Mish has a teardown of the latest outrage of Bank of America. It seems BoA’s counterparties are uncomfortable with BoA’s derivatives position and/or equity and would like either more collateral (yeah, right?) or else move the risk to the division which owns the retail banking and deposits from the public.
Moral Hazard: 1
Sanity: 0
But then Mish goes all non-sequitor. End all fractional reserve lending! This is like when there is a discussion of balancing the federal budget, and a “conservative” all of sudden interjects. “Let’s have a Constitutional Amendment to ban gay marriage!”
Whiskey. Tango. Foxtrot. Mish!
The problem here is clear:
1) Moral hazard,
2) National corporatism,
3) Insane derivatives growth …
4) … Which is itself a product of the Fed and its irredeemable paper currency,
5) Special franchises and subsidies for banks not available to anyone else
Fractional Reserve Banking has nothing to do with this.
It should rather read..
“End all fractional reserve lending! in its current form “.
There is a form of fractional reserve lending where individual depositors get to choose their time preference regarding their deposits. This builds in the resilience into the lending market such that the risk level of all market participants are embedded in the system.
What we have today is the epitome of moral hazard.
Agreed, austrian!
But then the point of this post is that the outrage du jour has nothing to do with FRB…
austrian, what you described is NOT fractional reserve banking. FRB is fractional (and morally hazardous) exactly because of the duration mismatch between the deposits (zero duration, i.e. “on demand”) and the loans. Nothing’s fractional when this mismatch is eliminated.
So what do you call it when a bank takes in $1,000,000 in 1-year time deposits, reserves 10% of them, and lends $900,000?
Their reserves are a fraction of the deposit. And, of course, this will expand credit too.
The whole $1m could be lent out for a year. There’s no credit expansion and there’s nothing fractional in this scenario as no conflicting claims to property exist.
The “depositors” have no access to their $1m for the duration of the year. Only the borrowers (the buyers of the $1m worth of 1yr bonds) do. No new $ claims have been created.
The above works the same if you replace $1m with 1000oz of gold. When maturities are matched, i.e. when there’s no conflicting property claims, the “bank” is nothing more than a simple asset manager (or financial adviser, or mutual fund manager) helping “depositors” (investors) allocate their capital among various bonds.
Sorry, correction above:
“(the buyers of the $1m worth…)” should say “(the SELLERS…)”
Let’s drill down. Initially, Joe deposits 1000 ounces of gold on one-year deposit. At that point, Joe has an asset of a 1000 ounce 1-year time deposit. The bank has an asset of 1000 ounces and a liability of 1000 ounces.
Next, the bank lends out 900 ounces for 1 year to Sue. The bank now has a balance sheet with the same 1000 ounce liability, but now its assets are split. It has 100 ounces of gold and 900 ounces of loan.
Next, Sue uses the money to pay Bob to build a house. Bob deposits 100 ounces on demand, and 800 ounces on 5-year time. NB: Bob is not limited by the duration of Joe’s time deposit nor Sue’s loan!
Now the bank has grown its balance sheet. Do you see it?
I wrote a piece on this: http://dailycapitalist.com/2011/03/22/fractional-reserve-banking-the-real-story/
Each individual chooses a fraction of his deposits to be lent out for a time duration. This fraction can be anywhere between 0 to 1. Not greater than 1, because an individual cannot choose to lend more than what he deposits.
It is fractional reserve lending, nevertheless who determines the fraction is the question to ask. If it is the individual, all is well.
With one quibble (the individual chooses what proportion of his money to lend to the bank on time deposit, and then the bank chooses what proportion of that to reserve vs. lend… both are 0 to 1), I agree 100%!
The key is that each individual chooses his own preference. And thus is likely to “get it right” (i.e. not have a need for the money prematurely), and if he gets it wrong, he assumes the risk of the bond market not having a good bid.
