Ignore Bad Moves – Fractional Reserve is the Cornerstone of Banking Prosperity

One aspect of the social media campaign is Republican opportunism – trying to use the bank failure and sales pressure on banks in general to attack the Biden presidency. Others, though lacking a clear political motive, are equally misguided, with some tweeters picking up threads of anti-fiat-money crusades of cryptocurrency zealots prior to last year’s crypto meltdown.

Let’s make one thing clear. There’s not only something wrong with fractional reserve banking. It has been one of the main drivers of growth and prosperity around the world, allowing society’s savings to be converted into productive capital while minimizing costs and optimizing returns. This Limited Liability Joint Stock Company stands together as a force for good, enabling prosperity, risk taking, broad-based growth and a steady improvement in the standard of living.

A bank performs three functions. It pools the savings of the society into a large pool which can finance large projects. Individual savers have different time horizons – that is, how long they can make their savings available to others – while those who use savings to create value in the form of capital have different time horizons. There are periods for which they require capital. Banks match the time profiles of assets (loans made by the bank) and liabilities (deposits by savers), primarily by pooling deposits of various maturities and servicing depositors who retrieve their deposits from the pool.

The third valuable function that banks perform is to reduce the cost of capital, by creating funds to lend, and by reducing transaction costs of collecting capital and identifying worthy recipients of the capital at their disposal. In the absence of banks, the vast information gap that separates savers and investors would make capital not only scarce but also prohibitively expensive.

Of course, these are quite different from the services that banks provide as safe custodians of the capital companies receive. They also facilitate transactions through instruments such as cheques, electronic transfers and cards.

Imagine a situation in which banks are not available for arbitrage savings to investors. Traditional actors such as moneylenders or modern electronic platforms that enable peer-to-peer lending will function. Both types of loans are expensive and only relatively small loans can finance them.

What about the bond markets, you ask. Don’t they mediate in lending? When a company issues bonds, considerable effort is required to identify viable, safe projects for investors. They take help from rating agencies, merchant bank advisory, brokerage research and so on. But if the entity that issued the bond goes bust, savers lose their shortfall.

When a bank makes bad loans, the bank takes a loss, and only in the rarest of rare cases are depositors required to share in the loss. Banks are supported by deposit insurance, supervision and regulation by a banking regulator, and capital adequacy norms, additional capital buffer to absorb any losses, periodic stress tests, and measures to recover salvageable value. Bankruptcy proceedings for, are strengthened by the addition of their reserves.

Banks can operate as they are required to keep only a small portion of the deposits they receive as reserves. In India, the credit-to-deposit ratio for banks rarely goes up to 1, although it can be quite high as depositors are not normally required to retrieve their deposits at once. The exception is when a bank faces a run on its deposits – that is, most depositors decide to withdraw their money because they believe the bank is going broke and will soon be unable to repay them. .

Social media can amplify the power of such rumors and banks face the risk of unfounded runs. The net effect could be to make relatively small banks unviable. Governments bail out large banks when they are in serious trouble because allowing them to fail would jeopardize the stability of the entire financial system. Depositors know this and may prefer to shun smaller banks altogether in favor of larger ones. But this is more a theoretical possibility than a practical one.

Security has been right in shape since the many banking failures during the Great Depression in the 1930s, and yet smaller banks have emerged rapidly and survived. This is because banks run on trust, and not every bank needs the ultimate guarantee of state support to win trust.

Solid regulation and prompt intervention to douse the fire will go a long way in securing public confidence in banking. In the absence of trust, paper money itself has no value. If money can be trusted, then fractional reserve banking can be trusted.