[Caption/Credit for above photo: Bank Panic–A.D. 1907
(courtesy Google Images)]
The Associated Press recently published an article entitled “The Latest: Will Greek banks have all their money next week?” That headline hints at the danger in fractional reserve banking.
As I understand it, in the US, the fractional reserve ratio is about 10:1 meaning that out of every ten dollars deposited into bank accounts, the bank holds one dollar in its vault to hand out to depositors and lends the other nine to borrowers.
The advantage and even necessity for fractional reserve banking is that it prevents currency from being hoarded in banks and shrinking the money supply needed to keep the economy growing. Instead, fractional reserve banking allows 90% of the currency saved to be loaned back into the economy to circulate and stimulate economic activity.
The danger in fractional reserve banking is that if an emergency arises when only 10% of the deposits are actually kept in the bank vault, and more than 10% of US depositors want to simultaneously withdraw all of their currency from their bank accounts, then there’ll be a “bank run”.
If enough depositors join the bank run, the bank will be unable to provide the funds owed to depositors since 90% of their deposits have been loaned out to others. Once the bank is shown to be unable to meet the depositors’ demands, the bank will be deemed to be insolvent and may be closed.
Although depositors might later be able to regain their deposits, for the immediate future, 90% of depositors will be unable to access any of their savings. Without access to their bank deposits, bank customers may have no money to buy groceries, pay their mortgages, or get to work. They’ll tend to panic. The economy may tend to collapse.
Fractional reserve banking is both necessary to a modern economy and also dangerous. If a nation’s depositors all try to withdraw their funds at once, they won’t be able to access their funds. They’ll tend to panic, throw things, riot, light fires and shoot.
• I don’t know what the fractional reserve ratio is in Greece, but I’ve heard that some European countries run ratios of 23:1. I.e., out of every 23 euros deposited in some banks, the banks only retain 1 euro in the vault. That means that if just 4.5% of the European bank depositors demand to withdraw their deposits at the same time, the resulting bank run could close the banks.
If the US fractional reserve ratio is 10:1, a catastrophic bank run would require 10% of bank depositors to demand funds at the same time.
If the Greek fractional reserve ratio were 23:1, a catastrophic bank run could result if just 4.5% of bank depositors demanded their funds at the same time.
Higher fractional reserve ratios (like 23:1) make banks and even national financial systems more vulnerable to panic and collapse.
• The threat of “panic” is inherent in, and created by, fractional reserve banking. I doubt that there’s another fundamental cause for bank panics and financial collapse besides fractional reserve banking.
Suppose I deposit $10,000 with you for safekeeping. Suppose you lend $9,000 of my deposit to a third party. Suppose I come to you at an unexpected or inconvenient time and demand my $10,000 and you can’t produce it. There’s going to be a problem. There’s going to be a panic. Violence is likely. Somebody–maybe you, maybe me–is going to get hurt. Bet on it.
The threats of bank panics and financial collapses are inherent in fractional reserve banking. Because (under fractional reserve banking) 90% of the savings deposited into a bank have been loaned out, no more than 10% of depositors can close their accounts at the same time. If more than 10% of depositors try to simultaneously close their accounts, 90% will quickly learn that their savings are no longer accessible. Panic will ensure.
Therefore, bankers must be extremely prudent and responsible in their use of fractional reserve banking. If they’re not, any miscalculation could cause a depositor panic, bank insolvency, and even economic collapse.
• My conclusion is that, more than the Greek government, the Greek banks may be the determining factor as to whether Greece has a problem or a catastrophe in the next days or weeks. Why? Because Greek banks hold Greek people’s savings. If enough Greek depositors demand their funds from banks, the banks may be shown to be insolvent, forced to close, and thereby precipitate panic, riots, civil unrest, and even government overthrow.
From a psychological perspective, it’s not the size of the debt, per se, that can precipitate a bank run and economic collapse. Look at the true size of the national debt of the US government. It’s said to be over $200 trillion. Does anyone care? Is anyone prone to panic because the national debt is over $200 trillion? No. We are largely indifferent to the size of the debt.
But, we will panic in a heartbeat if we find out that someone has stolen or otherwise disposed of our savings.
I don’t care if I’m in debt for $1 billion or $100 billion. But if you screw with my savings, I just might blow your head off. I suspect that most others think the same way. It’s not the size of the debt that will trigger a bank run and panic. It’s the loss of savings.
That’s why operation of the banks are so important. That’s where most of us keep our savings. If the banks fail and we lose our savings, we’ll go postal instantly. Dr. Depositor and Mr. Hyde. Screw the damn toasters! I want my money! (Savings)
• The potential chaos that follows from the loss of savings is probably why the IMF and ECB have continued to provide more “emergency funds” to Greek banks. They’re trying to increase the money supply in Greek vaults from 1 euro out of 23 deposited to 1 euro out of 10 or even 5. With more money in their vaults, the Greek banks are less likely to rendered insolvent by panicky Greek depositors. By lending more currency to Greek banks, a bank run will be less likely to prove the banks to be insolvent, less likely to destroy Greek depositors’ savings, less likely to leave the Greek people penniless, and less likely to cause infuriated Greeks to riot.
The same could be said for Greek currency controls that prevent depositors from withdrawing all of their savings at one time and restrict withdrawals to, say, €400/day. You’ve got to give the depositors some of their funds. You can’t give them all of their funds. It’s a dangerous game. If you miscalculate however much you give the bank depositors each day, they might still riot and take your head. Still, if you calculate correctly, you may maintain the depositors’ confidence that their savings are still intact–although not immediately accessible
Likewise, closing the banks for several days or even weeks could help prevent the ruinous bank run panics. If the banks aren’t open, there can’t be a bank run. Without a bank run, there can’t be absolute evidence that the bank is insolvent and the depositors’ savings are gone.
So long as the bank remains closed, the depositors can have hope, faith and/or confidence that they will soon access all of their savings. So long as the depositors have some hope, faith and confidence that the bank is not insolvent, and they’ll (eventually) be able to withdraw all of their savings, they’ll be less likely to riot, firebomb the banks and start shooting government officers and employees.
But once it’s clear that their savings are gone, the banks had better have good fire and life insurance policies.
The debt, no matter how enormous, does not inspire the emotion of panic to same degree as the loss of savings.
Written by Alfred Adask
Full report at Adask’s Law
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