Unsound Banking: Why Most of the World’s Banks Are Headed for
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You’re likely thinking that a discussion of “sound banking” will be a bit boring. Well, banking should be boring. And we’re sure officials at central banks all over the world today—many of whom have trouble sleeping—wish it were.
This brief article will explain why the world’s banking system
is unsound, and what differentiates a sound from an unsound bank. I suspect
not one person in 1,000 actually understands the difference. As a result, the
world’s economy is now based upon unsound banks dealing in unsound
currencies. Both have degenerated considerably from their origins.
Modern banking emerged from the goldsmithing trade of the Middle
Ages. Being a goldsmith required a working inventory of precious metal, and
managing that inventory profitably required expertise in buying and selling
metal and storing it securely. Those capacities segued easily into the
business of lending and borrowing gold, which is to say the business of
lending and borrowing money.
Most people today are only dimly aware that until the early
1930s, gold coins were used in everyday commerce by the general public. In
addition, gold backed most national currencies at a fixed rate of
convertibility. Banks were just another business—nothing special. They were
distinguished from other enterprises only by the fact they stored, lent, and
borrowed gold coins, not as a sideline but as a primary business. Bankers had
become goldsmiths without the hammers.
Bank deposits, until quite recently, fell strictly into two
classes, depending on the preference of the depositor and the terms offered
by banks: time deposits, and demand deposits. Although the distinction
between them has been lost in recent years, respecting the difference is a
critical element of sound banking practice.
Time Deposits. With a
time deposit—a savings account, in essence—a customer contracts to leave his
money with the banker for a specified period. In return, he receives a
specified fee (interest) for his risk, for his inconvenience, and as
consideration for allowing the banker the use of the depositor’s money. The
banker, secure in knowing he has a specific amount of gold for a specific
amount of time, is able to lend it; he’ll do so at an interest rate high
enough to cover expenses (including the interest promised to the depositor),
fund a loan-loss reserve, and if all goes according to plan, make a profit.
A time deposit entails a commitment by both parties. The
depositor is locked in until the due date. How could a sound banker promise
to give a time depositor his money back on demand and without penalty when
he’s planning to lend it out?
In the business of accepting time deposits, a banker is a dealer
in credit, acting as an intermediary between lenders and borrowers. To avoid
loss, bankers customarily preferred to lend on productive assets, whose
earnings offered assurance that the borrower could cover the interest as it
came due.
And they were willing to lend only a fraction of the value of a
pledged asset, to ensure a margin of safety for the principal. And only for a
limited time—such as against the harvest of a crop or the sale of an inventory.
And finally, only to people of known good character—the first line of defense
against fraud. Long-term loans were the province of bond syndicators.
That’s time deposits. Demand deposits were a completely
different matter.
Demand Deposits. Demand
deposits were so called because, unlike time deposits, they were payable to
the customer on demand. These are the basis of checking accounts. The banker
doesn’t pay interest on the money, because he supposedly never has the use of
it; to the contrary, he necessarily charged the depositor a fee for:
1.
Assuming
the responsibility of keeping the money safe, available for immediate
withdrawal, and
2.
Administering
the transfer of the money if the depositor so chooses by either writing a
check or passing along a warehouse receipt that represents the gold on
deposit.
An honest banker should no more lend out demand deposit money
than Allied Van and Storage should lend out the furniture you’ve paid it to
store. The warehouse receipts for gold were called banknotes. When a
government issued them, they were called currency.
Gold bullion, gold coinage, banknotes, and currency together constituted the
society’s supply of transaction media.
But its amount was strictly limited by the amount of gold actually available
to people.
Sound principles of banking are identical to sound principles of
warehousing any kind of merchandise, whether it’s autos, potatoes, or books.
Or money. There’s nothing mysterious about sound banking. But banking all
over the world has been fundamentally unsound
since government-sponsored central banks came to dominate the financial
system.
Central banks are a linchpin of today’s world financial system.
By purchasing government debt, banks can allow the state—for a while—to
finance its activities without taxation. On the surface, this appears to be a
“free lunch.”
