Fractional Reserve Banking No Necessary Evil: the McCulley Speech

The most remarkable aspect of PIMCO managing director Paul McCulley’s recent speech on the nature of banking is not its conclusion, seemingly radical in its emphasis banking is and will forever be a public-private partnership.  This conclusion follows quite logically from its assumptions.  The assumptions themselves are wherein the problematic facets of the argument lie—mainly the assumption that fractional reserve banking (FRB) is de facto necessary and any imitators should be reigned in to a regulatory structure that encompasses (or at least should encompass) FRB.  What is strange is that McCulley never states that FRB is necessary or why it should be necessary—merely that it is, and thus should be regulated, given the existence of a central bank and deposit insurance, both necessary bastions to prevent bank runs:

The essence, or the genius of banking, not just now, the last century or the century before that, but since time immemorial, is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post. In turn, the essence or the genius of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.

A second principle: A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver.

The conclusion of the second principle should at least cause a modicum of hesitation: an assertion that the banking system simply cannot deliver on its promise, given the mismatch between maturities, valuations and liquidity on its assets and liabilities.  However, as McCulley wisely notes, the public’s demand varies pre- to post-deposit.  They require immediate liquidity but after buying a deposit, rarely act on it en masse or for their entire deposit.  Jesus Huerta de Soto has an exhaustive study of the rise of FRB in the Western world and interprets it as a gradual subversion of the initial deposit contract, wherein banks would agree to hold, at all times, the entirety of any specie (typically gold or silver) deposited.  The deposit contract began to break down as bankers succumbed to the temptation to surreptitiously lend out deposited specie as they realized, as McCulley noted, the ex-ante and ex-post demand for deposit redemption was substantially different.  Depositors had a low coincidence of redemption demand unless and thus bankers could often accomplish the ruse, especially as a bank grew and coincidence of redemption between depositors became gradually lower with their increased numbers.

100% Reserve banks gradually gave way to FRBs as the public and, more importantly, governments began to allow the FRB deposit contract to exist.  Governments generally were lenient to banks as the state recognized them as an effective way to extract the savings of the populace in the form of loans from banks to the government.  However, runs on banks were a periodic and disastrous occurrence and more or less every bank that practiced FRB eventually collapsed due to a run.  An instructive example is the Bank of Amsterdam, which initially maintained 100% reserves for a 150 year period:

To all intents and purposes the Bank of Amsterdam maintained a 100- percent cash reserve. This allowed it, in all crises, to satisfy each and every request for cash withdrawal of deposited florins.  Such was true in 1672, when panic caused by the French threat gave rise to a massive withdrawal of money from Dutch banks, most of which were forced to suspend payments (as occurred with the Rotterdam and Middelburg banks). The Bank of Amsterdam was the exception, and it logically had no trouble returning deposits. (de Soto, p. 98)

The Bank of Amsterdam did eventually begin to violate the 100% reserve principle, losing its prominence due to this fact and the fact that England was replacing the Dutch in commercial power:

Unfortunately, in the 1780s the Bank of Amsterdam began to systematically violate the legal principles on which it had been founded, and evidence shows that from the time of the fourth Anglo-Dutch war, the reserve ratio decreased drastically, because the city of Amsterdam demanded the bank loan it a large portion of its deposits to cover growing public expenditures. (de Soto, p. 106)

Clearly evident is influence of government upon the bank to make fractional reserve loans in order to wrest citizens’ savings in order to finance a war.

Runs on FRBs then occur for two primary reasons.  Usually the loans the bank has made come into question, resulting in concerns about the banks solvency.  Depositors know the bank’s cash holdings cannot cover all the deposits but rest assured if the bank’s loans only default in small percentages, the bank should be able to handle a regular cycle of redemptions.  However, if the loans start to default in high percentage, this ability is called into question and depositors attempt to redeem while the bank’s cash holdings are still available.

Secondarily, a bank could be exposed to a large depositor, who, whether because they themselves experience financial trouble or merely wish to make a large long-term investment, withdraw their deposits which the bank cannot handle.  This is less of a concern since a bank could prevent exposure to such depositors by limiting deposit amounts—depositors were likely to do the same by spreading a their large deposit demand across multiple banks.

