Rick: How can you close me up? On what grounds?
Captain Renault: I'm shocked, shocked to find that gambling is going on in here!
– From the classic scene in CasablancaThere is a deep rooted and pernicious view that the crisis can be laid primarily at the door of a group of corrupt crooked bankers. It is easy to sympathize with the hostility to the many banks that behaved so recklessly in ways that damaged everyone else as they took on excessive risk in their quests for greater profits. It is described as a “market failure”? The term “market failure” suggests that markets normally function properly and that “market failure” is an exceptional occurrence. It focuses our attention on the exception rather than the norm. It leads us to seeking the the solution in a robust state that regulates markets. But we are not talking of an occasional lapse in how markets function; rather, we are talking of the regular state of markets, of how imperfect markets are when they function the way they are supposed to function. Such alleged solutions simply hide the fundamental character of capitalism. Bankers do not want transparency, because it will seriously cut into their profits.
The nature of banking is understood broadly as financial intermediation: if A has money he’d like to save and B needs money, then rather than A lending directly to B A might lend to C to lend to B, because C—a bank—is a specialist in assessing creditworthiness. To finance its operations C will need to borrow from A at a lower interest rate than the rate it charges B for a loan. It can minimize the interest rate it pays A by borrowing short term (the shortest-term borrowing being a demand deposit). This both reduces the risk of default to A and offers A continued liquidity; should it need the money it’s lent to the bank, it can get it back on demand. And the bank can maximize the interest rate it charges B by making the loan long term, thus transferring liquidity to B and assuming a higher risk of default. C can increase its expected return across the board by lending to borrowers whom the market rates as risky (this pushes up the market interest rate to such borrowers) but whom C thinks less risky than the rest of the market thinks them.
The bank’s business model is thus a risky one. Its capital is short term and thus can disappear with little or no notice (a bank run), while its assets (its loans) are long term and may be illiquid and thus hard to sell should the bank need to replace some of its capital. Government deposit insurance can reduce the risk of runs and by thus making depositors’ capital more secure reduce the interest rate the bank has to pay them. Bank regulatory agencies can further reduce the risk of banks’ defaulting by requiring banks to hold cash or cash-equivalent reserves, such as Treasury bonds.
But risk and return are positively correlated; by reducing risk, government intervention in the banking industry reduces expected return. This is true even at the depositor level: the interest rate that a depositor receives is reduced because the risk of his losing his money is reduced. And at the bank level, deposit insurance is a cost to the bank. The bank may therefore decide to augment its capital base by uninsured borrowing. It may also decide to offset the cost of its reserves (cash on which it receives no return), and amplify the spread between its cost of borrowed capital and its return on investment, by making riskier investments with its borrowed funds than mortgage loans, municipal and corporate bonds, Treasury notes, and other conventional bank investments: it may decide to speculate.
The trade-off between increased risk and increased expected return is attractive for two reasons. First, a risk is less likely to materialize in the short term than in the long term: a 1 percent annual risk of default becomes formidable only when projected over a 10-year or 20-year or longer period. A banker who has a high probability of making very large profits for the next 10 years may feel well compensated for taking a small risk of bankruptcy during that period.
Second, not only a bank’s financial capital but also its human capital is short term; very little financial human capital seems to be firm-specific, judging by the rate at which bankers move from firm to firm. Any firm that has short-term capital is under great pressure to compete ferociously, as it is in constant danger of losing its capital to fiercer, less scrupulous competitors, who can offer its investors and its key employees higher returns.
The complexity of modern finance, the greed and gullibility of individual financial consumers, and the difficulty that so many ordinary people have in understanding credit facilitate financial fraud, and financial sharp practices that fall short of fraud, enabling financial fraudsters to skirt criminal sanctions. These circumstances make an unregulated banking industry a Darwinian jungle, with bankers as predators and their customers (and each other) as prey. It may also explain why bankers are prone to cut corners—to take excessive risk from a social as distinct from their private standpoint (they like and are compensated for taking risk, remember)—and why banking is a regulated industry. It remains to explain why banking regulation seems largely ineffectual. when banks get into trouble, their capital starts to vanish, and they can’t function. Credit freezes—and the economy, because it runs on credit, also seizes up. Oddly, few economists seem to have understood modern banking, or its role in the economy. The banks resist effective regulation, so far effectively, because their managers are better off with the Darwinian business model, which enables the reaping of short-term profits great enough to compensate—not the country, but the bank’s managers and investors—for an increased risk of bankruptcy.
Financial intermediation was formerly dominated by commercial banks that borrowed short term and lent long term to local and sometimes national businesses. In those days, banking leaders denoted solid, respectable, if not very imaginative, individuals who were the pillars of society. Commercial banks are still important, but modern financial intermediation is dominated by investment banks, mutual funds, and hedge funds that often invest large sums of money in equities, derivatives, and other mainly risky assets, including junk bonds.
Claims that banks create money out of “thin air” are made by The New Economics Foundation (NEF), and repeated by credulous protesters who are convinced Fractional Reserve Banking is a stitch up. The NEF alleges banks can digitally create money that they then lend out. Naturally, this is nonsense. If this was true then banks would not need depositors. Perhaps you could explain why they do accept depositors. After all, the bank must pay interest on those accounts, deal with cash machines etc. Why not do away with depositors and just make loans "out of nothing"?
Money/cash notes (M0) is not debt based. Only the creation of M3 and M4 money is debt based. M0 is indeed different to M4. We need M0 to create M4. There is a direct correlation. M3 and M4 created by banks which use the cash they have received by depositors to make loans. New loans depend upon deposits. Without a deposit to lend there can be no loan.
Many economists merely use "out of nothing" to provide a simple way to explain the different measures of the money supply. The result is people think banks really can just print money willy nilly. In Double-Entry book-keeping when a loan is made the depositors account does not decrease directly. But the depositor base of the bank decreases instead. It is as though the depositors account has had cash deducted (showing this to customers directly this would merely freak the customer out, who may not understand that the bank will loan out the money they have deposited). But this is *very different* to money being created ex nihilo.
Money created from thin air proponents have to prove how banks can make loans without depositors (or by borrowing cash themselves from the market in the first place).
What bank reformers who seek the abolition of fractional reserve banking such as Carswell/Positive MoneyUK is doing is suggesting that banks offer safe deposit box style accounts, in which the cash you deposit can't be lent out. Not very radical (just silly, as no interest would be paid on the account. A fee would be levied too, to cover the admin costs of the bank)