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Weaknesses of fractional reserve lending

Video transcript

what we're going to talk about in this video are the negatives the negatives of fractional reserve lending and the biggest negative of fractional reserve lending and these are all related is that it's fundamentally unstable unless you have a lot of engineering on the part of central banks and governments to make it more stable but there are kind of unnatural engineering unnatural things have to be put in place in order to make it stable and the reason why I say it's unstable is because all of these depositors have been promised that their money is safe and sound that it's being that at any point they can come to the bank and get their money it's on demand but a good fraction of that money is being lent out and you can imagine let's say that all of these banks are lending out the money responsibly but let's say this Bank something shady happens it lends out money in a really bad way and it doesn't get it back or maybe it's even worse maybe there's some type of fraud taking place where executives were embezzling money or whatever these are good actors within a fractional reserve lending system this is a bad actor it made a bad loan and now all of a sudden this money is gone if you don't have any support from central banks or from governments now all of these customers are going to say wait I heard something shady happened at this Bank and they're all going to show up at this Bank they're going to show up at this Bank all on the same day and they're going to say give us back our money and then it'll be pretty clear that their money actually was not available that it was lent out some of it was lost and so they will be very upset these people right over here and it's not just bad for this bank it's not just bad for this Bank and this Bank might have it doesn't even have to be that this Bank actually did anything fundamentally bad if even rumors start to spread that something at this Bank is a little bit fishy you can imagine every one of these banks customers showing up when that news report hits and says give us back our money and they'll say well I can give you back 10% of your money the other 90% has been lent out and that won't just affect this Bank because as soon as these people try to go get their money and they're not able to see it then the rest of the economy all the other actors in it will say wow the banking system isn't as solid as I thought it was and so all of these other banks and maybe there wasn't any news report written about them and they didn't do anything shady all of their customers going to start showing up and they're going to say well you promised me that my money is available on demand well I'm demanding it right now and of course they're not going to be able to get it because their money their money was being lent out it's a situation that you have right here is called a run on banks because you know manx lent out 90% of the money and so really people cannot get access to it and so you can imagine this is a very very very bad situation you can have major bank failures a lot of lending starts to be the whole banking system essentially has to unwind in some way and you'd probably would probably throw the economy as a whole into something of a into something of a of a of a downward spiral and so the way that governments attempt to address this issue is that they say in particular it's usually the central bank because it's say okay we will insure banks and that's why you'll often see at the front door of a bank you'll see FDIC which means Federal Deposit Insurance Corporation which means that the Federal Reserve is insuring that bank so for whatever reason it's usually up to some amount of deposits if one of these scenarios happens and the bank does not have the money on hand the Federal Reserve will say okay you know what we'll just we'll just make sure we'll just make sure that you have the money and it's not an easy process it takes some time but eventually the Federal Reserve will give them the money but that by itself creates another problem so that creates really the second problem is bad bad incentive or non-market non-market I would say discipline bad incentives because in a traditional system if I was giving my money to someone and they were going to go and lend it to someone else I would really care how they're lending that money I would really care how they're managing their business I would really kind of want transparency in terms of what investments they're making how safe they are etc etc but in a situation where all of the banks have this FDIC insurance they essentially are they essentially are backstopped by the government now all of a sudden when customers go to the bank they're like you know what I really don't care what you do with my money I know that you have FDIC banking so all I really care about is if you if you have you know cute kittens on your checkbooks and you have a lot of ATMs have very impressive looking buildings and they really wouldn't scrutinize the financials so you don't have that market incentive anymore for banks to say hey look we are good shepherds of your money look at where your assets are being spent we want the market to scrutinize us on to whether we are making good loans or we are making bad loans the third problem the third problem of fractional reserve lending is that because of fractional reserve lending you're giving the private banking system a good deal of control over the money supply if they lend more so lending lending translates into into more money in the money supply or the other way around if lending were to go away that would mean contraction of money in the lending supply and the problem with this is is when the economy is weak when you have a let's say you have a recession when you have a recession standard monetary policy arguments you would say well you want to increase the money supply maybe you want to lower interest rates so that people will borrow and start to consume or invest again so you want during a recession you want more money but what's going to happen and the central bank tends to do that when they when it is clear that it's in a recession the central bank will attempt to print more money but a fractional reserve lending system that's only part of the money supply equation you also have the lending and when you're in a recession lending lending cut goes back so this is what you want so you want this and the central bank might do it that is what you want but the reality is in a recession the banks are going to get scared they're going to see a lot of their loans going bad you're going to have less lending less lending and that's going to essentially have the exact opposite effect of what you want you're going to have less less and I should put money in quotes because it depends how you define money but you have less money in circulation and the opposite happens in the boom so the economy is down and out in a recession that's going to be even worse when that lending dries up there's going to be even less money in circulation it's going to be even harder for people to get access to capital and the opposite true is in a boom in a boom and I'm running out of real estate on my screen in a boom when the economy is maybe is well heated or maybe overheating as central bank will start saying hey let me take a little bit of that fuel out of the fire so what you want what you want is less money less money in a central bank might do that by taking securities it owns selling it in the open market and then it takes that cash and it could even discontinue that cash but then and that's what a central bank would so the central bank could actually act on this but when a boom the banks get even more confident they get less risk-averse or their start understanding the risk and so the reality is you have more lending you have more lending so it essentially puts more fuel which is more money more money in the system and essentially adding more fuels to the flame of an economy that is already getting overheated so a lot of times this fractional reserve lending might create might lead to the money creation process going in the exact opposite direction of that you wanted to go if you really wanted to moderate the fluctuations in the economy