FRB commentary 3: Big picture

My motivation for doing this series of three or four videos on the fractional reserve banking system isn't because I expect some type of revolutionary change or I think that the world is going to end if we keep fractional reserve banking. The whole reason why I want to do it is just to kind of clarify our collective thoughts on what it is and what are its weaknesses. I mean, it is the system that we're in and by the way that it's often talked about, it's kind of viewed as the only system because banks around the world now use the system. But we have to realize this is a system, a structure, that's been in a place and its modern form for on the order of a hundred years. And it isn't the only way to do banking and this has some very obvious flaws that I've gone over in the last couple of videos. And just to kind of highlight them-- the first one-- and this is one that would strike anyone as, at least it would make them uncomfortable, is just this disingenuous nature of fractional reserve. Look, you tell someone you can get your deposits anytime you want, but the reality is you can get your deposits anytime you want as long as no more than 10% of people want their money at that same time. And obviously that by itself might make you a little uncomfortable, but that by itself isn't a whole reason to say a system is bad, but the more severe problem is that this kind of half-lie leads to the notion of a bank run. Everyone has the right to get all of their money back on-- essentially on a day's notice or an hour's notice, but the reality is that everyone can't get all of their money back on an hour's notice so that leads to an inconsistency and some people aren't going to get what they expected and this leads to a panic, this leads to a generalized panic-- which is, of course, a very unstable situation for your entire financial system. You don't want an unstable financial system. So to fix this problem of bank runs and panics, there have been kind of two fixes here. You have your lender of last resort in the Federal reserve and then probably more importantly, you have the notion of FDIC insurance. And in the last video, I talk about the idea that FDIC insurance-- the main negative I see-- it essentially gives all banks the same access to capital because they all say, hey, look give me your money. It's insured. So essentially it's a Federal subsidy for all banks. By definition the fact that the FDIC is about to be insolvent and will have to go back to Congress to ask for more money-- that means that it was undercharging for the insurance. So it was subsidizing these banks and since all of these banks have the same as the FDIC insurance and they're paying a slight different amount for them, what it leads to is, it encourages risk taking to essentially get more profits because all of the banks' borrowing costs are the same because when they take on more risk, people don't say, hey, you're a riskier bank. I need more money from you to give me your deposits. They'll say, no, I might be a riskier bank, but I'm FDIC insured just like that more conservative bank down the street. So I should be able to-- I'll just pay you a slightly higher deposit, just for giving me your business, but then I can go take big risks and it's essentially subsidized by the Federal government. But even here, you might say, hey, look, we've been-- the U.S. runs on a fractional reserve banking system and is clearly kind of the financial or the economic powerhouse of the world and those are both true. And obviously other modern countries are all based on on fractional reserve banking, so what's wrong with it? Maybe we have these weaknesses, but we've engineered away the problem. And the main-- I guess the best way to answer that question-- and I really don't want to-- I guess I want to make it very clear that when I started off thinking about this problem-- because I've gotten a lot of requests from people to think about the problem, I came at it from as neutral a position as possible. I said, I don't want to just say it's bad and be kind of this reactionary radical person, but the more you think about it, the more that you realize that there is something that just doesn't fit right here. For example, when you talk about any financial intermediary, what's it's purpose? Let me draw a financial intermediary right here. You have savers who like to put their money in a nice big vault someplace or maybe they would like it invested someplace, but they just don't know how to invest it or they don't have-- their money doesn't have the scale so it can be invested properly. And what the financial intermediary says is, hey savers, give me all of your money and I'll hire some really smart people to invest your money properly in good investments. So you have your savers on this side and then you have your projects or your investments on this side. They might loan out the money-- I'm speaking in very general terms. We're talking about a commercial bank or lending out the money. If you're talking about a venture capital fund, they're making direct investments in actual startup companies, but the idea for any financial intermediary is the same. For