McCulley notes that these issues have been experienced by bankers since the existence of banking, meaning specifically FRB[1].  Moreover, McCulley reiterates in his speech that: “Demand deposits, conceptually, have a one-day maturity. But in aggregate, they have a perpetual maturity. So, therefore, banking can engage in maturity, liquidity and quality transformation: a very profitable business. Banks can issue, essentially, perpetual liabilities – call them demand deposits – and invest them in longer dated, illiquid loans and securities, earning a net interest margin. It’s a really, really sweet business.” This is true inasmuch as the banking system is governed by a central bank which clears for all member institutions and can provide liquidity should one bank experience a substantial amount of redemptions.  More importantly, the existence of deposit insurance calmed the public’s rise in demand for liquidity of deposits, namely in times of crisis:

In order for that business not to be prone to panics and, therefore, financial crises, you needed to have deposit insurance. Deposit insurance, by definition, cannot come about as if by the invisible hand. Deposit insurance cannot be, cannot be a private sector activity. It is a public good. The deposit insurer must be a subsidiary of the fiscal authority. And in extremis, the monetary authority can monetize the liabilities of the fiscal authority. I’m not saying that pejoratively. I’m not being pejorative at all. Just descriptive. Bottom line: Deposit insurance is inherently a public good.

Access to the Fed’s balance sheet is also inherently a public good, because the Federal Reserve is the only entity that can print currency. So essentially, banking has two public goods associated with it. Therefore, naturally, it should be regulated.

There can be little disagreement that if deposit insurance is offered by the government, that regulation must follow or banks would merely take reckless advantage of the subsidy knowing that their deposits were always backstopped.  The banks would be able to shift risk to the provider of deposit insurance while reaping any of the potential rewards of speculative loans.  McCulley then criticizes the “shadow banking system”, which he refers to as any product that mimics an FRB deposit but is unregulated, for instance, money market funds:

Banking is inherently a joint venture between the private sector and the public sector. Banking inherently cannot be a solely capitalistic affair. I put that on the table as an article of fact. And, in fact, speaking at a Minsky Conference, I know I’m preaching to the converted. Big bank and big government are part of our catechism. And, in fact, that’s exactly what came to the fore to save us from Depression 2.0.

And I think the first principle is that if what you’re doing is banking, de jure or de facto, then you are in a joint venture with the public sector. Period. If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be considered functionally a bank, regardless of the name on your door. That’s the first principle.

Number two, if you engage in these types of activities – call it banking, without making a big distinction here between conventional banking and shadow banking, as Paul Krugman intoned this morning – in such size that you pose systemic risk, you will have higher mandated capital requirements and you will be supervised by the Federal Reserve.

None of this is tremendously debatable given the unspoken assumptions but it is notable that McCulley never makes the case of why FRB is necessary or why the public should be extorted via an ultimately taxpayer-funded insurance bulwark in order to gird its existence.  Given the last quote and what scholars analyze as the gradual move away from 100% reserve banking, one can imagine McCulley several hundred years ago (or de Soto in the present) demanding that any institution calling itself a bank and offering deposits much be made to have the 100% reserve ratio given the risks to FRB and creating a shadow banking system that promises the immediate liquidity inherent in the 100% reserve banks but “unregulated” by the 100% reserve requirement.

A FRB deposit may not be objected to if it is distinguished legally from a full reserve demand deposit[2].  To the point, an FRB security could likely not be called a “deposit” as such but rather a “Fractional Reserve Demand Share” or something of the like.  FRDS would function in much the same manner as either money market mutual fund shares or similar type instruments, with redemptions handled by the portfolio which would maintain some level of cash to deal with them.