/* With one quibble (the individual chooses what proportion of his money to lend to the bank on time deposit, and then the bank chooses what proportion of that to reserve vs. lend… both are 0 to 1), I agree 100%! */
You bring up a fair point, but it will work only when individuals trust the bank to lend responsibly. Clearly, presently – that is not the case.
I agree. This is one reason why I don’t take seriously claims to “back” the dollar with gold again. Either backing means “we have some gold over here, we promise, and we promise not to print more than X times that in paper” which is meaningless… OR … it means the dollar is redeemable in gold. But if so, the first problem is the fight between creditors (who want the fixed gold price to be low, and debtors who want it high). But then, why wouldn’t everyone just redeem their dollars? Confidence in the game is collapsing.
While I can understand the outrage at the thought of derivatives obligations being passed to an FDIC insure subsidiary, what I can’t understand is the lack of outrage that the FDIC has to back the derivatives obligations in the first place.
Contrary to convention wisdom, the founding fathers did not enshrine the doctrine that derivatives obligations are pari passu with demand deposits. It is not written in the Beatitudes, “As you honor thy demand deposits, honor thy swap obligations”.
No this is another legacy of the St. Ronald of Reagan — along with negotiating with terrorists, deficits don’t matter, no bank in a large American city should fail in an election year, and derivatives are passi passu with demand deposits.
Color me outraged, Barry.
Partisan points-scoring aside, I am outraged by bailouts of people who make bad financial decisions–corporate, personal, etc. FDIC is bailouts for the too-small-to-fails.
Not sure if you have listened to any of the GOOPERs running for President. But their view is that the banks are innocent victims of the Democratic Party. That the banks were forced to make loans to those not of white skin and that is what caused the credit crisis. No Republican (or anyone who voted Republican) shares any blame for any role in this mess.
Their ignorance of economics is trumped by their inability to think.
Barry,
Why don’t you take those questions to George Bush or Karl Rove? There aren’t any GOP fans (GOOPERS, natch) here.
But I’d have to say that ignorance of economics is vastly worse in the Occupy Wall Street / Democratic Party side of the false alternative we have today. But being economically educated, you knew that! :)
I would dare say, Keith old boy, that I would wager that not one person at the OWS believes that ‘we made money from TARP’ which is the mantra of those on the right in this country. I would also wager that not one person at the OWS believes it was loans to people not of white skin that caused the credit crisis. Yet, that is the thesis routinely played on the pages of the GOOPER news media such as the WSJ.
For that matter, you could randomly pick from OWS and have that person replace Brian “Welfare Queen” Moniyhan and see an improvement in the stock price.
Barry:
If you’d like to have a polite conversation, don’t call me “old boy.” If not, then don’t expect a reply at all–and don’t interpret my lack of reply as a lack of answer.
Apologize Keith, no harm intended.
Thanks. Then my answer is that both sides make egregious errors based on lack of understanding of economics. I am not fan of either party, and I doubt anyone else here is either.
But I insist that the outright marxism of the Left is worse than the mere cronyism of the Right, if one had to choose degrees of evil.
And I would beg to differ. I don’t think the OWS is for nationalization of the banking system, loan jubilees, free loans to those oppressed.
On the other hand, the right wing Republicans have since Jan 1981, created a financial system that effectively socializes losses. The seizure of FNM/FRE amounted to a debt jubilee to the bond holders of FNM/FRE. They were short credit put options on $5 trillion notional. The Republican Party took those put options and made the obligation of the US Treasury. $5 TRILLION — and the American people think Barney Frank and loans to those not of white skin are the problem.
Barry, please stop clutching to the tired, old Democrat/Republican, left/right, welfare/warfare dichotomy. That’s the horse and pony circus the (the fiat money monopoly) elites have been presenting the gullible masses for two centuries now. They really don’t give a rat’s a*s about which group is in power, as long as it is blind to scarcity, has “pressing needs”, and borrows ever MORE of “their” money into existence.
