Banks are failures (Background)

Banks are failures.

The United States of America has a fractional reserve banking system. This means that banks do not have to hold one dollar for every dollar they receive in deposits. Rather, banks, have to hold only a fraction of each dollar deposited. The fraction of each dollar deposited that banks have to hold is called a reserve requirement. Say under a fifty percent reserve requirement, a bank may invest (loan) fifty cents out of every dollar deposited. Most generally banks lend the available funds to someone who needs the money for some legitimate purpose. Even though the bank may have lent fifty cents of your deposit, you still own the fifty cents (indeed the whole dollar you deposited) that is on the bank’s books in your account. But the fifty cents is being used by the person who borrowed the money-that person owns the fifty cents too. So banks create money by accepting deposits and then lending out part of those deposits. The new money created in this way is called “bank money.”


Under fractional reserve banking, assuming a fifty percent reserve requirement, one dollar deposit becomes $1.50 when the bank makes the maximum allowable loan based upon the $1 deposit. Eventually, the original deposit of $1, as the fifty cents is deposited and fifty percent of it is loaned out and so forth, stimulates the creation of an additional $1. So, where there was $1, there is eventually $2 because banks create an additional $1 of bank money with all the cascading loans the bank makes based upon your original deposit of $1. By accepting deposits and then making loans based on the deposits, a bank creates money.


This process works as long as banks exercise due care and diligence in choosing borrowers who are almost certain to repay a loan. Banks exercise due care and diligence by requiring information and collateral from potential borrowers. Banks then evaluate the information and collateral to makes determinations about the borrower: whether or not to make the loan, and, if it makes the loan, what interest rate to charge and what collateral to require.


Rates of interest define the bank’s profit from making a loan. Despite the fact that the bank’s deposit and loan activity create money in the larger economy, the bank’s cut, so to speak, comes from the differential in interest and fees it receives from the borrower and the interest it pays the depositor for the privilege of using the depositor’s money minus any costs that bank operations incur.


Let’s illustrate with banks paying depositors 2% and charging borrowers 18% (note they pay 2% on 100% of the deposit but can only lend out 50% of the deposits under the fifty percent rule we are using here in our example. This means the cost in interest paid to generate a $0.50 loan from deposits is $0.04. The 18% interest received on the fifty cents lent yields 9 cents and a profit of 5 cents, for simplification we assume neither bank operating costs nor fees for originating the loan.) That means the bank’s gross proceeds are 5 cents for each half-dollar it lends (we will assume they are at maximum of what the reserve requirements allow to further simplify things).


To change its profits a bank can manipulate four variables: interest paid to depositors, interest (and other fees) charged to borrowers, the percentage of its allowable reserves it has on loan, and the manner in which it exercises the care and due diligence in choosing to whom it lends (or to put due diligence another way, how tight or loose the bank applies its rules for making loans).


Oddly, a bank’s most potent option for increasing its profits is its exercise of due diligence in screening loan applicants. In a nut shell, a bank can issue risky loans at a higher rate of interest. In boom times, bank lending practices increasingly move in the direction of riskier loans. Accordingly, in boom times, banks make high profits and create more money. However, as banks take on more risk with their higher profits, they expose themselves and the economy to losses.


Nominally, economists would say banks expose the economy to “potential” losses.   Historically, those “potential” losses have always materialized as bank or financial panics, stock market crashes, recessions and depressions.   Times of economic losses are quaintly referred to as contractions. The overall swing between high bank profits and the corresponding increase in the money supply and contractions with the relatively smaller increases in the money supply is quaintly referred to as the business cycle. Note that with the exception of a contraction that qualifies as a depression, the money supply increases, just at different rates


During a contraction bank profits are relatively low and bank money is created at a very slow rate. It is precisely when a contraction occurs that money needs to be in people’s pockets so they can spend to stimulate the economy. But, at the point when a contraction begins and for a long time after, banks tend to make relatively fewer loans creating much less money than is needed to move the economy back into a period of growth (another expansion or boom). Regardless, money is needed in consumer hands to stimulate demand-purchases. Loans are a poor way to put money into consumers’ hands. There is simply too long of a delay between a loan for business purposes and the money showing up as wages that get spent. In addition, business loans do not always result in additional employment-and hence do not always result in wages. Consumer loans are problematic for both consumers and banks during a contraction. Consumers are concerned about the stability of their incomes (employment); and banks are concerned about accepting collateral that is rapidly depreciating (loosing value). So, consumer loans, putting money directly in the hands of consumers where it is needed, is unlikely to play much of a role in a recovery.


