Tuesday, June 2, 2009

The Fractional Reserve Banking Paradox


  1. I agree with your conclusion. So the central bank serves as little more than a place to move money around and make sure there is enough to cover those unexpected days that are going to happen in the system.

    Without that in place, banks would up their own reserve requirements to avoid becoming a statistic, and the system would work better.

    I don't think the government would allow this b/c it would mean an end to the current economic and fiscal model which depends on (impossible) perpetual "growth" year after year to survive.

  2. To discourage the depositors from withdrawing their money I think you really need to sell them a bond and not have demand deposits. If you sell bonds of 10 years and make loans of 10 years then you are not at risk of a bank run. You can also loan out 100% of the money you got from the bonds. The reason demand deposits with long term loans seems fraudulent is that, no matter what the fraction kept in reserve, the bank could not really give everyone their money on demand.

    Vince Cate

  3. Vince, I agree with your logic. However, from a practical standpoint the loan and deposit durations are "never" in perfect alignment, so some kind of cushion is necessary. Keep in mind, if a depositor demands his deposit even if he will willing to take a surrender charge hit, then the bank has the ability to sell some of its loans to satisfy the redemption request. Of course, if you have mostly toxic loans that are not very marketable, then you may have to liquidate (declare bankruptcy)...

  4. While in the past the deposit durations have never matched loan durations, why could they not be matched? I can imagine a bank that only made mortgages after selling some bonds. Do you see any practical reason this could not be made to work?

    Really price should be where demand and supply meet. If nobody is willing to loan money to the bank at 4% for 30 years then clearly the bank should not be loaning out to customers on those kind of terms. The "yield curve" should be determined by the market.

    If people knew they were trusting a bank for 10 years they would probably be more inclined to check it out a bit.