Wednesday, May 22, 2013

Binary Banking Theory, V: Fractional Reserve Banking


As we have seen, commercial banks of issue can create money by accepting bills of exchange and issuing promissory notes.  If money is created properly, that is, only by issuing promissory notes to discount bills of exchange with real value, the money supply for an economy will be elastic (that is, expand and contract as needed), stable, uniform, and asset-backed.

The amount of loans a commercial bank of issue can make is, in theory, limited only by the present value of financially feasible capital projects in the area served by the bank, and on which bills are drawn and offered to the bank.  In practice, fractional reserve banking limits the amount of promissory notes a bank can issue.

Fractional reserve banking does this by requiring that the bank have on hand or on deposit at the central bank reserves of legal tender currency, that is, an accumulation of past savings.  Reserves should be sufficient to meet the bank’s transactions demand for cash, that is, to redeem financial instruments on which the bank is obliged, and which are not used to settle a debt that the holder of the instrument owes the bank.

To explain, if the holder of a financial instrument who does not owe the bank anything presents for payment an instrument drawn on or issued by the bank, the bank is obliged to give the holder cash.  The holder may also deposit the instrument in a demand or time deposit.  This does not cancel the instrument, because the bank must then use the instrument to purchase additional reserves to replace what was paid out, or to back the demand or time deposit.  The money the bank originally created by issuing the instrument remains in circulation.

(This is extremely simplified, of course.  It ignores all the complications of clearinghouse operations, interbank lending of reserves, compensating balances, and all the exceptions a practicing banker would instantly raise in a discussion that went beyond pure theory.)

A holder of a financial instrument who owes the bank something — a debtor — can also cash the instrument or deposit it in a demand or time deposit.  The debtor can also use the instrument to pay the amount the debtor owes to the bank.  This last cancels the instrument and reduces the bank’s outstanding liabilities (promissory notes and other instruments) and assets (debts owed to the bank, i.e., bills of exchange and mortgages) plus the amount of discount or interest that is recognized as revenue by the same amount.

If a commercial bank of issue is bound by a fractional reserve requirement, the amount of promissory notes it can issue is limited by the reserve requirement, not by the present value of the loans it could potentially make, however good the loans might otherwise be.  Since a commercial bank is established to finance “commerce” (hence the name), a term that in the United States covers industry and commerce, and by extension agriculture and all other productive activity, fractional reserve banking places an artificial constraint on money creation to finance productive activity — economic growth.

Binary economics would free economic growth from this slavery of past savings by abolishing any fractional reserve requirement and providing that all bills of exchange accepted for pure credit loans made for financially feasible qualified capital projects be immediately rediscounted at the central bank.  This would effectively result in 100% reserves of cash or cash equivalents in the form of commercial bank demand deposits at the central bank.  The other use of past savings, as collateral for pure credit loans, would be obviated by the use of capital credit insurance and reinsurance.

Pure credit financing of new capital and the replacement of traditional collateral with capital credit insurance and reinsurance would radically reduce dependency on existing accumulations of savings owned by the top 1%.  This would allow rapid economic growth in which the poorest of the poor as well as everyone else to take advantage of equal ownership opportunities in the future.  These opportunities, construed as a “new right of citizenship,” would be secured by means of the monetary and tax reforms offered by CESJ’s proposal for a “Capital Homestead Act.”

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