Banks do not have to make loans with depositors’ funds. Instead, they can buy relatively secure assets such as treasury obligations or highly rated, AAA+, corporate or foreign government securities. Banks buying such assets does not create money-it shuffles existing money within the financial community. During a contraction the relative security of almost no risk, albeit low profits, is very attractive to the bankers who created the contraction.


It is important to remember that banks create bank money as a bi-product of their primary business activity, which is making a profit for their owners (stockholders).


Prima facie, banks are a very unreliable and undependable way to create money when an increase in the money supply is needed. In addition, bank behavior is directly tied to the reason new money needs to be generated; it was increasingly risky bank loans (and/or investment in a relatively new financial instrument) that ultimately caused the contraction (note to self, this is a significant point and may explain why he business cycle was largely unexplained when I took economics in college in the middle of the 20th Century). Using a fractional reserve system to create money causes a business cycle (expansions and contractions) and a very uneven growth in the money supply. The side effects are that asset values vary greatly depending on where the economy is in a business cycle as do individual incomes, governments’ tax revenues and expenditures and business activity (economic transactions).


Assets depreciate in value during a contraction. Stock values go down as investors have less confidence in the ability of corporations to make profits (or indeed, not engender losses) during all contractions. Indeed, stock market crashes are both symptomatic of and can make contractions worse. Real estate values decline as people with the cash to buy are scarce and reluctant buyers when they do have cash; and, as we have already seen, banks become reluctant to issue mortgages (makes loans). For in a contraction banks, often find they have too large of an inventory of foreclosed and overvalued real property. Markets for used personal property such as jewelry, antiques, art and rare collectables become saturated. Hence formerly valuable personal property becomes less convertible into cash. Add to these woes the fact that the assets people have in their occupations, careers and vocations are threatened by loss of clients and even layoffs.


Yes, assets’ valuations have historically rebound in periods of expansion. However, those rebounds are in the long term-a period measured in years. During the contraction, it is difficult to count or rely upon the future value of assets when one is in the throes of an immediate crisis-the short terms measured in days, weeks or months.


Individual incomes vary directly with economic growth/decline. As Ronald Reagan put it “A rising tide raises all boats.”  He could have added a falling tide leaves all boats mired in mud. More individuals are employed during periods of expansion and at increasing wages and benefits. Fewer people are employed during periods of contraction and at relatively lower wages and benefits. Individuals’ assets- homes, retirement savings and other “market portfolios”-also increase in value during an expansion and decline in value during a contraction. Asset valuation fluctuations across a business cycle are not due to “normal market” behaviors; rather asset valuation changes across a business cycle is caused by changes in what might be called the velocity of money or the rate at which new money is created and the rapidity with which money changes hands (facilitates economic transactions). The velocity of money is determined by banks behaviors–lending actives. As the velocity of money slows, assets lose value as there are fewer dollars changing hands to liquidate assets, e.g. turn assets such as stocks, real estate and personal property into cash. (Indeed as we shall see one reason the velocity of money slows in a contraction is because a lot of economic actors liquidate assets or go to cash holdings-hoarding or holding cash.)


(Economists might be more comfortable referring to the multiplier effect that bank lending applies to base money rather than velocity. Regardless, as the multiplier declines because banks do not leverage all their eligible deposits, real and personal property depreciates because there is less money in circulation and individuals begin to hold cash.)


Notice that during a contraction most consumer, average citizens, resources contract. Precisely at the point where the average person needs to convert resources into cash, their assets are devalued by bank behavior that reduces the velocity of money as well as the overall size of bank money in circulation. Not to mention that more consumers lose income as jobs disappear.