them to create value, they're taking the saver's money and they're putting it in investments that should generate some positive yield. So it'll generate some positive return if they invested right. And they'll give some fraction of that return back to the savers. And they'll keep some of that for themselves-- which you might say is reasonable. If they're doing this work and they're allocating this capital, they're providing a useful function for society. These people deserve to be wearing their Armani suits and and have their Rolex watches. I'll put deserve in quotation marks. But you can say they are adding value to our economy. Is fractional reserve banking a requirement to have financial intermediaries like this? And the simple answer is, no. You don't need fractional reserve banking to do this. In fact, many financial intermediaries in no way participate in a fractional reserve lending system. I guess the most obvious one is venture capitalists and regardless of what you think of them, they are not-- there's not some kind of-- they tell their investors, which are the equivalent of the depositors for a bank-- they tell them, look, you're going to have your money locked up for X years. Or they'll say, look, we'll take your money as we need it. Once we take our money, it's going to be locked up. That's also true of private equity funds. Some people consider venture capital a subset of private equity, but private equity more invests in companies that already exist. They do that-- and hedge funds, maybe they don't have a lockup for the most part. Some of them might actually tell you, look, we're going to lock your money up. So they're being very upfront with their investors. I don't want to defend them, but the ones that don't have a lockup, they'll invest in liquid instruments. Hedge funds-- this is a big group of people. Some of them are adding some value to society. Some of them aren't. Probably the great majority of them are just trading funds between each other in some type of a game, but I won't go into that debate. I won't try to defend all of the hedge fund world, but that the notion is that to be a financial intermediary, you're not dependent on fractional reserve banking-- even if you wanted to run a commercial bank. I could take deposits. So let's say you come to me. Let's say a bunch of people come to me. Let's say this is your deposit right here. This is your money. Let's say you have $100 right here. I could tell you, look, if you want money on demand, I'm not going to pay you any interest on that. For the service of you having access to it on your ATM and for it to be secure and all of that, I'm actually going to maybe charge you a little bit of money for on demand money and everything-- and if you want interest on your money, you have to give me your money for a certain period of time. So what you do is-- so you've given me your $100-- and you say, I would like to get some interest on my money. I'm a sophisticated investor. I'd like to participate in the miracles of capitalism. So let me tell you what. Out of this $100, I only need $10 on a daily basis to run my business or my household so I'm going to make this a demand account. So that would be just a checking account-- and for that I'll get no interest. I might even have to pay some money. Now the other part-- the longer you're willing to lock up your money for, I'm going to give you more interest in it. So this is $10 right here. Let'sw say, well, I might need some of my money in a year. So let me put the rest of it in for one year. We'll call that a one year CD, which exists already. For this, the bank will pay you 2% or maybe 3%. And then you said, the rest of the money-- this is long term retirement money and I'll put it in a 10 year CD and because I've locked it up longer, I'm going to get more interest. Maybe I'll get 5% for that. And now me, the commercial bank that's not participating in fractional reserve banking, can say, look, this guy has this $10 that he wants access to whenever and I'm not paying any interest on that. I'm just allowing him to use my financial infrastructure so I'm just going to put that aside. I'm just going to put it in my vaults and he can access that from his ATM or wherever, but this money out here, I can then lend this out. So if someone comes to me and say, hey Sal-- or Sal Bank-- I have this project and I want to be able to borrow-- let's say that this right here is $45. I need to borrow $45 for eight years. You say, sure. I don't have to give this guy his money back until 10 years from now. So what you do is you take that $45 and you loan it out-- which is fine because you know it's going to be back. As long as you're loaning it out properly, it should be back in time to pay this guy. And this guy knows that you're loaning out this money so he knows that there's some risk inherentness and he should do his homework before he buys this 10 year CD from you. He should see where you're loaning your money and how risky it is and if it's really risky, he should want more than 5%-- he should focus on the interest rate or he should just not give you his money. So the natural supply and demand and the natural feedback forces