So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.
In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency copied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.
Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.
I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.
Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.
What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.
Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.
In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:
* Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
* Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.
From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.
You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.
Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.
The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.
From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.
You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:
If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)
This verse is talking about the prohibition of interest in loans to poor fellow believers. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, the collateral offered by the borrower is important. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.
As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.
So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.
In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency copied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.
Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.