Government tax revenues also vary directly with where the economy is in the business cycle. Government tax revenues are based on one or more of five economic actives: income, economic transactions (sales taxes, excise taxes and inheritance taxes, to give three examples), value added (this tax is not yet used in the US), user fees (gasoline taxes and entry fees to parks are two examples) and economic value (property taxes, for example). Except for inheritance taxes which do not provide a very large share of any US governments’ tax revenue (and which one hopes are not a direct result of economic contractions), all other sources of governments’ revenue (taxes) decline in a contraction and increase in an expansion. At the same time the need for government expenditures increases during a contraction and declines during an expansion. Hence, for governments to add significant spending during a contraction they must either spend down reserves or borrow. They could increase taxes. However, they then would be substituting government expenditures for consumer expenditures. Thus increasing taxes to increase government expenditures gains almost nothing in additional money being spent than would have been spent by consumers had the consumers not paid more in taxes.   This, however, assumes a uniform income tax rate. Government could spend more than consumers if they raised taxes on citizens prone to save or invest a significant portion of their incomes. Government spending is probably not more of an economic stimulus than a similar level of consumer spending. Government revenues and expenditures are as impacted by bank behavior then as are folks like us-you and I.


Not surprisingly, businesses-small mom and pop stores to multinational corporations-are impacted by the business cycle created by banks failing to provide a relatively steady and reliable supply of money through responsible lending behavior.   While politicians and bankers assert that businesses are not investing and not hiring because of the uncertainty caused by government regulation and policies, it is the uncertainty caused by the dramatic shift in how banks exercise their due diligence in screening loan applicants from very loose loan requirements to very tight ones. Businesses faced with this kind of uncertainty are prone to maintain cash positions and neither add capital assets nor employees. Indeed, businesses are prone to cut back their number of employees and convert old equipment into cash (sell non-productive assets at or below book value (the value at which the asset is carried in their financial records or accounting records).


During a contraction cash holds value better than non-liquid assets. Hence, it is rational for a firm to move to a cash position rather than attempting to produce goods or services in order to preserve value in the firm. (This is true of banks as well, during a contraction bankers feel secure in proportion to the liquidity of their assets.) During an expansion, just the opposite is true-businesses increase goods and services production to generate cash flow. In an expansion, reinvesting in capital equipment and employees generates a cash flow turning each invested dollar into more than a dollar of income-hence the term growth. To make a business grow (a quaint application of a biological term) the firm borrows to increase production faster, meet payroll in anticipation of sales and the like. Thus the “frenzy” of borrowing generates new money at a faster and faster rate as an expansion lengthens (actually banks maintain as close to fully loaned out as their reserve requirements and their current level of due diligence allows. So new money is created as fast as loans are repaid and that “chunk” of repaid bank, new money disappears). Because of the ease of borrowing from banks, firms construe this as predictability. Strangely, during a period of expansion, firms treat government regulation and policies as minor costs of doing business.   During a contraction, businesses cite government regulations and policies as an excuse for maintaining cash reserves rather than hiring and making capital investments; they blame governments for the banks failures to lend.

It clearly is changes in bank behavior that amplify or fuel both expansions and contractions-the so called business cycle-and the resulting “problems” for individuals, governments and firms.

So, why does bank behavior change? During “normal times,” or periods of near to full employment, low inflation, and close to full production, banks find a plethora of potential borrowers. Employing due diligence in selecting to whom to lend, banks earn a “respectable “level of profit. However, as with all businesses, banks would rather earn more profits. So, someone in a bank’s management points out that the bank could earn more profits if the bank took on more risk by lending to borrowers who in a period of contraction or an earlier point in an expansion would not have passes the bank’s due diligence hurdles; but the bank will make those loans at a higher rate of interest. After all, in the then present state of the economy, whatever enterprise the bank is loaning to can hardly fail to be a success. Unfortunately, that strategy works for a time and feeds on itself. In that period of time banks “feel their oats” and lend to riskier and riskier clients.   Indeed, banks may find “new instruments” such as derivatives, junk bonds, sub-prime mortgages, or even bundle the new instruments, sell them and then do it all over again and again.

As “good times” continue, banks increasingly take more and more risks until some financial business, say a firm like Lehman Brothers, can’t cover a simple overnight loan. One large firm experiencing a problem quickly changes the way that everyone in the financial community views his/her cash flow, balance sheet and exposure to whatever brought, say, Lehman Brothers to its knees.

Abruptly, all financial institutions/businesses exercise a draconian version of due diligence. Loans and the creation of new money come to a virtual standstill. This “lending model” can remain in place for years. To get out of a contraction takes an infusion of cash-a very, very large cash infusion. However, having been burnt by their own greed during the latter part of the previous expansion, banks are just a bit reluctant to take even “normal” risks. Yet, the prospect for growth (getting out of the current contraction) rests in the hands of frightened, risk adverse bankers.