The real dichotomy is the one between force/coercion/power and individual liberty. The OWS crowd feels that something has gone terribly wrong. If they knew ANY economics, or had any idea about how capital, wealth, and prosperity actually gets created, most of them would probably start chanting: “Ron Paul!”
My problem with Ron Paul is that he throws the baby out with the bathwater. We need an FDA to prevent thalidomide type disasters. We need a government willing to subsidize nascent industries like the telegraph in the 19th century and aviation/computers in the 20th century.
I see nothing wrong in a government role in feeding the hungry or providing health care to the indigent.
We would be a backward, agrarian society if not for the government taking a prominent role in technological advancement.
Barry,
The belief that government should provide welfare, and that without government picking winners and losers we would be backward … betrays a vast ignorance of economics.
Reality works diametrically opposite to what you just stated.
Barry, as both I and Keith said, it’s ALL about ignorance of economics — about the best (and oftentimes ONLY) possible means for achieving the ends shared by most humans, including you and the OWS crowd.
Austrian Economics has shown theoretically (deductively) and history has repeatedly confirmed empirically that free markets, i.e. respect for private property and voluntary exchange of same produces vastly better quantities and qualities of what’s needed (valued) than government, force, and coercion. The latter only CREATE the misery and destitution which it then uses to justify its inevitability and existence.
Ron Paul is keeping the baby. Everything he’s throwing out is dirty bath-water. And his latest program/proposal is just the beginning…
HF, I fully agree with you. I’ve seen it with my own eyes in third world countries where the solution to food shortages was not Peace Corps workers, Christian missionaries, or Ford Foundation experts. It was simply lifting colonial era price controls and lo and behold, non-productive farms turned productive and food suddenly appeared.
However, we still need government to play a major role.
This country overtook England and Germany in the 19th century because of government intervention in areas such as railroads and telegraphs. The land grant college program educated generations of people from the ‘working classes’ who otherwise could not have afforded an education.
Can anyone deny that the growth in computers was a direct consequence of federal subsidies in the 1940s through the 1970s? Mircoprocessors were a direct result of the space and missile programs.
A Ron Paul Presidency in 1945 would have stunted that growth.
Barry, you’re expounding on common fallacies which have been rebutted centuries ago.
First, the fact that government action has “created”/”given us” something by no means implies that the market (voluntary action) could not have provided more and better of the same. The USSR citizens must have thought that there would be no bread at all, if it weren’t for the government to provide it for them. Would you be equally thankful and reverential toward me if I broke your knees and handed you the crutch which you so badly needed?
Second, http://bastiat.org/en/twisatwins.html
Third, http://bastiat.org/en/government.html
There is a distinction between the government controlling all the aspects of production and a government providing subsidies to technologies that are not proven but whose potential impact could be enormous and that require massive investment.
The telegraph and computers come to mind readily. The telegraph had been around in Europe for awhile but only took off when the U. S. Congress funded a line. It was government orders for mainframes to a variety of companies that allowed private R&D efforts to take hold.
What private company had any interest in setting up the TVA? Christopher Columbus had to turn to the government because of private investors found his plans too risky.
Barry, if the “potential impact [of something] could be enormous” why wouldn’t capital gather together voluntarily to exploit it? Why is capital aggregation at the point of a gun (taxation) necessary for exploiting opportunities with potentially enormous impacts? Because markets are stupider and LESS forward-looking than governments, perchance?
HF,
I do understand your point. I can cite examples as well as anyone of government subsidies that created great harm to the economy.
Boeing with government subsidies built the B707. De Havilland with government subsidies built the Comet. One was an enormous success the other forever destroyed the engineering reputation of the nation that started the industrial revolution.
Markets simply don’t have the long time horizons that some projects require. In companies I’ve been involved, projects that didn’t have pay back periods of less than three years were shelved. We are talking about projects that require enormous up-front expenditures and perhaps 10 or 15 year time horizons for returns.