of capitalism would come into play. So you could completely run a financial system with banks and all sorts of financial intermediaries without fractional reserve banking. So now the next question is, OK. You can do without factional reserve banking, but what's really wrong about what fractional reserve banking is enabling? And for that I'll have to review the yield curve for you. So the yield curve-- it's nothing fancy. It's really just a graph showing how much interest you pay for different durations or how much interest you get. So let's say this is the yield curve. Let's say right here I have overnight money. So let's say this is if you give a loan for one day. This is if you give a loan for one year. And this is-- let's say you gave a loan for 10 years. And there could be all sorts of-- a duration is just how long you're giving the loan out for. Now, if you're lending money to the government, which you view as safe-- maybe the safest person to lend money to, then you can say, look, the government for one day-- I'm willing to lend money to them for 1%. For one year-- I'm locking it up-- maybe 2% and then for 10 years, I'm willing to lend it to them for 5%. The yield curve will look something like this. Doesn't always go upward sloping like that, but it tends to go upwards sloping like that. So that's the yield curve and this might be for treasuries. So one day, 1%, one year, maybe-- the way I drew it-- maybe this is 3%, maybe for 10 years, this would be 5%. This isn't the current yield curve, but you you get the idea. This would just be for treasuries, the safest borrower. Now for investment grade companies-- if I'm trying to lend money to them, maybe to a GE or someone like that-- or a Berkshire Hathaway, I'd want some premium over the treasuries because they're not as safe as the U.S. government, but it's going to have a curve similar to that. Maybe it looks like that, right? And this premium right here is essentially the amount of more interest you'd want from these still relatively safe companies. relative to treasuries, but you still have this upward sloping as you go up. And then, finally, you might have your really risky guys-- and every company will have its own yield curve based on its borrowing costs, but you might group a bunch of risky guys together and say, look, the risky guys-- the yield curve looks like that. If there's some guy who's looking to start some biotech firm and he wants to borrow money from them, I'm going to charge a much higher premium over treasuries because I don't even know if he's going to be around in five years. So this is just the yield curve and the whole reason why I drew this is to show how fractional reserve banking allows banks to essentially take advantage of the yield curve without really adding any true value to society. This notion of a financial intermediary does add value to society. When you have fractional reserve banking, what you're allowing banks to do is to take deposits and this-- fractional reserve banking isn't the only place where this happens. This happens a lot of places, but they take deposits-- and they're demand deposits, right? These are checking deposits, which are essentially loans from their depositors and they are essentially overnight loans, right? These are on demand loans. They're essentially-- when you give your money to a bank in a checking deposit, that's essentially every hour that you don't go and take your money back, they're essentially just renewing that loan. It's kind of the shortest possible duration loan. And every day you don't do it, it's just kind of a renewal of that loan, right? You could imagine a world where every year you renew a loan. Every year that you don't withdraw it, you just keep rolling it over. When you do on demand, it's every second that you don't withdraw it, you're renewing it. So they're able to borrow money at this part of the yield curve and they can do it very safely, pay very little interest, because people-- even though they might be doing risky activities. Maybe they're lending to people like this guy. Because of the FDIC insurance, people are lending to them like they're the government because they're going to get paid back if the government can pay them back. So it really lowers their borrowing costs, so they borrow down here and what it does is, it allows them to lend money over longer durations. So this could be a 10 year loan. So the money doesn't get paid back, only interest does in the interirm, but the money doesn't get paid back for 10 years. Maybe this right here is a five year loan. And they can do it to riskier investments. I mean, one, they could just borrow money here, which is what they're paying the depositors-- like 1%-- and then they could just invest it if they wanted to and if the yield curve looked like this, they could invest it in treasuries or maybe investment grade bonds, essentially lending to the Berkshire Hathaways of the world-- and getting a lot more interest. And what they did here-- it doesn't take any special genius to do this. Everyone knows that you'll get higher interest here than over here, but the only reason why they can do it this way is because they have this implicit