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Midweek Stewardship: Fractured Banking

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Defining Our Terms

The focus for this edition of Midweek Stewardship is all the turmoil in the banking sector and how this relates to the broader economy.  First it is helpful to define our terms.

Fractional Reserve Banking:  This is a term that refers to the type of banking system in the world today.  It means that banks only need to have a fraction of their deposits “on reserve” and available for withdrawal at any given time.  The rest of the deposits are lent out to customers.  The problem is that the bank can lend out many more dollars than it has in its total reserves.  Compare it to a warehouse.  If you store items at a warehouse, they give you a receipt.  You can later present that receipt to the warehouse and get your stuff (your deposits if you will) back at any time.  Imagine that the warehouse pledged your stuff (reserves) against a bunch of additional receipts that they printed up.  So, at any time a holder of these receipts could present them to the warehouse and get “their” stuff handed to them.  That is fractional reserve banking.  The point of this is that banks become uber profitable because they lend out all the additional money (receipts) that they create.

You should be able to immediately see the problem.  If too many people holding these receipts come to the warehouse at one time then the game is up.  The warehouse cannot make good on all these claims at once.  The difference is that all the stuff at the warehouses called banks is the same.  It is money deposited on a “demand” basis.  This gives a depositor the legal right to claim their deposits at any time.  This largely works because everyone’s stuff is the same, as money is interchangeable.  Yet, the same problem exists as in our warehouse example.  There is not enough stuff in the vault to make good on the legal claims of all the depositors.  This means that at any given time every bank in the nation is insolvent.  Further, to compare it to an actual warehouse is to see that the warehouse would be criminally liable for fraud if they do what banks do every day.  Yet, this is the nature of modern banking in our world.  It is an immoral fraud built on financial insolvency.  This is why runs are so dangerous.  They expose the essentially fraudulent nature of this system.

The only reason that banks don’t crumble all the time is that the governments create a central bank, the Federal Reserve, in the case of the US.  They have the monopoly on creating new money out of thin air to keep the fraud going longer than it otherwise could.  This is what is meant when you hear about the Fed “injecting liquidity” into the system.  These “injections” lead us to our next term.

Inflation: Most pundits define inflation as a rise in the general price level.  This is incorrect.  Inflation is an increase in the money supply, full stop.  Rises in prices are a consequence of inflation.  These price rises are never uniform throughout the economy, and they can be masked for a time by increases in production.  Yet, at all times prices will be higher than they would otherwise be in the absence of the inflation.  Also, an inflated money supply alters the relative prices of various assets which makes it impossible to make rational decisions regarding the allocation of scarce resources.

How this money enters the system is the key to see who benefits.  I went over this in some detail here and here, so I will not go into such detail again.  The short story is that whoever gets the newly created money first gets additional purchasing power before the general price rises flow through to the rest of the economy.  In a nutshell these “first receivers” of the newly created money are the so-called F.I.R.E. sector of the economy, Finance, Insurance, and Real Estate.  These groups receive something for nothing, while the rest of the economy gets nothing for something.  Yet, without the central bank to rig the system the whole thing would have crumbled decades ago.  This is what keeps banks in such a perpetual state of terror.  Now let’s turn to how the banking system gets fractured.

The Business Cycle & Its Impact on Banking

To understand how the banking sector is put at risk by this central bank induced inflation of the money supply we need to discuss how this inflation creates the business cycle.  We subscribe to the Austrian Business Cycle Theory.  A visual may help:


The main thing to keep in mind is that the money that the central bank creates tells the market that real savings have accumulated, as in a true deferral of consumption.  Think of Robinson Crusoe not eating all the bananas he could so that he has enough to eat while he builds a ladder to harvest even more bananas.  The made-up money does not represent real savings or capital accumulation.  This means there are not enough saved up resources to complete all the projects that have been started because of the artificially lowered interest rates.  As Ludwig von Mises put it, it would be like designing a house thinking that you had 20% more bricks than you actually possessed.  The bust period occurs when market participants realize that they don’t have the savings to complete the projects and then they must liquidate.  This is a depression/recession.

Banks obviously have a crucial role in all of this.  They are the intermediaries that facilitate the lending out of all this so-called capital.  They of course, make a tidy, if unrighteous sum in the process.  During the boom phase banks have a large amount of “money” to lend at forcibly reduced interest rates.  Banks take in deposits from customers that have also been artificially inflated because of the inflationary policy of the central bank.  Banks also source out funds from other lenders-typically those that have been some of the first receivers of the newly created money.  They do this via very low short-term borrowing rates.  They then lend to their customers at higher rates (still lower than market) over longer-terms.  It is called borrowing short and lending long.  The formal term is “mismatching your maturities”.  When the bust  inevitably comes this is an extremely dangerous policy, as we shall see.

When the central bank needs to raise rates and slow the growth of, or reduce the money supply, which they must do or face hyperinflation, then all of this easy money profit works in reverse.  Borrowers begin to struggle to pay back their loans as their business projects are not sustainable (think again of the house design thinking you have 20% more bricks).  Business bankruptcies increase and debts must be written off.  Additionally the banks may have purchased long-term US government debt (which is just lending them money).  This seemed safe, yet as rates rise the value of these bonds decline.  If a bank holds them to maturity they would be alright but if they need to sell them to meet the demands of their demand depositors they are in serious trouble.  If they try to borrow short to maintain this longer-term lending they will find that short-term interest rates have gone up.  The borrow short, lend long easy money days are now over and the bank is faced with the real prospect of going under.  This is what happened with Silicon Valley Bank.

In addition to that as short-term rates go up money market funds offer a real alternative to bank interest rates.  This encourages depositors to withdrawal monies form their banks and move them to money market funds.  This is in fact what has been occurring:


This coupled with the almost certain downturn in the economy means that banks will be under tremendous financial pressure.  Short-term lending rates rising, longer-term loans (including bonds) worth less and monies flowing into funds with better yields will crater the balance sheets of a large number of banks.  What we witnessed with Silicon Valley Bank and Signature Bank may very well seem tame by comparison.

None of this is beyond repair.  It is beyond repair without pain and serious economic dislocation and adjustment.  There is not space here to get into how to fix all of this, that is for another post.  The point here is to explain how the banking system works, and how it is in the process of fracturing. 

At a minimum consumers should not carry more than the  $250K that is explicitly insured by the FDIC in their bank accounts.  In the case of Silicon Valley Bank the FDIC guaranteed all deposits, even those in excess of the $250K maximum, and by implication all deposits everywhere. However, you should play it safe and keep your deposits under that threshold.  This is especially true if you bank at a smaller regional bank, as opposed to the larger banks such as JP Morgan Chase or Wells Fargo.  This should help prepare you for what may be a great deal of pain and to give you a heads up on the need to protect yourself.

Praise Be to God

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