Keith Weiner at the Daily Capitalist purports to explain the Fractional Reserve Banking: The Real Story
Weiner makes a case that the problem with fractional reserve lending is one of “duration mismatch”. If you don’t understand the term “duration mismatch”, please don’t stop reading. I provide an easy to understand example below.
While “duration mismatch” is a huge problem, it is by no means the only problem. Thus Weiner misses the overall picture.
Fractional Reserve Banking Defined
Before we can state the problems and concerns with fractional reserve lending we need to define the term. Here is the meaning I use for my analysis:
Fractional reserve lending is the act of lending out more money than banks have ownership of. “Ownership” can be temporary.
Clearly, I cannot lend you $1,000 if I only have $1.98.
However, and this may surprise many people, banks can. Moreover, the fact that banks can lend more money than exists is at the very root of the financial crisis we are in today.
It is illegitimate to lend out more money than you have “ownership of”.
The key question is what constitutes a “legitimate right-to-lend”? The answer involves banks’ “right-to-use” deposited money.
CDs provide an easy to understand example of right-to-use. Consider a 5-year CD. A person buying a 5-year CD gives up the right to use his money for 5-years in return for an agreed upon interest rate. The bank then lends the money out for a higher amount of interest.
Keith Weiner complains (and rightfully so), about banks securing funds for 5 years, then lending them out for 30-year mortgages. That “duration mismatch” is certainly a problem, but it is not the only problem as discussed below.
First let’s consider a 100% gold-backed dollar.
A 100% Gold-Back Dollar Would Not Stop Lending
Note that a 100% gold backed dollar would not stop lending. One can easily relinquish ownership of gold for as long as one wants (say 5 or 10 years), and at the end of that period the bank would have to return the gold to its owner, plus interest.
Thus a 100% gold-backed dollar would not stop lending as many misguided souls think.
Also note that the commonly attributed meaning of fractional reserve lending is complete silliness in that it fails to address the crucial issue of “ownership”
I suspect this is what led Keith Weiner astray in this admittedly very complicated issue, even though I agree on his central thesis that “duration mismatch” is a huge problem.
Duration Mismatch Schemes Guaranteed to Blow Up
Weiner states ….
Borrowing short to lend long, aka duration mismatch, inevitably implodes. This is not a matter of odds or probability. Like a geological fault line, one can try to assess probability of a destructive event in any given year, but sooner or later catastrophe is certain. When a business knowingly engages in an activity that is guaranteed to cause it to dishonor its obligations, that is acting in bad faith. Such a business has no intention of honoring its obligations over the long term, only in the short term when it is expedient.
Finally, fractional reserve banking is one of those issues where there is a deep misunderstanding in Austrian circles. This is compounded by the dearth of information about duration mismatch (I am only aware of Professor Antal Fekete writing about it, and of course some of his students such as myself) and the proliferation of misinformation about it.
Duration Mismatch Articles
For starters, I have written about Duration Mismatch 17 times since 2007 as the link in this sentence shows. Two of the articles are from 2011.
Here are some of the key posts.
Borrow-short lend-long strategies have caused more pain and grief than nearly any play in the book. They are virtually guaranteed to blow up given enough time if the duration mismatch and leverage is too great.
For those who do not know what I am describing, a couple of examples below will help explain. The first example is a look at “cost of funds” and guaranteed profits that banks can make. It is not a borrow-short lend-long strategy but will morph into such a scheme as I vary the parameters. ….
February 02, 2007: Central Bankers Cry Wolf
Key GSE Points
- Size and leverage of Fannie Mae and Freddie Mac is enormous.
- The Fed does not want to be responsible for a blowup at either company.
- Both pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch.
- Both hold long-term mortgages and mortgage-backed securities financed by short-term liabilities forcing them to synthetically create a duration match via massive amounts of derivatives.
- The stocks act as if there is implicit government guarantees. There are no such guarantees.
- The lack of market discipline is striking.
- The Fed can provide liquidity not capital.
- A crisis is not unthinkable. Those that think so need a course in economic history.
November 03, 2009: What is Money and How Does One Measure It?
Given there are no reserves on savings accounts, as much as $4.5 trillion people think is in their savings accounts is not there either. Moreover, the duration mismatch on savings accounts, sweeps, and likely even CDs is massive.
If even 20% of the people tried to get their money out the system would freeze up.
The banking system is clearly insolvent. Such is the folly of fractional reserve lending.
September 10, 2007: Duration Mismatch Causing Severe Stress Everywhere
Duration Mismatch and Leverage
Leverage is a wonderful thing when spreads are moving in your direction. It’s now payback time for those who borrowed short and lent long. Short term borrowing costs are rising while the value of long term assets, especially mortgage debt is sinking.
See Duration Mismatch to Bankruptcy (in one week flat) for the saga that caused Sentinel to go bankrupt in short order once their mismatch mattered.
The issue is not whether it’s absurd for Lehman or Bear Stearns debt to be trading at a discount to Columbia, the issue is how much leverage Lehman (LEH), Bear Stearns (BSC), Merrill Lynch (MER), Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS) are using as well as the timing and size of needed debt rollovers.
