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.