Historically, events external to the financial community and even external to the economy have “jump-started” stagnant (contracted) economies: war for instance, or a space race. In any event, the banking system has proven itself unable to return to even “normalcy” without some external jolt. Sadly, once an external event/action forces banks to lend again, the bankers all too quickly regain too much confidence and the cycle starts all over again leading to the next contraction.

The movement of an economy through repetitive cycles of expansion and contraction is as inevitable as death as long as a nation relies on a fractional reserve banking system to create money. Yes, governments have put in place mechanisms, The Federal Reserve Bank and various state banking oversight authorities, to prevent past causes of “financial institution crises” from reoccurring. This is not just locking the barn door after the horse got out. It forces bankers to find new and creative ways to make a profit. Or, to put it another way, it stimulates bankers into inventing new ways to get into trouble (and bring the economy to a standstill again).

In a way the financial sector is like a forest. In a forest if managers aggressively suppress wild fires, over time fuel builds up on the forest floor. Eventually, when a fire does start, and it is a certainty that eventually one will, it will be a disastrous conflagration. In the “financial industry” if regulators are too aggressive in suppressing risky lending behavior when some loan officer finds a way to increase profits that can get by the Feds and state bank auditors that new way to make a profit will become the preferred business practice throughout the industry: in short leading to a financial disaster of biblical proportions.

At this juncture we need to remind the reader of the nature of money. Money, today, is fiat money. Take out a bill-a one, five, ten, twenty, fifty or hundred. Look at the front up and to the left of the portrait. There you will find the words “This note is legal tender for all debts, public and private.” It is the law that the note you read these words from is money-fiat money. Most people think there is something backing their money such as gold. That, however, is not the case. What backs up the note you held in your hands are the words you read from it and the law that put those words there. There is also the acceptance of that note as money by almost everyone in and around a nation that adds to “backing” the legitimacy of that and all other notes as money. But, in reality nothing physical “backs” the dollar. The dollar stands on its own. And some of those the dollars are created by banks as we described in the opening paragraphs of this chapter.

Indeed, gold proved to be a very unsatisfactory backing for money. Quite simply, there is not enough gold to go around, much less allow for the expansion of the money supply required for growth, increasing populations or just to maintain an economic status quo. Google “How much gold exists in the world?” The answer will astonish you at how little gold actually exists. Now, translate that into on average how much every man, woman and child would have if it were spread equally? Would that be enough money to run any nation’s economy, much less the world economy?

No.   There is not enough gold, silver, platinum or other precious mineral, or all combined, to provide a viable monetary basis. But a fiat money can be expanded and contracted as needed. The trick is to find a mechanism for creating money. We have already shown that using a fractional reserve banking system is not particularly responsive to economic needs and indeed has built-in glitches that cause the “counter-cyclical” need for monetary expansion at precisely the point when banks are not creating money. However, banks have a history of creating money. Indeed, going back to goldsmiths issuing receipts that “so and so” has so many ounces in the goldsmith’s care, financial institutions have issued paper currencies, and then generally on a fractional reserve basis.



8 thoughts on “Banks are failures (Background)

  1. Yes, go back to Adam Smith and the pin maker makes pins to make a profit and his pins are useful to others while they make clothes to keep us from running around naked. So the pin makers, as side effects from their profit making endeavors, provide a basis for staving off hyperthermia and forcing modesty. Historically banks have made profits from holding gold and issuing paper receipts which gave the bank (initially goldsmiths) a way to profit from the gold they hold. As a side effect the certificates acted as money which make more economic transactions possible. Run with the analogy and ask at the end if side effects should justify some of the current problems with money–poverty and wealth accumulation and political policies making both worse.


  2. I find it incredibly fascinating that banks were originally owned by goldsmiths. I guess It makes sense in hindsight, and it also explains a lot of things.


    1. Actually my assertion is a bit of an oversimplification. In Europe and the Middle East the Knights Templar acted as a kind of proto banking system for the nobility (knights on crusades prinicpally). When the French King wanted their wealth they were destroyed. Then Italian families initiated the modern banks in Europe. Thanks for the comment.


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