guarantee-- actually it's an explicit guarantee-- from the FDIC. So this FDIC insurance is what allows people to lend them money. People are only willing to part with their money at this point of the yield curve because of the FDIC insurance. And then the bank can then go and invest at this point of the yield curve and then make the difference on the spread. They'll get 5% on the money and then only pay 1%. And where's the value here? Because I could do this, but I'm not an FDIC insured entity. Clearly these people would love to get 5% on their money, get that money that the bank's getting, but they don't get that insurance from the FDIC so it doesn't allow them to. So essentially what fractional reserve banking and the insurance that's come about to make fractional reserve lending viable-- all it does is it allows banks to arbitrage the yield curve-- to borrow money at the short end and lend it out in the long end, and make up the spread. And this is kind of a, one, that doesn't add any value. Anyone can do this. You don't need a a fancy MBA to figure this out. This doesn't add any true value to society. It actually just flattens out the yield curve a little bit, but we can debate about the value of that. But I want to kind of make a bigger point here-- is that obviously a lot of people in the banking system are kind of the champions of capitalism and unless they're being bailed out, they're the first ones to be against any form of government intervention or government safety net. But their whole industry is predicated on a government safety net. This notion of a financial intermediary that I outlined here and venture capitalists and private equity-- they still operate on this model right here. They are in no way dependent on the Federal government. I mean, some of them might end up being indirectly, but they don't need a whole elaborate system of FDIC insurance and the Federal and the discount window and all of these interventions that the Federal government does. They don't need that to operate efficiently-- or to operate in general. And even this banking system here, where you just had people get CDs instead of having this kind of halfway truth of fractional reserve lending-- this could completely operate without any government intervention. This system, on the other hand, fractional reserve lending-- it could not exist without government intervention. And so you have to you have to debate-- or I guess think in your mind-- some system like fractional reserve banking that is dependent on the government-- is this even capitalism? I mean, where is the competition here? Where is the innovation here? If you're big enough, you get your FDIC insurance and you just keep arbitraging the yield curve and you make money to buy your Rolex and your fancy trips in your private jets, but there's no innovation here. You're just big and you were one of the lucky ones to get a bank charter with the FDIC and be insured by them-- there's no innovation here. Where's the competition? If anything, the person who takes the most risk and who does the most silly things is going to be able to generate the highest yield and they have the subsidized insurance from the Federal government and so they're going to be the most successful. It's all dependent on government. It's all dependent on a subsidy. And in the end, this money that these people are making by arbitraging this, this is coming from a subsidy from the Federal government and it's coming from the taxpayer. So you essentially have the taxpayers subsidizing this world where people can just arbitrage this yield curve-- not take on real risk and make real investments and efficiently allocate capital, just arbitraging the yield curve with cheap insurance-- and you're essentially making a small percentage of the population-- being able to extract, essentially, rents or or some type of subsidy from the rest of the population. And obviously this isn't the part of our economic system that is the most in need. So I'm not saying this to kind of impugn the financial system. I think for the most part, people here, they're taking on risk and they're getting return and the savers here know what they're getting into, but there's no government intervention here. There's no implicit government subsidy. This whole thing is based on a government subsidy. Fractional reserve banking could not exist without the FDIC and the FDIC could not exist without the implicit backing that the Congress would make them solvent if they ever ran out of money, like is the case right now. Anyway, hopefully this informs your view a little bit more. I don't want to be some kind of crazy reactionary. I'm resigned to the fact that fractional reserve banking isn't going to go away, but it does bother me a little bit because it is completely dependent on government intervention. As you see right now over the past year, you have this whole financial system where we're piling more and more money into the very same entities that took on the most risk-- and essentially they have us at gunpoint. They're like, you better pour more money into us or else we're going to blow up because of the risk I took, but I'm going to take you down with me.