The National Road required government funding. The transcontinental railroad required government funding. The telegraph required government funding. Building airports required government funding. The space program provided an enormous boost to our high tech sector — if nothing other than the funding that produced engineers and physicists.
Barry, as I said, citing examples of what government has “provided” doesn’t help your case. It misses the “unseen”. From the first Bastiat link I recommended for your perusal (pls read them both, they’re very short, digestible, and hard-hitting):
“The advantages which officials advocate are those which are seen. The benefit which accrues to the providers is still that which is seen. This blinds all eyes.
But the disadvantages which the tax-payers have to get rid of are those which are not seen. And the injury which results from it to the providers, is still that which is not seen, although this ought to be self-evident.
When an official spends for his own profit an extra hundred sous, it implies that a tax-payer spends for his profit a hundred sous less. But the expense of the official is seen, because the act is performed, while that of the tax-payer is not seen, because, alas! he is prevented from performing it.
You compare the nation, perhaps, to a parched tract of land, and the tax to a fertilizing rain. Be it so. But you ought also to ask yourself where are the sources of this rain and whether it is not the tax itself which draws away the moisture from the ground and dries it up?
Again, you ought to ask yourself whether it is possible that the soil can receive as much of this precious water by rain as it loses by evaporation? ”
Your implication that voluntary investments (capital employment) must exclusively be short-term profit oriented and never long-term forward looking is, sorry to say, preposterous.
Finally, what of the government “projects” that you, yourself claim could have caused “harm to the economy”? Could you imagine the free market “giving us” projects like: Auschwitz, Treblinka, Hiroshima, Vietnam war, Iraq war, Afganistan war, bombers, carriers, drones, etc.? If I’m not OK with the projects BMW or Walmart is “giving me” I can opt out from funding (interacting with) them. Could you say the same about your government’s projects?
Barry: what you are doing is repeating the fallacies that have been long debunked by the Austrian School and its predecessors (such as Bastiat).
These ideas are wrong in theory, and evil in practice. The world is drowning in the consequences of these ideas. You are not going to hoodwink anyone here. More importantly to you, you will not learn if you’re trying to argue.
Why not, instead, read the links HF generously provided and stick around and read the articles that Jeff, DoctoRX, and I post and read the comments?
Who knows, you may even learn something. I am pretty sure you’ve learned that this is not a GOP site looking to score points against the Democrats! Why not stay and learn a little about how economics really works?
Keith: “…Bob is not limited by the duration of Joe’s time deposit nor Sue’s loan!
Now the bank has grown its balance sheet. Do you see it?”
Keith, could you please explain your point better? It seems as we (and Mish) are debating semantics, i.e. the meaning of “fractional reserve” and “duration mismatch”, but I don’t see any fundamental disagreements. I couldn’t see where you and Mish disagree.
All debates on “banking” inevitably get bogged down by semantics (“reserves”, “deposits”, etc.). I believe this obfuscation by nomenclature is done on purpose by the suporters of the fractional reserve status quo. The issue of property, and the legitimate, voluntary control and exchange of same is really very simple, whether that property is wheat or gold.
If I lend you 1 bushel of wheat for a year, and you immediately lend it out to Bob for TWO years, after which he lends it out to Joe for TWENTY years, no new wheat has been created. What have been created are conflicting claims to ownership of this single bushel of wheat. You own (and can legitimately control) the bushel for one year only. You cannot legitimately lend it out to Bob for the SECOND year, because that’s when I expect to own (control) it, not you, not Bob. “Full reserve” simply means non-conflicting claims to property. “Fractional reserve” and “duration mismatch” produce conflicting property claims which makes them inherently fraudulent.
HF, I agree with what you say in this comment. The issue is the right of property and contract including the right to enforce the terms of a contract. If I lend Joe an ounce due in Nov, I have a contractual right to demand that Joe honor that.
In your wheat example, I agree. Those loans are illegitimate, counterfeit.
Here is how I define “fractional” reserves: when a bank keeps some portion of its deposits on reserve, and lends the remainder out.
