If the world wants a solution to instilling public confidence in its universally insolvent banks, it should turn to the lecture notes of Robert J. “Bo” Sudderth and a history of Chattanooga banking. In 1992 Mr. Sudderth recalled a ruse by American Trust & Banking Co., founded by Harry Probasco in 1911. ‡ During the Depression, money and credit were scarce, and many banks, faced with panic withdrawals, went down in flames, taking their depositors’ life savings with them.
American Trust’s Scott Probasco and D.H Griswold came up with a “unique solution” to panics, according to the Chattanooga News-Free Press. “They put $3 million [sic] from the bank vault on public display — stacking it in neat rows behind the tellers’ cages where it was watched over by rifle-toting guards. Their theory: ‘If people see their money is here, they won’t want it.’ It worked. The great piles of greenbacks looked like ‘all the money in the cash-starved world — and any lingering doubts about liquidity were promptly resolved in the bank’s favor.”
Now, as then, banks operate on the basis of a fractional reserve. Theirs is only a show of solvency, a media event, a stage act. They do not have reserves of 100 percent, and cannot pay off all depositors. So they rely on projections of an image of serene strength, vaulted wealth and generosity. A 100 percent ratio is unprofitable, would require a change of their hallowed business model. But a 10 percent or a 0.05 percent ratio allows for flexibility and new credit — “economic growth,” as it’s hailed in the newspapers. The smaller the ratio, the less stable the company. The less stable the company, the nearer the caring embrace of Uncle Sam and his caretaker. The nearer that bear hug, the more difficult the rise of local economy.
Dr. Ron Paul
Last week my subcommittee held a hearing on fractional reserve banking and the moral hazard created by government (taxpayer) insured deposits.
Fractional reserve banking is the practice by which banks accept deposits but only keep a fraction of those deposits on hand at any time. In practice, nearly 100% of deposits are loaned out, yet depositors believe that they can withdraw the full amount of their deposit at any time. Loaned funds are then redeposited and reloaned up to the limit of the bank’s reserve requirements, compounding the effect.
As Murray Rothbard put it,
Fractional reserve banks … create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.
While mainstream economists extol this “money multiplier” as a nearly miraculous process that results in a robust economy, low reserve requirements actually enable banks to create trillions of dollars of credit out of thin air, a process that distorts the structure of production and gives rise to the business cycle.
Once the boom phase of the business cycle has run its course and the bust commences, some people will naturally look to hold cash. So they withdraw money from their bank accounts in order to hold physical currency. But bank deposits consist of a huge amount of credit pyramided on top of a small of amount of original cash deposits. Each dollar of cash that is withdrawn unwinds the multiplier, resulting in a contraction in credit.
And if depositors en masse attempt to withdraw more funds than are available in reserves, the entire of house of cards comes crashing down. This is the very real threat facing some European banks today.
Since the amount of deposits always exceeds the amount of reserves, it is obvious that fractional reserve banks cannot possibly pay all of their depositors on demand as they promise — thus making these banks functionally insolvent. While the likelihood of all depositors pulling their money out at once is relatively rare, bank runs periodically do occur. The only reason banks are able to survive such occurrences is because of the government subsidy known as deposit insurance, which was intended to backstop the stability of the banking system and prevent bank runs. While deposit insurance arguably has succeeded in reducing the number and severity of bank runs, deposit insurance is still an explicit bailout guarantee. It thereby creates a moral hazard by encouraging bank deposits into fundamentally unsound financial institutions and contributes to instability in the financial system. ‡‡
The solution to the problem of financial instability is to establish a truly free-market banking system. Banks should no longer have a government backstop of any sort in the event of failure. Banks, like every other business, should have to face the specter of market regulation. Those banks which engage in sound business practices, keep adequate reserves on hand, and gain the confidence of their customers will survive, while others fall by the wayside.
Banking, like any other financial activity, is not without risk — and the government should not continue its vain and futile pursuit of trying to eliminate risk. Get government out of the way and allow the market to function. This will result in a more stable system that meets the needs of consumers, borrowers, and investors.
‡ This bank obtained a national charter in 1948 and changed its name to American National Bank & Trust Co.
‡‡ The bite of a bank failure goes two ways, against the depositors and against the borrowers. When Tennessee bank Hohenwald Bank & Trust Co. collapsed in 1982, it created a disaster for retail businesswoman Carol A. Halbrooks, who was dunned by the FDIC for immediate repayment of her debt. “What the news didn’t tell us was that when a bank goes under, the FDIC has the job of collecting all outstanding loans, as quickly as possible. Notes that were set up on a repayment schedule were safe the time was granted to the borrower to repay it. But short-term notes were called due and payable at once. I was one of the unlucky people. I had a term note. My business checking account was applied toward the note, without my permission, and I was left without any working capital in a dead economy. *** I was forced to sell my inventory at half the wholesale cost to my competition in the next town.” “It can happen here,” Newsweek, Nov. 26, 1990
Sources; Lewrockwell.com (our favorite website)
“At The History Museum: The Banking Probascos,” Lin Parker, Chattanooga News-Free Press, Sept. 22, 1992