Tuesday, December 1, 2009

The Engine: Fractional-Reserve Banking (Part 2)

In the previous section we discussed how fractional-reserve banks perform the schizophrenic feat of treating cash demand-deposits as if they were loans from depositors and available for the bank's discretionary and profit-seeking use, while simultaneously acting as custodians, promising full liquidity, and providing bookkeeping and cashier functions to those same depositors. The depositors do not see themselves as having made loans to the banks---they continue to treat their demand deposits as cash equivalents with full liquidity, and view the banks primarily as secure warehousing facilities. The old cliche about fractional-reserve banking promised a simple and quite agreeable lifestyle by having bankers follow the "3-6-3" rule: borrow from depositors at 3%, loan to borrowers at 6%, out on the golf course by 3 PM.

We also saw how the accounting conventions allow the bank to create money ex nihilo, a process many of you will have heard referred to as the "bank multiplier effect." Particularly when chains of banks are used, each one generating the multiplier effect, this system provides greatly enhanced credit within the economy and allows banks flexibility as intermediaries linking depositors and borrowers who may have different risk appetites, time horizons, and so on.

We then looked at the downside from the position of an individual, isolated bank---should a large group of depositors attempt to draw on their demand-deposits in a concentrated way, at the same time, the fractional-reserve bank would be unable to meet its obligations and would be insolvent if it was unable to access emergency funding from other banks. If this were to happen in a relatively contained way, we might refer to it as a banking panic. If systemic risk was present and a large number of bank failures occurred, we would have a full banking crisis on our hands.

The economist Charles Calomiris of Columbia University has recently published a research paper exploring banking crises in a broad historical context. His conclusion is that, for a true banking crisis to occur, we normally must have a combination of monetary policy mistakes and price distortions or incentive problems occurring at the microeconomic level. I find his work quite compelling, and it has both helped me to organize my own thinking on the recent crisis and heavily informed the engine/fuel/steering/gas pedal analogy that is being employed in these blog posts.

Calomaris found that there were four serious banking crises in the period from 1874 to 1913, chosen to represent the first wave of true financial globalization and international trade---Argentina in 1890, Italy in 1893, Australia in 1893, and Norway in 1900. Of these, Argentina and Australia featured bank losses of around 10% of GDP (it is also interesting that the crisis in Argentina was associated with government mortgage guarantees, while the Australian crisis was directly connected with government subsidies for real estate development). Given a similar time from, from 1978 to the present, there have been 140 banking crises that meet the same threshold, with 20 of these crises exceeding the Argentina and Australia debacles of the late 1800s (and some exceeding 20% of GDP). What he found was that, in the modern period, systemic risk factors have increased, largely due to government actions that have decreased short-term banking panics at the cost of an increased probability of far more destructive, but also less frequent, true crises.

In the United States, there had been a series of banking panics---contained, rather than true banking crises by this definition---that culminated one way or another in the creation of the Federal Reserve in 1913. The Fed was useful in stabilizing the short-term seasonal liquidity issues that had affected various independent banks, particularly banks that had been heavily exposed to the cotton market. It should be noted, however, that during this time period banks in the United States were prohibited from operating in multiple locations: the US had a "single-unit banking" structure and this directly led to banking panics in some locations, as single unit banks could have completely undiversified portfolios, particularly in regards to agricultural industries. Canada, on the other hand, had a "branch banking" structure during this time---banks could operate multiple branches---and was not afflicted with these problems.

In other words, the Federal Reserve was created to solve a recurring problem within America's fractional-reserve banking system---to serve as the "lender of last resort" in the event of banking panics, when isolated, unit-banks with undiversified exposure to, say, the cotton market were not able to borrow from fellow banks and were suffering runs. It is not clear whether or not these banking panics could have been solved by simply loosening regulations on banks and allowing branch banking, because the Fed was put in place long before branch banking.

Given the inherent quasi-insolvency of banks in a fractional-reserve system and the speed at which institutions can collapse, an interlocking series of safeguards is used to try to prevent excessive pro-risk behavior. Implementing these safeguards or making sure that they are in place is the concern of three particular groups:

1. Depositors. Depositors who are aware that only a small percentage of their supposed demand-deposits are actually available during a crisis would under normal conditions be expected to shop around to find banks that are particularly safe. In other words, banks would need to compete along the dimension of safety in order to attract deposits.

2. Owners. Those with an equity position in the bank would normally want to prevent the bank from imploding because of imprudent risk-taking, as their capital would be destroyed by bad loans.

3. Regulatory authorities. The government would normally want to try to impose risk limits on banks and to discourage banks from making high-risk loans.

In the next section, I will describe how each of these three groups was compromised during the period leading up to the housing/debt crisis that so mauled the global economy last year. Depositors have ceased to apply market discipline on banks and owners have been seduced by moral hazard problems created by government policy. The government in turn has used regulation to push for social goals that in at least one sphere (affordable housing) have actively encouraged excessive risk-taking by banks.

FURTHER READING: I purchased the Calomiris paper from the NBER website and I think it should be well worth your time.

2 comments:

  1. Influence can be defined as the power exerted over the minds and behavior of others. A power that can affect, persuade and cause changes to someone or something. In order to influence people, you first need to discover what is already influencing them. What makes them tick? What do they care about? We need some leverage to work with when we’re trying to change how people think and behave.

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  2. Influence can be defined as the power exerted over the minds and behavior of others. A power that can affect, persuade and cause changes to someone or something. In order to influence people, you first need to discover what is already influencing them. What makes them tick? What do they care about? We need some leverage to work with when we’re trying to change how people think and behave.

    www.onlineuniversalwork.com

    ReplyDelete