I think the big obfuscation is between the two very different concepts of “money” (i.e. gold) and “credit” (i.e. paper). Via fractional reserves and the action of the markets, banks can expand credit. This can be a legitimate expansion if the durations are matched, or an illegitimate expansion if not. But either way, the banks’ balance sheets expand and total credit outstanding expands.
That was my point in my previous post. Credit can expand. Some people oppose any expansion of credit as “inflationary” because they adhere to the linear Quantity Theory of Money. I am saying one must differentiate between legit and countferfeit.
I have very little real knowledge of “fractional reserve lending ” and would like a little help,so may I impose a
few questions ?
Would you say that any additional lending after the first loan that has a fractional reserve of 10%,should be considered illegitmate?
If so,would that mean the 9 times leverageing of $1 million would be illegitimate.The $1 million would create a note for $900,000 which would be an asset of $900,000.
Having $1,000,000 in the bank with a note for $900,000,can allow the holder of the note to make a new note for $810,000 and so on and on until there are notes as assets in banks for $9,000,000 with only a real monatery base of $1,000,000 behind it.ALL of which is already owned by someone other than the lender?
If these notes were at an average of 4% , would it mean that if the average note time was for 18 years THE LENDERS WOULD WITHDRAW from circulation $9,000,000 as a profit to their institution?To use for their own enrichment?
I personally believe “the rub” is in the INTEREST,money making money as its end product.As Einstein said,”The most powerful force in the universe is compound interest”
Can you consider a better use of this “most powerful force” for mankind?
@justaluckyfool — Even the first $900k loan is illegitimate/fraud as that property is equally claimed/controlled by both the (on demand) depositor and the borrower, at the same time.
There is nothing wrong with interest, per se. It’s not a magical force. What’s illegitimate and fraudulent is a government monopoly mandate given to entities to create money out of thin air which enables them to earn interest on lent capital/property which is not theirs.
Take a look at Rothbard’s “The Case Against The Fed” ( http://mises.org/books/fed.pdf ) to learn 90% of all you need to know about fractional reserve banking. It’s a short read, well worth your time.
lucky: It is not necessarily illegitimate. Let’s say I lend you an ounce due back to me Dec 15. You lend it to HF due back Dec 1. HF lends it to Barry due back Nov 15. That is perfectly legitimate. *Credit* (but not money!) has been multiplied. But there are not multiple claims to the same gold coin *at the same time*. Time is the key.
NB: What I propose for legitimate fractional reserve banking can multiply credit to any particular multiple over the gold base–in accord with the time preferences of the savers, whose decision it is. If people prefer demand deposits, or 1-week time deposits, then the interest rate on 30-year loans must rise to attract some supply.
NB2: This does *not* mean that any bank can create money (or even credit) out of thin air. To understand why, one must understand double-entry accounting and the balance sheet. The bank has increased its assets but also its liabilities.
I’ve written several pieces on FRB and duration mismatch. Do a search on this site for my name and “fractional”. My papers can provide a lot more detail and explain it better than I can in an ad hoc comment.
“I think the big obfuscation is between the two very different concepts of “money” (i.e. gold) and “credit” (i.e. paper). ”
Exactly, except, by my understanding (definition), what you describe as “duration-matched fractional reserves” is not “fractional” at all. There’s nothing “fractional” when I own 2 bushels of wheat and lend you only one (i.e. a fraction) of them for a year. ;^)
Your reserves are only a fraction of your deposits. And credit (but not money) is expansed. The terminology doesn’t matter that much so long as the key concepts are communicated.
I agree. Still trying to understand why you would use such terminology, though. I don’t see anything “fractional” with non-conflicting property claims and when all contract durations are matching, i.e. when the CASH reserves match ON DEMAND deposits and X-year loans match X-year “deposits”.
Check out the video on fractional reserve. http://www.youtube.com/watch?v=fflvocQ2PTw&feature=related
I simply am amazed at the Fed.