"Woman plus..." The Myth of the Banking System

The Myth of the Banking System

by Boris Lvin

Excerpts from the study Specifics of Banking and Monetary Systems

When back in August 1998 some newspapers reported the collapse of the national stock market, the general public failed to pay due attention to the news. And next, the entire national finance system fell apart, which was broadly perceived to be a "flash of lightening out of the blue". Few economists could explain what exactly had happened. Today the word crisis is the word for what we have to live with, just as with the bad weather. Essentials of and reasons for the 'crisis', however, stay unclear. So we suggest that our readers may want to get some insight into what has happened recently within the national economy and we offer two articles that present somewhat different outlooks.

Probably the most sustainable myth of the modern time has been the myth of the banking system and the central bank stability. In recent years, its deceptive power got a hold over the minds of practically all Russian economists, writers and politicians. According to this myth, the banking system is the nerve of the national economy and the principal vessel of capital investments and growth; thus, upholding the banking system and keeping it operational should be the primary concern of the federal government. The widespread belief is that while the national economy reform may have failed in some ways, it has accomplished the two major goals: development of a profound operational banking system, and the independent statutory Central Bank to uphold the national reserve system. Therefore, any damage inflicted to these two institutions would produce adverse effects in the national economy, impede further reforms, and endanger democracy and progress. This myth, however, should be critically reviewed.
Problems apparent in the national banking system fall in two categories: fractional reserve banking problems and central banking problems. Problems in these areas are distinctly different, though to some extent interrelated. First, we address problems with the fractional reserve banking system.

FRACTIONAL RESERVE BANKING

The specificity of modern banking is that any bank's long-term assets (i. e., direct and portfolio investments of limited liquidity) are budgeted with short-term liabilities (private and corporate accounts and short-term investments). In other words, a commercial bank's actual liquid assets would not cover the total of its payable liabilities on coherent request by claimants.
In Russia, a commercial bank would usually accrue clients' accounts in a single pool. From an economic standpoint, however, this pool should be viewed as the combination of two clearly distinct components:
-· Clients' savings intended to secure their solvency in current operations. This component was not meant to generate incomes, but rather to be a set-aside reserve. In this sense, these savings may be viewed as the cash available for out-of-pocket payments. Hence the function of the bank is to store client's money and perform transfers on his request.
- · Clients' investments intended to generate income with the return on reinvestments by the bank. This component comprises funds loaned to the bank on the interest basis. In this case, the bank's role is of a third party between actual investors (looking for profitable application of their accruals) and businesses (looking for start-up capitals to open promising operations).
As long as money is a homogenous mass, banks are free to mix the above-mentioned components together.
As long as money is a homogenous mass, banks are free to mix the above-mentioned components together. Another specific feature inherent in commercial banks is that their assets (both total and itemized) may suddenly drop in their market value thus decreasing the capital worth of the bank. Meanwhile, the total of bank's liabilities will never fall below their initial net worth (unless the bank have collapsed). In other words, in the face of market pressures, while a bank may force down rates of return on clients' investments, bankers cannot reevaluate the sum total of these investments in order to decrease the level of liabilities.
The above-described operational distortions result in modern banks' universal exposure to one particular risk. And that risk is of a highly peculiar nature: a bank has to assume obligations to the amount beyond its capability to recover with its fluid assets; and whenever all or most of bank's eligible creditors may happen to claim withdrawal of their accounts all at once, the bank is ruined.
Some critics of modern banking argue (with grounds enough) that banks, in fact, practice deceit, since they deliberately make their clients believe that they may retrieve their accounts at any time, which is not true; thus, banking practices are both unethical and illegal and may be qualified as fraud. Austrian school of economy asserts that fractional reserve banking is essentially harmful, as it forces people to overestimate actual resources in their possession.
Consider the following situation: Mr. Jones has deposited $100 on his current account which results in bank's liquidity increase by $20 (in cash and/or surrender to the Central Bank) and $80 one-year credit issued to Mr. Brown. Now, Mr. Brown has $80 in cash, and Mr. Jones - $100 readily available from the bank.
Do miracles really happen? Is it possible that few simple entries in banking accounts brought Jones and Brown an 80% return in cash in almost no time? Some sense of reality suggests that 'no" is the answer. No actual value was added. What happened may be described as an artificial increase of credit resources offered. If commercial banks never existed, Mr. Johns might as well credit Mr. Jones with 80 bucks. In this case, however, Jones would have only 20 dollars of 100 hundred left, and 80 dollars would be a risk investment with the potential either to gain or lose on it. Moreover, with only $20 available, Jones would think twice before crediting someone else or making further investments, while with $100 available from the bank he feels secure and in a position to invest further.
You may wonder, what is wrong with the increase of credit resources? After all, complaints about too expensive or unavailable credits are heard from all around?
It should be emphasized here, that it is not money which is either produced or consumed. It is tangible resources. Money is only the means to procure such resources. Therefore, increase in available credit resources does not at all implies a proportionate growth in tangible resources.
What is the actual implication of the above? In terms of resources, bankers produce (and profit on) the lag between the volume of resource-based savings corresponding to underlying tangible values and the volume of 'investable' money. As soon as this lag has developed, people begin to misuse tangible resources and rely largely on virtual resources available as bank credits, which would not be the situation in the absence of artificially boosted credit resource availability. Misguiding cheapness of readily available low-interest credits results in long-term resource-consuming projects and ventures with much longer expected cycles of return.
At this phase, the demand for capital resources (i. e., durable equipment, machinery, natural resources, real estate) would steadily grow, and so would the share of such resources captured in long-term projects of doubtful cost-effectiveness. This phase of investment boom is often mistaken for economic upsurge. Sooner or later, however, investors would find themselves short of actual resources required to complete most of long-term projects undertaken. The demand for durable equipment would shrink, and so would the market of long-term investments. Many banks that use to capitalize on excessive credit offers would come to the turning point unprepared. While failing to return long-term credits, banks would face massive claims to withdraw from private accounts and find themselves insolvent. To prevent collapse of the entire banking system, the Central Bank (in its function of the national reserve administrator) may order the emission of cash to the volume required to cover unpaid liabilities of private banks, thus spiraling the inflation.
The model described above is aptly illustrated with the following example. Imagine a powerful hypnotist who has succeeded in making everyone believe in being richer than they are in fact, while supplies and prices stay unchanged. Happy with heaven-sent riches, folks will start to invest the imaginary surplus into development, rather than consumption. They will engage in long-term projects and operations - invest in construction, equity, business. The economic boom will be visible and palpable with development and construction projects, long-term investments, and growing demand for durable equipment and means of production. Unfortunately, as soon as folks find out that their money are gone (to their utter surprise), the illusion will cease, folks will stop investing in long-term projects and durable equipment and redirect all their future incomes to recover their solvency as consumers. Economic cutback is thus inevitable.
The imaginary hypnotist just described is exactly the role for a fractional reserve banking system. And the process it activates is known as the Austrian economic cycle model.
Therefore, national economies develop in cycles not at all by virtue of their 'capitalist' market nature, as Marx used to propound, and as many keep on believing today, even in the West. Rather the fractional reserve banking model should be held responsible.

