In an FEE conference lecture, Lawrence White argues that fractional reserve banks can exist legally (under libertarian law) and are viable businesses because people primarily use banks to exchange deposit balances with one another rather than for safe storage of money. I think this argument appears to have some merit on first glance but ultimately breaks down on closer inspection.
It is true that bank customers primarily use their bank account as a money-exchange device - just calculate the average volume of check/debit or other ledger payments versus cash withdrawals. The percentage of cash flow which is ledger payments (rather than cash deposits or withdrawals) is almost 100%, and there is no reason to believe that it would be significantly less in a free banking economy. However, the root problem of paying interest on demand deposits is that, as Rothbard puts it, the bank is technically insolvent, since its liabilities have zero maturity and its assets have maturities out to 30, 60, 90 days (typically) and loans which have an even longer time horizon. A fractional-reserve bank, no matter how useful and attractive it might at first seem to customers, even under libertarian law, would always be liable to bank runs. During times of uncertainty, bank runs would occur and such banks would, in fact, collapse.
It is often pointed out by defenders of fractional reserves that all businesses are liable to go bankrupt due to mistakes or failure to foresee bad economic conditions. Collapse of fractional reserve banks, on this view, is no different - no one could have foreseen that economic uncertainty would occur and, as a result, bank panics and collapses. However, this is a false claim - successful businesses and individuals do in fact predict and prepare for "rainy days" and hold liquid assets for the purpose of self-insuring against unforeseeable (therefore, uninsurable) calamities. Over time, a "market level" of such holdings will emerge, such that, successful businesses are those which typically hold X% of their assets liquid in the event of unforeseeable economic conditions.
The same would hold true of time-deposit structuring in a free banking economy - banks would need to be able to calculate their exposure to unforeseeable risks and, over time, those banks which fail to make the time structure of their assets and liabilities solvent will collapse and serve as "object lessons" to the industry. In essence, the fractional-reserve banker is making guesses about the time horizons of his customer's deposits... "I guess they won't be demanding this money for X days, so I can loan it out to ABC Corp. for X days and provide some interest-sharing to my depositors to incentivize deposits to my bank." Banks which use time deposits do not have to take on the risk of mistaken guesses about the time horizons of its customers... the customers themselves estimate their time horizons and bear the risks of miscalculation. This distributed knowledge is certainly more accurate than the centralized knowledge of the banker and, in any case, ensures that the risks of economic uncertainty are being borne by those who actually want it. If you want to take on the risk of locking your money away in a time deposit, you can do so and assume the risk of bankruptcy if you are unable to meet your own liabilities in time... but other customers of the bank do not have to bear any of the risk you are taking on to yourself.
White suggests that the fact that people primarily use their deposits for purposes of exchanging with other account-holders implies that fractional reserves banking is a viable business model - but this fails to take into account the time horizons problem and treats monies of different maturities as if they are homogeneous. Essentially, White is claiming that people would want to perform ledger transfers between accounts whose deposits have been loaned out at various maturities. Imagine I have a time deposit with 25 days remaining to maturity. I cannot exchange dollars from this time deposit at a 1:1 ratio with deposits of zero maturity for the same reason you cannot sell a bond at face value - no one will ever pay the full price of the bond in the present because time preference is never zero. If I wanted to buy a $2500 flat screen with money from my 25-day maturity time deposit, I would have to adjust for the interest rate over 25 days. Let's say the interest comes to 0.5% (roughly 6% per annum). I would have to add $12.50 to the "zero maturity" purchase price In order to pay the TV seller out of my 25-day to maturity time deposit. The $2500 television would cost $2512.50 to purchase out of my 25-days to maturity time deposit.
