October 10, 2011,
If Banks Are Outlawed, Only Outlaws Will Have Banks
Yglesias tells us that some Occupy Wall Street protesters have picked up Ron Paulish monetary ideas — although some know better. I thought I’d say a word about one particular idea that sounds plausible to some people but is actually quite wrong: banning fractional reserve banking.

I know that’s a popular theme among some Austrians. But it’s actually neither a good idea nor even feasible.

The crucial thing is to understand what banks do. And it’s not mostly about money creation! Instead, what banks are for is helping to improve the tradeoff between returns and liquidity.

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees. And by the way, the FDIC-plus-regulations system kept us free of banking crises for 50 years after the Great Depression; it was only when financial deregulation eroded that system that the bad stuff started happening again.

So what would happen if you simply tried to eliminate fractional reserve banking?

First of all, you would be trying to ban a genuinely productive activity. Dick Fuld banking may have been a bad thing, but Jimmy Stewart banking was very much a useful profession.

Second, you would run smack into the problem of defining what constitutes a bank.

One of the great things about Diamond-Dybvig is that it immediately punctures any superficial notion that a bank can be defined by some traditional appearance — that it basically has to be a marble building with rows of tellers, i.e. a depository institution. Any arrangement that borrows short and lends long, that offers investors claims that are liquid while using their funds to make illiquid investments is a bank in an economic sense — and is potentially subject to bank runs. Indeed, what we had in 2008 was mainly a run on shadow banks, on non-depository institutions.

So, are you going to ban fractional reserve strategies by money market funds? Are you going to ban repo? Auction rate securities? Where does it stop?

To be fair, it’s difficult even to regulate shadow banking. But if there are benefits to being under the regulatory regime — insurance, access to lender of last resort, etc. — you have at least a fighting chance of getting most of the dangerous stuff under the umbrella. If you try to ban banks from, well, banking, all the banking is going to take place in the areas not subject to the ban, leaving you more vulnerable to crisis than before.

Let me add that the fractional reserve thing exhibits a characteristic common to a lot of what I see in the Paulist camp: they have an oddly antiquated notion of what money and finance are about, one that misses the “virtualness” of the modern world. They still think of money as being pieces of green paper, rather than what it mostly is now, zeroes and ones in some server somewhere. They still think of banks as being those big marble buildings, in a world in which most banking is a lot more abstract than that.

This is, after all, the 21st century. Things have moved on a bit.