The New Banking Rules

Due to factors beyond our control (i.e., we didn't get the work done), our regularly scheduled broadcast of the posting in the series on Say's Law of Markets will not be seen today. Instead, we bring you this special news report on the new banking rules, allegedly promulgated To Solve All Of Our Problems. As described in "Economy 101: Who Benefits from the New Banking Rules" (Associated Press, 09/13/10), the most significant rule change is to raise reserve ratios from 2% to 7%. This is supposed to make banks "safer," but what does it really mean?

Absolutely nothing. You see, fractional reserve banking started as a way of "insuring" the convertibility of notes issued by commercial banks into specie, that is, gold and silver — "real" money, to give people confidence in the paper currency. Reserves are not, repeat, not the backing for banknotes and demand deposits. Rather, commercial bank notes and demand deposits are backed 100% by the bills of exchange that the commercial bank discounts, "paying" for the bills by printing banknotes or creating demand deposits and extending credit to the borrower in the form of a loan. In classical bank of issue theory, this gives the currency a 100% asset backing.

Of course, the present value of the assets on which the bills of exchange were drawn might turn out to be worth much less than estimated, or even nothing at all. A sound bank will thus require additional backing for its notes and demand deposits in the form of collateral. Depending on the creditworthiness of the borrower, this can be a fraction of the face value of the loan (don't confuse this with fractional reserve banking — we're not there yet!), or a multiple. A borrower with good credit will put up only a fraction of the value of the loan as collateral, sometimes nothing at all other than an unsecured claim on his or her other assets, while a borrower with bad credit might have to scrounge up collateral with a value 200 or 300% of the face value of the loan.

When there is a central bank or central banking system involved, the notes and demand deposits are further backed up by the general creditworthiness of the central bank, and its task of supplying emergency funds on an as-needed basis to prevent "runs" on member banks.

Why, then, have reserves? Because not everyone who presents a check for payment or a banknote for redemption at a commercial bank is repaying a loan. (There have been banks that operated by accepting their obligations only in repayment of loans, but it is not common.) If that were the case, all the commercial bank would have to do is cancel a portion of the loan instead of paying out cash. Instead, some people receive checks or banknotes as payments from the borrower in the course of business, and want "real" money for them, and bring them to the bank that issued them for redemption. Other recipients of the bank's obligations ("holders in due course") will deposit them in their own banks, whereupon the other banks will bundle the obligations and, through a clearinghouse, offset the obligations against those drawn on the other banks, and either pay or receive the difference by a transfer of reserves, depending on whether there's a surplus or a deficit. The vast bulk of the obligations are returned to the bank that issued them and cancelled, not redeemed for reserves. It would be counterproductive for a commercial bank under a fractional reserve system to keep more gold and silver reserves on hand than is absolutely necessary to convert its obligations into legal tender on demand.

Of course, it is immediately apparent that fractional reserve banking assumes as a given that "reserves" means "gold and silver" or "bills of exchange" that can be sold ("discounted" or "rediscounted") by the bank for gold and silver. That is not, in fact, the case today. We have a fiat money system, and gold and silver no longer circulate as currency as a regular thing.

The advantage of a fiat money system is that you can actually have 100% legal tender cash reserves behind every single obligation of a commercial bank, as opposed to 100% cash in the form of bills of exchange (yes, in classic banking theory, bills of exchange are money and therefore, in a pinch, count as "cash"). It is only necessary to rediscount all bills of exchange immediately at the central bank, which then creates demand deposits or prints banknotes to purchase them. This gives the commercial bank immediate 100% legal tender cash reserves, defining "cash" as banknotes of the central bank, or a check drawn by the commercial bank on its demand deposits held at the central bank. In this way, the banknotes and demand deposits are 100% asset backed.

Unfortunately, most central banks of the world, including the Federal Reserve, do not typically rediscount financially sound bills of exchange for commercial banks. Instead, they purchase government debt paper on the "open market," creating demand deposits and printing banknotes to purchase the securities. Thus, instead of 100% asset-backed currency, most currencies throughout the world today are 100% debt-backed.

Raising the reserve requirements of commercial banks is therefore completely meaningless as a "safety" measure. They are not increasing cash reserves of an asset-backed currency, but of a debt-backed currency. Instead of banknotes or demand deposits at the central bank, either of which is backed by liens on financially sound hard assets, reserves consist solely of claims on debts financed by taxes that haven't been collected yet — and if the world economy continues to decline, will never be collected because no one is producing anything to tax.

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