Banking On Failure: Money, Lending And Inflation

WORLDWORKS by Joe Pimbley

The previous excerpts for Chapter 10 explored connections between Inflation, the Money Supply, Lending, and Boom and Bust.

Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt.

Fractional Reserve Banking Increases Lending

A tremendous irony of the “bank lending creates money” paradigm is that the banks themselves do not and need not perceive that they hold this role. The bank CEO may well see her business landscape as simple and straightforward. Equity shareholders own the bank while the other investors are the depositors and other creditors (lenders to the bank). On the asset side of the balance sheet are a large number of loans, securities, other investments, fixed assets, cash, and reserve deposits at the central bank. As with every balance sheet, the assets equal the sum of liabilities and equity. To make a new loan, this bank must exchange cash or reserves to provide funds to the borrower. In this sense, the new loan is merely the conversion of one asset type to another. The CEO, of course, must be confident that her team’s review of the new loan finds that the risk and return are acceptable and that the bank continues to satisfy regulatory requirements for capital, reserves, concentration limits, et cetera.

Banking on FailureAn opposing view has emerged recently that it is incorrect to characterize banking as “borrowing and lending” in this manner with the bank acting as intermediary.[1] An argument is that banks need not borrow first and then lend. Rather, banks create their own deposits by virtue of lending. Thus, as this line of thinking goes, banks create money when they lend and this “created money” becomes the funding for the loan itself.[2]

This view and depiction of banking is false. We ascribe the error to the non-intuitive nature of fractional reserve banking as well as the confusion of an individual bank with all banks in aggregate. When Bank A lends, it must first have the cash or (excess) reserves to wire to the borrower unless one assumes that the borrower will simply hold the funds with the same Bank A. But the new deposits that this lending creates need not reside within Bank A. Rather, they may all land at Bank B. The money supply M2 increases since M2 aggregates deposits at all banks within the country. For Bank A individually, though, it must have available cash or excess reserves prior to making the loan.

As we noted earlier, it is the centuries-old practice of fractional reserve banking that enables “bank lending creates money.” Deposits in Bank A are “money” because depositors are free to take “their money” at any time. Yet Bank A does not hold immediately available assets (such as cash and deposits at the central bank) to pay all its depositors on demand. Rather, by custom and government regulation, the bank must hold only the “reserve requirement.”[3] Bank A and all other banks will lend most of the depositors’ funds. Hence, total bank lending is much larger than it would be in the absence of such deployment of depositor money.

Since fractional reserve banking increases bank lending, it also increases the money supply. As of June 2016, the seasonally adjusted M2 (in the U.S.) stood at $12.8 trillion.[4] The “monetary base” (currency in circulation plus banks’ reserve deposits)[5] was much lower at $3.83 trillion.[6] The difference between M2 and the monetary base is essentially the money supply due to bank lending of deposits. Thus, if banks did not have “permission” of regulators and the “agreement” of its depositors to hold less than 100% of cash and reserves, the U.S. money supply would be 70% lower.[7] Due to the connection of money supply and prices, the general price level would be much lower as well, all else equal.

Reverting to the irony, Bank A is a central player in the determination of the country’s money supply and price levels by virtue of its lending of deposit liabilities and its decisions to increase or decrease such lending. Yet Bank A does not act from any motive or concern for the money supply. When market demand for its loans exists with good yield spread relative to the risk of loss, Bank A increases its lending (and, inadvertently, the money supply). When borrower demand wanes, yield spread becomes unattractive, or loan losses damage its capital ratios, Bank A decreases lending (and the money supply).

Why Fractional Reserve Banking?

One wonders: why is the banking world so committed to fractional reserve banking? Earlier chapters have noted that banks fail due to “runs” that are entirely rational when the public suspects insolvency. Even in the age of government deposit insurance, chapter 5 noted that U.S. banks including Washington Mutual and IndyMac suffered runs prior to failure. More important is the risk principle. On its face, it is not a “safe and sound” business practice to promise immediate access of funds for all depositors and then to belie deliberately this promise by committing the majority of such funds to other uses. It looks like fraud![8] Further, this fractional reserve banking marries the money supply to the credit cycle. The banks are fragile and they commit the economy to periods of inflation and deflation.

Our goal here is not to list the weaknesses of fractional reserve banking. Rather, what are the alleged advantages? The most evident advantage is that banks are able to invest the deposited funds at a positive yield and pay a portion of such yield to the depositors. We also gain the supposed monetary advantage of “greater money supply” with an attendant increase in economic activity.

Let’s investigate just the alleged monetary advantage through hypothesis. Specifically, imagine the current banking world required the banks to hold funds of all demand deposits in reserve (“full reserve banking”)[9] and that this requirement had been in force for many years and decades. Would it make sense now to drop the reserve requirement from 100% to, say, 10% “overnight?” What would happen? For discussion, let’s say the money supply would grow roughly by a factor of 3.3 in line with the ratio of the June 2016 M2 and monetary base values of the U.S.

Regardless of the time interval for this tripling of money supply, we know: (i) price levels would inflate (devaluation of money) and (ii) supply of bank lending would increase. Would society and the economy benefit? Though difficult to be certain, we say “no.” Perhaps the most apparent outcome would be the disparity of consequences to citizens based on their personal balance sheets. Those who have little borrowing and purely “money assets” such as cash and rights to fixed payments of cash (pensions, annuities, bonds, et cetera) would lose tremendous value. Price inflation would decimate all these money assets. At the other extreme, citizens with significant debt and non-money assets (e.g., houses, real estate, and gold) would thrive as their assets are immune to the currency devaluation while their debt diminishes in real terms.

We view this “disparate impact” outcome as negative. Yet it’s conceivable that increased economic activity through greater lending and consequent broad reduction of capital costs would balance the disparate impact problem. We defer further discussion of this question to chapter 12.

The next and final excerpt for Chapter 10 will discuss a “Tale of Two Countries”

[1] See, for example, M. McLeay, A. Radia, and R. Thomas, “Money creation in the modern economy,” Bank of England Quarterly Bulletin, Q1 2014, 1-14.
[2] See “Bank of England Admits that Loans Come FIRST … and Deposits FOLLOW,” WashingtonsBlog, March 20, 2014.
[3] For context, as we’ve noted in prior chapters, the reserve requirement in the U.S. in 2014 is roughly 10% of deposit liabilities. As per J. N. Feinman, “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, 1993, the most recent adjustment to this reserve requirement was in 1992.
[4] See .
[5] See .
[6] See .
[7] That is, with June 2016 values, the money supply would be $3.83 trillion rather than $12.8 trillion.
[8] For a complete and sound articulation of the “fraud” assessment, see J. G. Hülsmann, “Has Fractional-Reserve Banking Really Passed the Market Test?,” The Independent Review VII(3), 399-422, Winter 2003.
[9] See, for example, J. Benes and M. Kumhof, “The Chicago Plan Revisited,” IMF Working Paper WP/12/202, August 2012, and W. R. Allen, “Irving Fisher and the 100 Percent Reserve Proposal,” Journal of Law and Economics XXXVI, 703-17, October 1993.


Joe Pimbley
Joe Pimbley
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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