Only deposits with identical maturities could be exchanged at a 1:1 ratio. This is the result of time preference and arbitrage. Any other arrangement would cause someone to bear losses and provide risk-free profits to someone else. Banking institutions could separate deposits into classes on the basis of maturity and neither banking institutions nor risk-averse depositors would want to bear the risks which other depositors choose to take on without compensation that is in direct proportion to the risk being borne, the fractional reserve system would fall into disuse after a few banking panics which leave mostly non-fractional reserve banks standing. Fractional reserve banks induce each customer to share in the common risk pool of all depositors. The profit-sharing paid from the bank's interest proceeds is pro rata to the size of each interest-bearing deposit but all depositors bear equally the risks which the bank's management takes. If the bank's assets become illiquid and it is unable to meet its obligations, all depositors lose some or all of their money, even if they wanted the bank to hold their money at zero maturity, on demand. Full-reserve banks could pay as much or more interest on time deposits without pooling risks between unlike depositors.
Fractional reserves should not be prohibited in libertarian law, IMO (I reject the argument that they necessarily constitute "fraud") but they also would not be very prevalent (again IMO). I think White's argument is neither here nor there in this regard because he fails to take into account that money at different maturities would not exchange dollar for dollar in a free banking economy.
Any thoughts?
Clayton -
ClaytonB:Collapse of fractional reserve banks, on this view, is no different - no one could have foreseen that economic uncertainty would occur and, as a result, bank panics and collapses. However, this is a false claim - successful businesses and individuals do in fact predict and prepare for "rainy days" and hold liquid assets for the purpose of self-insuring against unforeseeable (therefore, uninsurable) calamities. Over time, a "market level" of such holdings will emerge, such that, successful businesses are those which typically hold X% of their assets liquid in the event of unforeseeable economic conditions.
You have it backwards. A reserve ratio is 5% because there is no bank run. That is the market level holding against uncertainty and the rainy days.
ClaytonB: However, the root problem of paying interest on demand deposits is that, as Rothbard puts it, the bank is technically insolvent, since its liabilities have zero maturity and its assets have maturities out to 30, 60, 90 days (typically) and loans which have an even longer time horizon.
The deposits are backed by outstanding loans and capital, so the bank is not necessarily insolvent.
ClaytonB:White suggests that the fact that people primarily use their deposits for purposes of exchanging with other account-holders implies that fractional reserves banking is a viable business model - but this fails to take into account the time horizons problem and treats monies of different maturities as if they are homogeneous. Essentially, White is claiming that people would want to perform ledger transfers between accounts whose deposits have been loaned out at various maturities.
I don't think he ever talked about deposits with different maturities. The whole discussion was about demand deposits, which have the same maturity .
My thought is that this whole debate SHOULD be unnecessary in a free market for banking services. In this somewhat ideal world, the customers would determine the best way for banks to behave and banks would behave differently for different customers. Banks would be free to write any contract they wish with their depositors. You would have an incredible variety of deposit contracts that have various mechanisms providing only 1 owner of a deposit at any given time and limiting the exposure to fractioned deposits.
This is unlike the over-regulated "fraction all the money" and let the Fed/FDIC/Treasury bail you out when a small number of borrowers fail to make their monthly premiums. In the awful system run by the Fed, banks operate at lower than market interest rates and therefore lower than market spreads. So to make money they have to focus on volume instead of quality. THen to make matters worse they get stung by the DOJ if they don't loan enough. So we have hidden insolvent banks that are on the edge of being complete failures.
Also, the banking system is insolvent as its current assets (reserves) are less than its current liabilities (deposits). So it is only a matter loan quality that the incoming payments plus money loaned from other banks fail to meet the demand for deposits.
Bogart:Also, the banking system is insolvent as its current assets (reserves) are less than its current liabilities (deposits).
No, they have vastly more assets than just cash reserves.
scineram: Bogart:Also, the banking system is insolvent as its current assets (reserves) are less than its current liabilities (deposits). No, they have vastly more assets than just cash reserves.
If the bank's fractional reserve loan portfolio needs to be marked-to-market during a general bank run, its asset value is anywhere from 0% to 100% of deposits. In order to pay back depositors on demand, immediately, the bank must liquidate its loan portfolio immediately. The loan is a future good, hence its present good value is much less than its face value, particularly when the market is experiencing a sudden demand surge for cash liquidity. If it fails to do that the bank has failed and the problem of paying back depositors goes to a bankruptcy judge who will pay back depositors only the share of cash that has been recovered in the liquidation of the bank's remaining assets.
