Wednesday, November 19, 2008

A Short Course on Banking Theory

A "bank" is defined as a financial institution that takes deposits, makes loans, and issues promissory notes. There are two basic types of banks, the "Bank of Deposit" (deposit bank), and the "Bank of Issue" (issue bank, or circulation bank).

A deposit bank aggregates the savings of depositors and loans them out. The amount of loans that can be made is strictly limited by the amounts that have been deposited. The most common forms of deposit bank are credit unions, savings and loans, and investment banks. A deposit bank is what most people think of when they hear the word "bank." This results in a serious misunderstanding of the greater part of banking theory, which is what underpins the bank of issue, more archaically referred to as a "bank of circulation" due to its function in providing a community with circulating media (i.e., currency).

An issue bank makes loans on financially feasible projects, taking in return a lien on the assets being created and creating demand deposits or currency out of the lien, which backs the deposit or currency ("promissory notes"). As the projects financed by the loans become profitable, the loans are repaid, and the currency or demand deposits are canceled. Thus, assuming that all projects are feasible, the money supply exactly matches the production of goods and services being financed in this manner. (Since we know that all projects are not equally feasible, and some actually fail, capital credit insurance can operate as collateral to replace the money spent without being productive, and the insurance proceeds are canceled in place of the loan that wasn't repaid — thus, the existing pool of savings (the insurance pool) is reduced by the same (or nearly the same) amount that the money supply was increased by the bad loan, countering the inflationary effect of a bad loan with the deflationary effect of canceling money out of existing savings.) The most common form of issue bank today is the commercial bank.

"Fractional reserve banking" is an attempt to combine the existing liquidity (money) that a bank of deposit has with the ability of a bank of issue to create liquidity. A bank using fractional reserve banking can, in theory, loan out 100% of the cash on deposit. Practically speaking, however, if a bank did that, there would be nothing on hand to cover the daily demand for cash payouts. If a bank discovers that, for example, only 20% of its total deposits are likely to be demanded in the form of cash at any time, it can loan out 80%, retaining a "fraction" of its assets in the form of cash reserves (hence "fractional reserve banking"). If the bank has the power to create money, it can (again in theory, practice is somewhat different due to banking laws), it can use its existing cash reserves, and create money in the form of demand deposits by making loans, preferably for assets that will generate cash in the future to repay the loans and allow the bank to cancel the money it previously created. As long as the amount of new money does not cause the percentage of cash reserves to fall below the level required to satisfy the daily demand for cash, everything (in theory) should be fine.

A central bank is a hybrid creature. It is intended to be a bank of issue for commercial banks, but a bank of deposit for a government. Under the distortions that galloped into our financial system as a result of the hegemony of Lord Keynes, however, this has been reversed. The Federal Reserve functions largely as a bank of deposit for commercial banks, but a bank of issue for the State — a recipe for disaster. What we propose is to reform this and return the Federal Reserve to its original purpose by restoring its original character. By instituting a 100% reserve requirement for commercial banks to be solely in the form of cash (demand deposits) or qualified government securities, the Federal Reserve will no longer have any reason to deal in "secondary" government securities to affect reserve requirements — that only applies in fractional reserve banking, not 100% reserve banking. By adding the expanded ownership features of Capital Homesteading, a major (and relatively "painless") reform of the financial system can be carried out, a reform that does not rely on taxing the poor to support the rich, or vice versa.

Donations to CESJ support our Capital Homesteading projects and Just Third Way initiatives, and are tax deductible in the United States under IRC § 501(c)(3).





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