But it’s actually quite pernicious and is the engine of
currency debasement.
Central banks may seem like a permanent part of the cosmic
landscape, but in fact they are a recent invention. The US Federal Reserve,
for instance, didn’t exist before 1913.
Unsound Banking
Fraud can creep into any business. A banker, seeing other
people’s gold sitting idle in his vault, might think, “What is the point of
taking gold out of the ground from a mine, only to put it back into the
ground in a vault?” People are writing checks against it and using his
banknotes. But the gold itself seldom moves. A restless banker might conclude
that, even though it might be a fraud on depositors (depending on exactly
what the bank has promised them), he could easily create lots more banknotes
and lend them out, and keep 100% of the interest for himself.
Left solely to their own devices, some bankers would try that.
But most would be careful not to go too far, since the game would end
abruptly if any doubt emerged about the bank’s ability to hand over gold on
demand. The arrival of central banks eased that fear by introducing a lender
of last resort. Because the central bank is always standing by with credit,
bankers are free to make promises they know they might not be able to keep on
their own.
How Banking Works Today
In the past, when a bank created too much currency out of
nothing, people eventually would notice, and a “bank run” would materialize.
But when a central bank authorizes all banks to do the same thing, that’s
less likely—unless it becomes known that an individual bank has made some
really foolish loans.
Central banks were originally justified—especially the creation
of the Federal Reserve in the US—as a device for economic stability. The
occasional chastisement of imprudent bankers and their foolish customers was
an excuse to get government into the banking business. As has happened in so
many cases, an occasional and local problem was “solved” by making it
systemic and housing it in a national institution. It’s loosely analogous to
the way the government handles the problem of forest fires: extinguishing
them quickly provides an immediate and visible benefit. But the delayed and
forgotten consequence of doing so is that it allows decades of deadwood to
accumulate. Now when a fire starts, it can be a once-in-a-century
conflagration.
Banking all over the world now operates on a “fractional
reserve” system. In our earlier example, our sound banker kept a 100% reserve
against demand deposits: he held one ounce of gold in his vault for every
one-ounce banknote he issued. And he could only lend the proceeds of time
deposits, not demand deposits. A “fractional reserve” system can’t work in a
free market; it has to be legislated. And it can’t work where banknotes are
redeemable in a commodity, such as gold; the banknotes have to be “legal
tender” or strictly paper money that can be created by fiat.
The fractional reserve system is why banking is more profitable
than normal businesses. In any industry, rich average returns attract
competition, which reduces returns. A banker can lend out a dollar, which a businessman
might use to buy a widget. When that seller of the widget re-deposits the
dollar, a banker can lend it out at interest again. The good news for the
banker is that his earnings are compounded several times over. The bad news
is that, because of the pyramided leverage, a default can cascade. In each
country, the central bank periodically changes the percentage reserve
(theoretically, from 100% down to 0% of deposits) that banks must keep with
it, according to how the bureaucrats in charge perceive the state of the
economy.
In any event, in the US (and actually most everywhere in the
world), protection against runs on banks isn’t provided by sound practices,
but by laws. In 1934, to restore confidence in commercial banks, the US
government instituted the Federal Deposit Insurance Corporation (FDIC)
deposit insurance in the amount of $2,500 per depositor per bank, eventually
raising coverage to today’s $250,000. In Europe, €100,000 is the amount
guaranteed by the state.
FDIC insurance covers about $9.3 trillion of deposits, but the
institution has assets of only $25 billion. That’s less than one cent on the
dollar. I’ll be surprised if the FDIC doesn’t go bust and need to be
recapitalized by the government. That money—many billions—will likely be created
out of thin air by selling Treasury debt to the Fed.
The fractional reserve banking system, with all of its
unfortunate attributes, is critical to the world’s financial system as it is
currently structured. You can plan your life around the fact the world’s
governments and central banks will do everything they can to maintain
confidence in the financial system. To do so, they must prevent a deflation
at all costs. And to do that, they will continue printing up more dollars,
pounds, euros, yen, and what-have-you.
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lunes, 20 de abril de 2015
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