If such a legal separation is possible, it might also then remove the FRDS’s current subterfuge of mismatching ex-ante liquidity with ex-post liquidity reality.  Holders would likely be much more cognizant of the possible lack of liquidity, although they could become complacent over sustained periods of plentiful liquidity—this is similar to what occurred with auction rate preferred shares, while complacency could be a problem with any financial product.  In this revised separation between 100% reserves and FRDS, there would be no government mandated deposit insurance[3], nor a central bank.  The FRDS would be managed as any other investment fund, albeit with more generous liquidity terms.

The necessity of fractional reserve banking as currently constructed is, once again, largely assumed in discourse, though there are supposedly well and good reasons for it.  Most look to FRB’s ability to expand the money supply and credit availability to support economic growth.  However if such credit is created by an obfuscation on the part of bankers, aided by a direct subsidy by the federal government, it calls into question how effective this credit is.  The existence of such a blatant subsidy would logically precipitate an overabundance of credit, or credit on artificially easy terms, or both.  If such is the case, even if it would contribute to some economic expansion, that growth may be largely artificial itself, not conforming to either the populace’s desire for further investment or time preference.  This is a crux of de Soto’s argument, although I would submit that investment would still be funneled properly if there was a legal separation between a 100% demand deposit and a FRDS, as well as the elimination of government FRDS insurance and the central bank.

What, in essence, support for an FRB regime that engages in legal obfuscation and endorses a “public-private” venture between banking and the government with attendant regulation to protect the banking system’s assets is essentially support for a corporatist policy.  This policy extracts the savings of a reluctant public who demands more liquidity than is available for certain investment products, particularly in the long-term loans made by the banking system[4], in order to invest in state motivated projects[5].  While the system isn’t completely socialist, the corporatist nature is similarly as detrimental as it will likely lead to overinvestment beyond the desires of a public—what are essentially transfers wealth to certain parties via easier loan terms than would normally be available.

The subtlety of the system is its genius—there is nothing to prevent someone from creating their own 100% reserve deposit by storing money in a safe deposit box, for instance.  However, the subsidized product benefitting from a legal obfuscation could easily crowd alternative products out of the market.  A notable exception was in the 1970s during the rise of money market funds that only came about because of a mandated cap on the payment of interest on deposits while money markets were able to gain higher rates in that inflationary decade.

In the end, the argument for the current FRB system, whether one argues for more regulation or more “free-market” mechanisms, will always be an argument for a massive corporatist structure as long as it presupposes the existence of a legal obfuscation between 100% reserves demand deposits and FRDS, fractional reserve deposit insurance and a central bank.  This structure will likely not produce the balanced outcomes[6] of an alternative free-banking system, even outside of any credit excess, and, as the current crisis well demonstrates, will likely be abused by the parties supported by it, despite the efforts of regulators.

[1] 100% reserve banks would have had no such problem with a typical bank run.  However, a 100% reserve bank could have difficulty redeeming specie if its deposits were destroyed or lost by a natural disaster or fire or stolen in a bank robbery.  These issues could be deferred with fire, disaster or theft insurance which would function more clearly as insurance than what is now deposit insurance.  Deposit insurance is, in essence, a combination of a liquidity backstop with a credit-default swap.  While theoretically possible, it differs notably from property-casualty insurance.

[2] There is large disagreement within the ASE on whether a fractional reserve bank can legally exist; I believe de Soto falls in the camp that it is impossible.

[3] It wouldn’t be required: if people wanted full liquidity, they could opt for a demand deposit; if they were willing to undergo some liquidity, as well as credit, risk, they would opt for the FRDS.

[4] As opposed to short-term loans of money-market funds, which still aren’t fully liquid as a 100% reserve and carry some credit risk

[5] I note “state motivated” since regulation governing what type of investments are allowed with bank funds will be driven by a government process.  Regulatory capture is certainly possible under such a regime, as we have witnessed.

[6] That is, balance between investor’s time preferences and liquidity desire and borrowers’ desire for loanable funds on certain terms to fund a project


1 Response to “Fractional Reserve Banking No Necessary Evil: the McCulley Speech”

  1. 1 Marek
    July 27, 2010 at 7:49 pm

    this Pedigree commercial, which you have in your later post, is the best illustration yet of the fractional reserve banking and the credit economy; for what McCulley needed so many words.

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