Fractional Insanity Banking

Greek savers may be gripped by a “great fear that could develop into panic,” President Karolos Papoulias warned last Tuesday. He said that Greeks withdrew some €800 million from Greek banks on Monday, fearing their imminent insolvency and the prospect of Greece leaving the Euro currency union.

The Eu…ropean Central Bank (ECB) said on Wednesday that it had stopped providing liquidity to some Greek banks. “As recapitalization wasn’t in place, the ECB stopped monetary policy operations,” a Euro zone central bank source told Reuters, essentially calling these Greek banks insolvent in their eyes. These banks are now being supported by emergency liquidity assistance (ELA) from the Greek central bank.

El Mundo newspaper Thursday reported that about €1 billion ($1.3 billion) of deposits had been pulled from Spanish nationalized bank, Bankia, over the past week. Moody’s Investors Service is expected to downgrade the credit rating of Bankia and several other Spanish banks. Standard & Poor’s cut its credit ratings for eleven Spanish banks on April 30.

What does all of this mean? Why are these banks suffering such problems? It all comes down to fractional reserve banking. Investopedia.com defines fractional reserve banking as “a banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal.” In other words, when a customer deposits funds into their account, the bank is able to lend many times that amount out to others, who may also deposit or buy things from others who will deposit—this newly borrowed money into the bank as well. But the new deposits are essentially imaginary: they are only backed by that original deposit which is a fraction of the total. Nonetheless, all customers think that they are entitled to withdraw their full amount at any time. This is done to expand the economy by freeing up capital that can be loaned out to other parties, according to Investopedia. It’s also done to make bankers very rich, of course.

If it sounds shady, that’s because it is. But this is how almost all banking systems in all countries work, including our own. Banks are legally permitted to create money out of thin air and lend it out as if it were “real.” In the nineteenth and early twentieth centuries, bank panics were common. If customers lost confidence in the ability of their bank to honor their deposits because too many of the bank’s loans defaulted, they rushed to withdraw their funds before the bank ran out of money and left them with nothing. There was a real issue of trust which had many people keeping their money under their mattress instead.

This problem was addressed via the creation of central banking systems such as the Federal Reserve in the U.S., the Bank of England in Britain, and the ECB in Europe. Central banks serve three key functions in a fractional reserve banking paradigm: they produce a common fiat currency which all banks share, they act as the lender of last resort if a bank panic should occur so that depositors are made whole, and they regulate the banks under them. In particular, they determine what reserve ratio (imaginary money to actual cash) banks must maintain.

Even if, in theory, central bankers were smart enough to know exactly how to manage this system so that it didn’t implode, they are ultimately subject to political pressures. When politicians want to promote economic activity in order to further their reelection campaigns, they induce the central bankers to both print more currency to buy more sovereign debt so that the politicians can heap largesse upon the masses, and they encourage them to reduce the reserve ratio requirement so that people can obtain easier, cheaper loans. This results inevitably in financial bubbles. Sometimes the bubbles form in stock markets, sometimes in real estate, sometimes in entitlements. And when those bubbles pop, lots of loans default, already low reserve ratios are violated, and banks get into real trouble.

Well, shouldn’t the central bank step in and print as much money as they need? Typically this is what happens, particularly if the bank still has sufficient reserves. But the European common currency union is severely stressed by several nearly bankrupt nations, and analysts are seriously debating whether or not the coalition will survive. If countries such as Greece and Spain are forced to leave the Euro in order to service their sovereign debt, then people fear their bank deposits will be automatically exchanged from Euros (which are strong due to their backing by Germany and other economically stronger nations) to much weaker national currencies, significantly decreasing their purchasing power. Therefore, the central bank protection scheme has broken down, and customers are fleeing with their Euro-denominated deposits.

In most cases, once a bank run gets underway, it becomes a self-fulfilling prophecy, sending the bank to ruin. In this case, it may also force these countries to abandon the Euro in order to provide liquidity to their banking systems in their national currencies, which they can print freely without foreign oversight.

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