Save and Conquer

Several people have asked me how a “run” on a bank can result in its closing when they have their customer’s money in the bank. They acknowledge that, sure, some of the money is tied up in hard assets, but eventually it can be resolved. Right? Why is the bank closed and why does the FDIC need to pay.

This goes to the heart of our current banking system. Long ago, it used to be that banks would only lend what they had in the vault. They subsisted on a portion of the interest of repayment from borrowers. Some of that loan interest was paid to the people who kept their money in the bank as incentive to leave it there.

Eventually, some smart guy figured out that their bank could lend out more than the money that was actually in the bank. Depending on their size, banks in the U.S. have been allowed to lend out 9 times the amount of money they actually have on hand. This is called a 10% reserve ratio. So, if they have $1000 in deposits, they keep that $1000 and loan $9000 out of the air. Say they lend this for a period of 1 year at 6% interest. If everyone pays them back, with interest, the bank will get back the $9000 which they just made out of nothing, and they will earn $540 for lending this money they did not actually have.

The big problem with any reserve ratio is it can be abused. Say a person borrow that $9000 and puts it into a different bank that is paying high interest. Then that bank takes that $9000 and lends $8100. If that is repeated a few times, you can see the ponzi scheme that is developed. This can lead to the printing of lots of money from nothing which then results in inflation.

Another thing that is a bit underhanded about lending more than what they have is that the banks are allowed to put into their books that they have all that money that they lent out. If they lend $9000 based on the $1000 they have in the vault, they don’t just say they have $540 in assets that is due to them. They say they have the whole enchilada that they pulled out of the air. They say they are owed $9540. This is very troubling to me, but that is how they count their assets.

When the U.S. was on the gold standard, there was actually a hunk of gold in the bank (and eventually the Federal Reserve) that stood for each dollar. When a depositor put in a dollar’s worth of gold they would get a gold note. They could trade it back for their gold or they could trade it with other people, who likewise could go and get the gold from the bank whenever they chose. Most people chose to use the gold notes because they were not as heavy as gold coins. Their pockets lasted longer. (OK, I made up that part about pockets.)

When lenders could only lend one-for-one, they could only lend a note for a dollar’s worth of gold held in the Reserve. When the Federal Reserve said banks were allowed a 10% reserve ratio, then the gold in the Reserve essentially became diluted by a factor of ten, but at least everyone could still get a piece of gold for their notes.

In the 1970s, the U.S. went off the gold standard and went to a system called fiat money. Essentially, the government said a dollar is worth a dollar because we say so. This is not new. There were religious fiat tokens used for trade more than 2500 years ago.

The big problem not only with fiat money, but with things like 10% reserve ratio lending is that if people lose the ability to pay back their loans (sound familiar?), then the banks will not have the money on hand to give back to their creditors. If loans start to go bad, the banks need to raise capital to pay to their customers. One way to do that is to not pay share holders as much, by cutting dividends. Another is to stop lending money that comes in. Another is to borrow money based on their outstanding loans. (Don’t forget that most of the outstanding loan value is based on made up money.) They borrow from the Federal Reserve. Where does the Reserve get money from? Since it is fiat money, they just print more.

At this point in the our current credit crisis, lots of people have stopped paying their debts to the banks. The banks are not getting the full payments they were counting on to keep the cash flowing. They still need to have cash and assets to pay their depositor’s. Thus, they are slowing the rate of lending and borrowing cash from the Federal Reserve. Even with that, if enough people say, “Give me my money!” and the bank does not have it, they have to close the door and fail. In the days before the Great Depression, a bank failure meant you lost any money you had deposited in the bank. Of course if you owe money to the bank that failed, you might be happy, but in most cases, the loans will be sold to other institutions for pennies on the dollar, and the money from those sales will be given back to remaining bank creditors.

The Federal Deposit Insurance Corporation (FDIC) was set up after the Great Depression to insure bank accounts after bank failures. The FDIC is funded by charging fees to the banks that they insure. The fees come from reduced interest payment rates. So as a depositor, you pay for the insurance. Considering how fragile this whole banking thing is, that is a good thing.

Stumble it!