For this reason, fractional reserve banks are fundamentally insolvent.
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But these assets cannot all be liquid at face value, even though the liabilities behind these assets are due instantly. This makes the bank inherently insolvent by any sound financial standard normally applied to any other business.
The only way to theoretically overcome this is by removing the obligation on the part of the bank to redeem on demand or by any other specified amount of time.
scineram: ClaytonB:White suggests that the fact that people primarily use their deposits for purposes of exchanging with other account-holders implies that fractional reserves banking is a viable business model - but this fails to take into account the time horizons problem and treats monies of different maturities as if they are homogeneous. Essentially, White is claiming that people would want to perform ledger transfers between accounts whose deposits have been loaned out at various maturities. I don't think he ever talked about deposits with different maturities. The whole discussion was about demand deposits, which have the same maturity .
I know - my point is that this would be the defining distinction between full-reserve (or nearly full-reserve) and fractional-reserve banks. In a full-reserve bank, deposits would be segregated by their maturity, such that, 30-day time deposits do not exchange 1:1 with 90-day time deposits, neither of which exchange 1:1 with demand deposits. In the fractional-reserve bank, this distinction is ignored and all interest-bearing deposits sit in a common pool of heterogeneous risks... 30 year mortgages, 90-day loans, 4-year car financing, etc. all rolled into one big glob which either remains profitable or takes down all depositors.
I suspect that some level of fractioning will occur even in a free market - I can't imagine depositors purchasing 30-year time deposits and patronizing only banks which fund their 30-year mortgages from 30-year time deposits. If the bank plans to remain in business for more than 30 years, it can reasonably expect a future supply of shorter term time deposits that, when added together, fully covers its 30-year assets. But I think that, without the protection of the central-banking system, there will be market pressures which dictate how much risk can reasonably be taken in this regard. Perhaps a bank would have to fund 90% of its 30-year mortgages with 10-year time deposits, and the remaining 10% however it likes, or maybe something much riskier. All I'm saying is that by failing to fully cover its loans over their full duration, banks are taking on risk of insolvency which is being borne by all of its customers since, if the bank is forced to default, it will not be able to repay even its demand depositors the full value of their deposits in liquidation. Banks which better cover their outstanding loans with time deposits will be able to better shelter their customers from risk of deposit loss. How much risk banks are permitted to take, by the market, will dictate reserve ratios. It is my belief that reserve ratios would be much closer to 100% than 10% in a free banking market. I also believe there would be non-zero demand for 100% full-reserve banks.
ClaytonB:I suspect that some level of fractioning will occur even in a free market - I can't imagine depositors purchasing 30-year time deposits and patronizing only banks which fund their 30-year mortgages from 30-year time deposits.
You don't need fractional reserves for this. You can buy a 30 yr mortgage security just like any other type of security and sell it anytime before it matures. No fractional reserves or maturity mismatching is necessary. This is really no different from today's bond market.
Everybody in debt is insolvent, great.
scineram: Everybody in debt is insolvent, great.
Your knowledge in finance is impressive.
If you owe someone a payment that you can't make, you are insolvent.
Stranger: scineram: Everybody in debt is insolvent, great. If you owe someone a payment that you can't make, you are insolvent.
Time structure is completely absent from his analysis.
Solvency and liquidity are two different things. Fractional reserve banks are not inherently insolvent.
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Esuric: Solvency and liquidity are two different things. Fractional reserve banks are not inherently insolvent.
You need liquidity to make payments on your obligations. If your current obligations are 100% of your assets, then you need 100% liquidity.
Stranger:You need liquidity to make payments on your obligations. If your current obligations are 100% of your assets, then you need 100% liquidity.
Bankers observe market conditions (trained to do so) and determine the adequate level of liquidity required at any given moment. The same way that entrepreneurs look at market demand conditions and determine how much to produce, and what to produce, ect. If a bank incorrectly assesses market conditions, then it will go bust, and some people will lose money (if it's insolvent). But when firms go out of business, people also lose money, and others lose their job. But in both situations, capital and labor would be freed up for other more warranted economic employments, and their failures would send vital information signals to other market actors. This is how the market operates.