It was a huge mistake for corporations to assume they could perpetually roll over short term debt at good prices. If you stop and think about it, many homeowners over leveraged in homes have a similar mismatch problem. Incomes have not risen as expected but short term financing costs have gone through the roof with no way to roll over the debt.
Duration Mismatch Not the Only Problem
Fractional reserve lending go far beyond duration mismatch. Here are few key points.
- Fraudulent lending (banks lending more than they have ownership of) pushes up assets prices and favors those with first access to cash (banks and the wealthy). The housing bubble was a result of such fraud.
- The existing fractional reserve system allows lending of money that is supposed to be available on demand. Lending of money banks have no ownership of is outright fraudulent.
- Excessive credit backed only by artificially inflated asset prices is simply another form of fraud. Moreover, such lending also sends false signals to the market about the true state of the economy.
- In the ensuing and inevitable busts, the central bank inevitably punishes savers by artificially holding rates too low.
Central Bank Authorized Fraud
Point number two above involves sweeping of checking deposit accounts into saving deposit accounts by banks, unbeknown to customers, then lending the money out.
Greenspan authorized sweeps in 1994 as a way of allowing banks to put “idle cash” to use. There are no reserve requirements on savings accounts.
Thus, money that is supposed to be available on demand isn’t. People think that money in their checking accounts is sitting in banks. It most assuredly isn’t. It has been “swept” away nightly into savings accounts that banks can lend out. Bookkeeping says the money is there. Physically it isn’t.
Lending of money in “available on demand” checking accounts is purposeful fraud. Greenspan authorized the practice, but that that simply makes it central-bank authorized fraud.
Savings Accounts Fraudulent as Well
With savings accounts, customers do relinquish control of deposits, at least in theory. For example, customers deposit money in a savings account and receive an agreed upon interest rates. Everyone understands their banks will lend that money out.
Nonetheless, should someone walk into the bank the next day and request to pull money out of “their savings”, it will be given to them. Unfortunately, control of “their savings” was relinquished to the bank who then lent the money out.
It is illogical (and fraudulent) for money that is already lent out to be available on demand. Thus savings accounts are nothing but another form of “have your cake and eat it too” fraud.
Whether the loans are backed by assets or not is irrelevant.
Problems Measuring “True Money Supply”
It is this very savings account debate that has caused two Austrian economic camps to split into two camps as to how to measure “True Money Supply“.
The TMS2 camp says that money in savings accounts is available on demand and thus needs to be factored into money supply figures. Meanwhile the TMS1 camp that I am in says that the right-to-use the money was transferred (whether it is fraudulently available on demand or not) and thus should not be counted in money supply figures.
For further discussion, please see Money Supply Divergence – TMS1 vs. TMS2 vs. M2 – What does it Mean?
The above link also contains a discussion of sweeps and how they distort money in checking accounts.
Regardless of the “correct” measure of money supply, both the TMS1 and TMS2 camps generally believe the practice of lending of savings accounts while simultaneously making the money available on demand is fraudulent.
Reflections on “Legitimate” Right-To-Use
Some argue that as long as customers agree to these various banking schemes it is OK. That line of thinking says as long as it’s in the agreement for banks to sweep money from checking accounts to savings accounts and lend it out, then it’s OK for banks to do so.
However, it’s not OK because such lending is nothing more than a gigantic kiting scheme. Moreover, it affects others by cheapening the value of money, pushing up asset prices for the benefit of those with first access to money, the banks and the wealthy.
Logically, two people cannot have the right to use the same money at the same time, whether they agree to such a scheme or not!
Money Multiplier Theory
Compounding the issue, money that is lent out then redeposited in another bank, can be lent again and again and again. In theory, the same money can be lent an infinite number of times (10 times if you prefer, with each bank keeping 10% in reserves). This is the “money multiplier” theory of fractional reserve banking.
However, such analysis is further complicated by the fact that in a fiat-credit based banking system, lending comes first and reserves come second.
Thus, money multiplier theory as commonly understood is simply wrong.
For a discussion of the “money multiplier” issue please see Fictional Reserve Lending And The Myth Of Excess Reserves
Clearly, money is a complicated subject involving numerous competing definitions of money. Fractional reserve banking and invalid money multiplier theories greatly compound understanding.
Unfortunately, Weiner adds to the confusion with analysis that suggests that duration mismatch is the only issue in regards to fractional reserve lending.
Fractional Reserve Lending is Fraudulent and Must Stop Entirely
Lending what you do not have “ownership of” is the issue. Duration mismatch is a form of that problem, but it is not the only form of that problem. Numerous complications arise when multiple people have immediate access to the same money at the same time.
Housing and credit lending bubbles constitute unmistakable proof that fractional reserve lending in any form is fraudulent and must stop entirely.
The solution is to abolish the Fed, institute a 100% gold-backed dollar, and disallow banks to ability to lend money they have no legitimate right-to-lend.
At the Suggestion of James Turk I made a quick change to my definition above
From Fractional reserve lending is the act of lending out more money than banks have a legitimate right-to-lend
To Fractional reserve lending is the act of lending out more money than banks have ownership of.
That was the way I originally wrote it, but changed it at the last moment. “Ownership” of course can be temporary. I made a few other changes of “right-to-lend” to “ownership” as well to make it more clear.
Mike “Mish” Shedlock
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