Fractional reserve banking system is a fraud (but a genius)[Column]| coindesk JAPAN | Coindesk Japan

The failure and bailout of First Republic Bank, the second largest bankruptcy in US history, has raised serious questions about the solvency and liquidity of the global banking system.

Banks are supposed to be boring but honest businesses. Customers can deposit money in their bank accounts for safe keeping and withdraw whenever they want. And for the most part the system works.

What is Fractional Reserve Banking System?

But banks also have to make a profit. Most American banks offer free or low fees for accounts. So how do you make a profit? By lending customers’ deposits to riskier businesses and earning interest, of course.

The actual banking operations are carried out as follows. First, short-term, safe customer deposits are deposited with banks, which invest them in long-term, risky assets in exchange for future financial returns. And pray to heaven that all your customers don’t withdraw their money at once. Short-term deposits are invested in long-term assets and are no longer usable.

This is the “fractional reserve banking system” (banks hold only a portion of customer deposits as reserves) and is a well-known fraud.

But while it was definitely a scam, it was in a way beneficial to society. Still, it would be nice to have an option that doesn’t involve this kind of scam.

Writer and computer programmer Steve Randy Waldman’s blog, Interfluidity, nicely illustrates the problem of fractional reserve banking.

“The financial system helps us solve collective action problems. In a world of investment projects with fully disclosed costs and risks, most individuals would be terrified… Banks The system is a combination of fraud and genius that puts itself between investors and entrepreneurs.”

What do you mean?

Simply put, if banks can’t invest short-term, low-risk customer deposits in long-term, high-risk assets, most of the world-changing, crazy ideas that entrepreneurs come up with will not be funded by investments. not being able to receive an offer. Banks play a role in spreading the risk of financial capital.

deception and genius

Without the banks participating in this genius scheme, the financial system would be such that the only financial capital that would make long-term risky investments would be the capital that agreed to make long-term risky investments.

But here lies the deception. Most people who deposit money into bank accounts don’t know they are opting for these solutions for financial capital.

However, this genius mechanism was good for society in a sense. We have all been tricked into making productive investments without even knowing it. Of course, there were unproductive investments, but it would be difficult to argue that without the fractional reserve banking system, more productive investments could have been made.

But alternatives like Custodia Bank and The Narrow Bank with 100% reserves have not become available or permitted by law. First, it is a problem that fractional reserve banks are backed by the US government.

Related article: Why is the Fed rejecting crypto banks with ‘100% reserves’?

They should be given the option of depositing in so-called “narrow banks” (banks that manage safe assets such as government bonds but do not lend with risk) that do not use fractional reserves. As we recently witnessed, when fractional reserve banks go awry, the impact can be devastating.

Thankfully, banks appear to be moving to the narrow model. Indeed, if fractional reserve banking becomes less common, less capital will be available and it may become more expensive for companies to raise money. But that’s fine.

Those who make high-risk, high-return investments should be limited to those who clearly declare that they want to make high-risk, high-return investments. Otherwise it’s a scam.

The modern financial system is built on “fraud and genius.” Is genius an excuse for deception?

Probably not.

｜Translation and editing: Akiko Yamaguchi, Takayuki Masuda
| Image: Federal Reserve Headquarters (AgnosticPreachersKid/Wikimedia)
｜Original: Fractional Reserve Banking Is a Fraud (but It’s Genius)