Chicago, IL
By A.B. Dada
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It’s a wonder that so many people are debating the idea of whether or not to bail out the banks from their losses during the subprime “crisis” that we’ve been warning about for years here. There’s two schools of thought: bail out the banks by boosting their reserve assets through additional monetary inflation (Federal Reserve/Treasury collusion to print more money), or let the fail. Both sides ignore a market truth that needs to be settled during this crisis: fractional reserve banking always leads to bank failures and bank bailouts.

In the short history of the U.S. central bank (since 1913), we’ve seen the problem of bank runs rear its head over and over. We’ve had numerous big bailouts over that time-frame, but we also have a daily form of bailing out called the Discount Window that the Federal Reserve uses to shore up bank reserves that go below the Central Bank’s mandate. The Discount Window is where banks can borrow money against assets held to keep their reserves over a certain pre-set percentage (thought to be 10%, but it could be less). The problem with this discount window is that the assets used to borrow short term money from the Fed are assets that are generally already guaranteeing other loans to borrowers. The bank is allowed to double-dip. In the past, the discount window was for a VERY short period of time, usually overnight, giving the bank time to acquire private deposits or investments to shore up that reserve ratio.

Because of the banking crises we’ve faced, the Fed has allowed banks to borrow money “overnight” for 30 days, and extend it almost indefinitely. This gives banks little reason to acquire their own private deposits to back up their ratio. What is worse is that the Fed’s money may allow the banks to save more than their reserve requirement, and when this happens the bank can now create new loan money “out of thin air.” If a large bank is mandated to keep a 10% reserve ratio (10% cash versus 100% loans) and it drops to 9%, it can borrow from the discount window to bump it up. Let’s say the big bank borrows enough to bump it up to 12%. This now allows them to loan out an additional 20% to new borrowers, which increases the bank’s leveraging risk, and causing price increases through new monetary inflation.

The bifurcation between the overnight rate and the lending rate gives banks reason to try to extend as many loans as possible versus their reserve ratio. If the bank borrows at 2% and lends at 7%, why wouldn’t the bank take huge risks since the money can be re-borrowed again and again?

My solution is to neither bail out the banks nor let the fail, but to remove the Federal Reserve from the picture entirely. If banks need money, they can acquire it from depositors by offering a generous and competitive interest rate (higher). If the banks have too much money, they can loan it out at generous and competitive interest rates (lower). The Fed’s artificially low interest rates give the banks almost no reason to try to get private depositors. They can borrow at ridiculously low rates and lend at ridiculously low rates. This is a long term problem that is made worse and worse by the Fed’s ever loosening rules for how banks can borrow money for the “short term” (which ends up being the long term).

The Fed’s policies are the number one reason for bank failure. Requiring just 10% reserves means the bank may loan out 900% more than they legally could in a free market. Allowing the bank to borrow money at low interest rates and lend at higher rates means the bank will take higher risks with taxpayer dollars than they might with private depositor dollars. Freeing the bank from paying on their defaults due to protection from the FDIC means the banks will take much higher risks with the money they’re lending out. The Fed is, and will always be, the number one enemy of a country’s economy. Savers create wealth and price stability, borrowers create unhealthy price increases.

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