In the previous posting on this subject, we looked at how commercial banks really create money. It turns out that (contrary to popular belief) commercial banks don’t usually make loans out of their reserves, but by creating money backed by the value of the financial instruments they accept.
|Keynes: "My myth ath good ath a mile."|
We also discovered that the so-called Keynesian money multiplier is a myth. Depositing a check in a commercial bank does not increase the amount of cash in the system. Instead, since a check is a claim on existing reserves, all that happens is that reserves are moved from one bank to another. The amount of cash in the system stays the same.
That being said, what then is the use of having reserves?
As we explained in the previous posting, reserves must be on hand to ensure that if someone presents a check or other obligation drawn on the commercial bank for payment, the commercial bank will have enough cash on hand to satisfy the legal claim for cash.
Of course, since banks are presenting claims to other commercial banks at the same time other commercial banks are presenting claims to them, commercial banks don’t have to satisfy every claim in cash.
For example, if I owe you $20, and you owe me $25, do I need $20 to pay you, and you need $25 to pay me, for a total of $45? Of course not. All we need in total is $5 in your pocket to pay me the difference between what I owe you and you owe me. The $20 I owe you cancels out $20 of the $25 debt you owe me, leaving you owing me the net of $5.
Thus, of the total demand for cash of $45, we only actually need $5, so why carry around cash we don’t need? After all, we all have better uses for cash than to carry it around. We only need a “fraction” of the total cash involved in the transactions — we can have “fractional reserves.”
|Clearinghouse operations (simplified).|
Commercial banks operate the same way. Because not all obligations of a commercial bank will come due at the same time, and because many if not all obligations the commercial bank owes to others can be offset against what others owe the bank, banks only need to have a relatively small amount of cash on hand at any one time.
And that could cause problems. For example, there was a “dirty trick” banks used to play on other banks they wanted to drive out of business back before there was a regulated clearinghouse system. Rather than banks presenting obligations directly to other banks, a clearinghouse acts as a middleman between banks, making sure that all obligations are met and preventing the dirty trick we’re about to describe.
|Dirty tricks common in banking and Hollywood|
Bank A wants to drive Bank B out of business, and Bank A knows that Bank B only has $100,000 in reserves on hand. Bank A “holds back” the obligations of Bank B it receives until they total more than $100,000, and presents them all at one time to Bank B for payment. If Bank B cannot find more reserves quickly, it goes bankrupt, and gets taken over by Bank A as the new owner. Bank B had assets worth far more than the amount of obligations that Bank A suddenly presented for payment, but they were not in cash, and could not be turned into cash fast enough to satisfy Bank A . . . especially if Bank A had already gone around to any other banks in the area and told them not to buy any of Bank B’s assets for cash.
Clearinghouses were invented in part to stop this sort of thing. If more obligations came through the clearinghouse than a member bank could meet at one time, the clearinghouse could lend the bank additional reserves, or immediately arrange for the bank to borrow additional reserves, charging a fee for the service — and keeping the bank in business. Further, if it was obvious that one bank was playing the dirty trick on another bank, the clearinghouse could warn the offending bank or even deny access to the clearinghouse.
|Bankers get nervous|
There are other problems with fractional reserve banking that are not so easily solved. By making the amount of money a bank can create depend on something other than the creditworthiness and financial feasibility of the borrower and the actual loan, a monkey wrench is thrown into the decision-making process.
For example, suppose there is a 10% reserve requirement and a bank has $100,000 in reserves. Unfortunately, while the bank can legally create new money in the amount of $1 million, only $600,000 worth of sound loans are brought to the bank for financing.
Bank management gets nervous. “We’re losing money by not making another $400,000 in loans!” They have an incentive to make bad loans just because they can, in an effort to make more money.
But what if more good loans are offered to the bank than the bank is allowed to make? The same thing happens in reverse. Bank management gets nervous. “We’re losing money by not making perfectly good loans!” They have an incentive to agitate for lower reserve ratios . . . which is fine until good loans stop coming in, in which case they again have an incentive to make bad loans.
The problem is that fractional reserve banking is not supposed to encourage bad loans or discourage good loans. It is supposed to be a way to ensure that existing obligations of a bank have adequate “coverage.”
|An essential tool ... if used properly.|
Frankly, with modern communications and a clearinghouse system overseen by a central bank, there is no need of reserves for anything except to satisfy customers who want cash in hand. Today, any and all financial assets of a bank can be converted into additional reserves in an instant. That being the case, all outstanding obligations of a bank should be converted into reserves immediately by selling them to the central bank.
Because only “qualified paper” (i.e., sound loans) can be sold (“rediscounted”) to the central bank, thereby increasing the probability that only good loans will be made. If a bank’s loan officer knows that a loan must be rediscounted, and cannot be made unless it is believed to be a good loan, the incentive to make bad loans knowing they are bad disappears.
Further, if a bank must have 100% reserves, no matter what, there is no need to try and manipulate a change in reserve requirements which can cause future problems. Loans can be judged solely on whether they are good or bad in and of themselves. All good loans can be made, while bad loans won’t qualify for rediscounting and so won’t be made in the first place.
Of course, all we’ve been discussing up to now is what money is and what commercial banks and central banks do. There is a lot more to that, but before we go any further we need to know not only what money is, but what it, too, does — and that involves looking at something called “Say’s Law of Markets,” which will do in the next posting on this subject.