FRB commentary 3: Big picture

my motivation for doing this series of three or four videos on the fractional 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 don't 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 it's kind of you know banks around the world now use the system but we have to realize that this is a system a structure that's been in a place in 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 is at least it would make them uncomfortable is just this disingenuous nature of fractional reserve practice ingenuously 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 a little uncomfortable but that by itself isn't a whole reason to to say that a system is bad but the more severe problem is 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 on an hours notice but the reality is that everyone can't get all of their money back on an hours 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 and which is of course a very unstable situation for your entire financial system you don't want an unstable financial system unstable financial system 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 lender of last resort in the Federal Reserve of last resort and then probably more importantly you have the notion of FDIC insurance FDIC insurance and in the last video I talked about the idea that FDIC insurance the main negative I see it it essentially gives all banks the same access to capital because they all say hey look give me your money and it's insured so essentially it's a federal subsidy federal subsidy for all banks for all banks I mean by definition the fact that the FDIC is about to be insolvent will have to go back to Congress to ask for more money that means that it was under charging for the insurance so it was subsidizing these banks and since all of these banks have the same FDIC insurance and they're paying a slight different amount for them what it leads to is encourages risk-taking it encourages risk-taking risk-taking to essentially get more profits more profits because all of the bank's 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 deposit they say hey no I might be a reformer secure 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 the 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 you know the u.s. runs on a fractional reserve banking system and it's 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 you know 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 for people to think about the problem I came of it I came at it as as from as neutral a position as possible you know I said you know 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 it there is something that just doesn't fit right here when you talk about any financial intermediary what's its purpose let me draw a financial intermediary right here financial intermediary you have savers you have savers who like to put their money in a nice big vault some place 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 to have the scale so it can be invested properly and what the financial intermediary says 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 you have your investments they're essentially they might loan out the money as if it's you know I'm speaking very general terms and 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 savers money and they're putting it investments that should generate some positive yield so it'll generate some positive return if they invested right so some positive return and they'll give some fraction of that return back to the savers so they'll give some fraction of that return back to the savers and they'll keep some of them for themselves which is you know 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 so this right here is a useful function for society and these people deserve to be wearing their Armani suits and and have their rowlock Rolex watches output deserve and quotation marks but you can say they are adding value to our economy now what it will does is 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 and in no way participate in the fractional reserve lending system I guess the most obvious one is venture capitalists regardless of what you think of them capitalists they are not there's not some kind of they tell there 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 you're going to have your money locked up for you know X years or they'll say look we'll take your money as we need it once we take your money is going to be locked up that's also through private equity funds some people consider a venture capitalist subset of private equity but private equity more invest in companies that already exist they do that and hedge funds maybe they don't have a lock-up hedge funds 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 up front with their investors you know and I don't want to defend them but you know on the ones that don't have a lock-up they'll invest in liquid instruments they invest in liquid instruments and I don't you know 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 you this to be a financial intermediary you do you're not dependent on fractional reserve banking even if you had a 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 this right here is $100 I could tell you look if you give if you want money on demand I'm not going to 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 secured 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 you've given me your $100 just like that and you say you know what I would like to get some interest on my money I I'm a sophisticated investor I'd like to participate in the miracles of capitalism so let me tell you what I only need out of this hundred dollars I'm ten dollars 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 no interest I might even have to pay some money now the other part the more the longer I'm willing to lock up my money for I'm going to I'm going to give the more that you're willing to lock up your money for I'm going to give you more interest in so let's say that you other so this is ten dollars right here let's say well I might need some of my money in a year so let me put the rest of it in for one year so we'll call that one year CD which exists already the one year CD and for this the bank will pay you two percent or you know maybe maybe three percent and then you said you know the rest of the money this is long-term retirement money and I'll put it in a ten year CD ten your CD and because I've locked it up longer I'm going to get more interest maybe I'll get five percent for that and now me the commercial bank that's not participating in fractional reserve banking can say look this guy has this ten dollars 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 blend borrow you know let's say that this right here is let's say this is right here is $45 I need to borrow $45 for eight years they say sure you know I don't have to give this guy his money back until ten years from now so what you do is you take that $45 and you loaned 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 inherent this and he should do his homework before he buys this ten-year CD from you he should see where you're loaning your money and how risky it is and if it's not if it's really risky he should want more than 5% you should