So what shall we change in the banking system?


From the above discussion, it must be clear that an ideal bank will have to separate its depository and account management functions from its investor and creditor functions. In other words, whatever amount you depose in the bank on your current account, it will stay there - either in cash depository or on the bank's swap accounts in the central reserve bank or other fluid assets. Certainly, this would leave bankers some space for violations, but the systematic risk of bank's insolvency is eliminated completely. Under such a model, one would not expect profits generated by his money deposed on the current account. Moreover, banks may charge their clients operational costs associated with deposits and transactions.
On the other hand, investment accounts may be offered to those who wish to generate return with their spare money, in which case the bank will act in the role of a fund-holder in some form of trust arrangement, while clients shall be fully informed of risks associated with investing their money in such operations.

The fact that funds of different origin (e. g., savings and investments) are consolidated in banking accounts and practices is, in fact, the invitation for bankers not only to boost credit resources during the phase of economic growth (or, to be correct, to induce temporary economic growth with boosted credits and trigger the Austrian cycle), but also to apply for government support during the following stagnation phase. It should be emphasized, that failure to gain on and even regain risk investments and failure to retrieve bank deposits result in somewhat different attitudes. This point is best illustrated with the recent stockholding market collapse resulting in commercial banks' insolvency. On finding out that their money has gone, investors feel like having lost the game, while depositors feel like having been robbed.
Depositors' open (and somewhat violent) pressure on the government have resulted in government measures to 'save' private banks at public expense - primarily with the means of printing more paper money. Since money-printing operations do not produce any value added, the government is simply spreading the burden of the recent national banking crisis over to those who have already suffered most: government employees with fixed incomes and those who have relied on in-cash, rather than on in-kind savings.