Banks and the Stock Market, VII: The Flaws of Fractional Reserve Banking

As we hinted yesterday, the real problem with fractional reserve banking is not that it permits commercial or mercantile banks to create money.  That is what such banks — a combination of banks of issue and banks of discount — were invented to do.  No, the problem is more subtle than that.

Medieval Banking: Making Loans

Let’s take a scenario.  Assume that a bank opens for business with $1 million in capitalization and deposits.  The legally mandated fractional reserve requirement is 20%.  What does the bank do?

Assuming that the bank’s loan officers are being prudent within the established framework, they will make $5 million worth of loans as fast as they can.  Anything less means that the bank has idle cash in the form of excess reserves, which it may or may not be able to lend to other banks that are short of reserves.

Institution of Glass-Steagall in 1933.

By the way, we’re also assuming that Glass-Steagall or something similar is in operation, and the bank can’t go and put its excess reserves into the stock market where the speculative returns tend to be greater than are generally realized through the business of making commercial loans.  No, the only thing this bank can do is make loans, take deposits, discount bills, and issue promissory notes.

You see the problem, of course.  A loan officer who doesn’t make loans up to the maximum is costing the bank money, and that will probably cost him or her that job.  It is irrelevant whether there is less than $5 million in feasible loans, or much more.  The target is $5 million in loans.

Of course, a loan officer will do due diligence of a sort to verify that it is a “good” loan.  In the back of his or her mind, however, will always be the urge to fudge a little, especially if upper management or some government agency is putting on the pressure to make certain types of loans that the bank ordinarily wouldn’t touch.  Many experts blame the home mortgage meltdown on this tendency to fudge a little, and start down the slippery slope of making loans based on something other than financial feasibility.

There is also the danger that reserves will be used for purposes other than intended if a bank is permitted to own shares other than its own stock.  That is what happened with the repeal of Glass-Steagall and the merging of commercial and investment banking functions.  Instead of making commercial loans, banks will be tempted to go into the stock market, driving up prices and giving the illusion of economic growth when, in fact, the economy is actually stagnant or even contracting.

"Money Famine" during the Great Depression of 1893-1898.

It can go the other way, too.  Feasible projects will go begging for financing if the bank has already maxed out on the amount of loans it can make constrained by the fractional reserve requirement.  Economic growth will be unnecessarily restricted, and a contraction of reserves can even trigger a financial panic and a depression.

This happened in 1893, when foreign investors demanded massive liquidation of American investments and required payment in gold — the National Bank Notes, the reserve currency of the National Bank System, were of no use to foreign investors.  Gold reserves plummeted, and banks began calling loans due to the bank not having sufficient reserves to cover the loans.  Companies that had been “blue chip” only weeks before found themselves insolvent, and the Panic of 1893 was in full swing, followed by the Great Depression of 1893-1898.

"Keep Off the Grass"

The Panic of 1893 and the following Great Depression, by the way, provided the impetus for the development of conspiracy theory; this gave birth to the legend of “the Crime of ’73.”  Not understanding the role of reserves or how banks operate, many people believed that “international bankers” were behind the lack of money and the widespread unemployment, and it was necessary for government to assume control over the whole of the money supply and start creating jobs.

The demands of “Coxey’s Army” in 1894 were, to all intents and purposes, a precursor of the New Deal — as many recognized when on May 1, 1944 Jacob Coxey gave the speech from the Capitol steps he had been prevented from giving in 1894 — being arrested for walking on the lawn, making "Keep Off the Grass" a populist political slogan.  The various "armies" that converged in protest marches on the nation's capital also gave us incomprehensible-to-modern ears aphorisms, e.g., "Enough food to feed Coxey's Army," "Hungry as Coxey's Army," "Ragged as Coxey's Army," "Dirty as Coxey's Army," and so on.

So, the big problem with fractional reserve banking is that it alternately encourages bad loans and prevents good loans.  This is not an insurmountable problem, however, as we will see next week.

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