focus on the interest rate or he should just not give you his money so the the natural supply and demand and kind of the natural forces feedback forces of capitalism would come into play so you can completely run a financial system with banks and and and all sorts of financial intermediaries without fractional reserve banking so now the next question is ok you can do it without fractional reserve banking but what is the real what is the real what 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 what people are 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 say this give you give 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 as safe maybe it may be 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 one percent for one year I'm you know I'm locking it up maybe it's 2 percent and then for 10 years I'm willing to lend it to them for 5 percent so this is the yield curve will look something like this actually let me just draw it like this the yield curve tends to look something like that doesn't always go upward sloping like that but it tends to go upward sloping like that so that's the yield curve and this might be for this might be for Treasuries that's for Treasuries right there so one day to one percent one year maybe the way I drew it maybe this is like three percent made for 10 years this would be like 5 percent this isn't the current yield curve but you get the idea and this would just be for Treasuries to risk it the 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 our Berkshire Hathaway I'd want some premium over the Treasuries because they're not as safe as the US government but it's going to have a curve similar to that maybe it looks like that alright and this premium right here is essentially the amount of more interest you would want from these still relatively safe companies relative to Treasuries but you 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 cost but you might group a bunch of risky guys together and you say look the risky guys the yield curve looks like this that you know if there's some guy who's looking to start some new biotech firm and he wants to borrow money from him I'm gonna charge a much higher premium over Treasuries because I don't even know if he's going to be around in let's say this is you know in five years so because 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 you know fractional reserve banking isn't the only place where this happens this happens a lot of places but they take deposits and their 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 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 are essentially just renewing that loan it's a continuous on this kind of the shortest possible duration loan and every day you don't do it is just kind of a renewal of that loan right you could imagine a world where every year you Rin you alone every year that you don't withdraw it you just keep pulling 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 they 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 be paid them back so it really lowers their borrowing cost so they borrow down here and what it does is it allows them it allows them to lend money 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 interim but the money doesn't get paid back for 10 years maybe this right here is a 5 year loan and they can do it two more two riskier investments I mean one they could just 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 want to do it if the yield curve look like this they could invest it in Treasuries or maybe investment grade bonds essentially lending to you know the Berkshire Hathaway's of the world and getting a lot more interest but 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 then 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 from the FDIC so this FDIC insurance is what allows people to lend the 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 is the value here because I could do this but I don't I'm not an FDIC insured entity you know 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 it's really all it does is it allows banks to arbitrage the yield curve to borrow money at the short end and lend it out at the long end and make and make up the spread and this is kind of a you know one that doesn't add any value anyone can do this you don't need a fancy MVA to figure this out this doesn't add any true value to the site it actually just flattens out the yield curve a little bit but that you know 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 I'll even write it down here champions champions of capitalism you know and they they unless they're being bailed out they're the first ones to be against any form of government and intervention or government safety net but their whole industry the whole industry is predicated on a government safety net this notion of a financial intermediary that I outlined here with venture capitalists and private equity and they 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 and you can even or to operate in general and then even this banking system here where you just had people get CDs instead of having this kind of halfway truth of fractional reserve vending this could completely operate without any government intervention this system on the other hand fractional reserve lending it could not exist without government intervention it could not exist without government intervention and so you have to you have to debate or I guess you know think in your mind some system like fractional reserve lending or banking that is dependent is dependent on the government is this even capitalism 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 arbitrage in the yield curve and you make money to buy your Rolex and and your you know your fancy trips and 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 and be insured by there's no innovation here and 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 this money that they're making by arbitrage in this this is coming from a subsidy from the federal government is 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 if ashlee allocate capital just arbitrary just arbitrage in the yield curve with cheap insurance and you're essentially making a small percentage of the 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 of our economic system that is the most in need so I'm not saying this to kind of impune the financial system I think for the most part people here they're taking on risk and they're getting returned and you know 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 bank backing of the 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 you know a crazy reactionary I've kind of resigned to the fact I'm resigned to the fact that you know fractional reserve banking isn't going to go away but it does bother me a little bit because it is it is completely dependent on government intervention as you see right now over the past year you have this whole financial system where where we're piling more and more money into the very same entities that took on the most risk and essentially they have us they're you know they have a set gun point they're like you better pour more money into us or else we're going to blow up because of the risks I took but I'm going to take you down with me