dilemma seems eternal, like the monetary dilemma, the tax dilemma,
and the marital dilemma. The essence of the banking dilemma, however,
is that the depositors’ money is not in the vault awaiting the depositors’
decision to withdraw it. Instead it is out on loan or invested in
the money market or in mortgage-backed securities.
of the money is in the vault or on deposit with the Federal Reserve
– these funds are called bank reserves – but only a few
cents of every dollar. Depending on the specific management, depositors,
and financial markets, the average bank may be prepared to accommodate
a sudden demand for repayment by a sizable minority of its depositors.
Almost no bank in modern times, however, has been able to accommodate
a sudden demand for repayment by a majority of its depositors.
Murray N. Rothbard,
the economist and libertarian philosopher, has a forcible view on
the institutions of fractional-reserve banking: it is "a giant
Ponzi scheme in which a few people can redeem their deposits only
because most depositors do not follow suit."
of the modern banking dilemma are new, notably the socialization
of credit risk during the Reagan years. It was decided that no money-center
bank would be allowed to fail and that no depositor, even a sophisticated
one, would be allowed to lose his money in a failure, if it could
possibly be helped. But other problems are cyclical and still others
are chronic. Reading up on the subject, one becomes fatalistic about
days, before the "too-big-to-fail" doctrine and other
modern banking improvements, national banks were bound to hold reserves
amounting to 25% of demand deposits. By our standards, this was
a lavish margin of safety, even if, as Rothbard notes, capital reserves
were often tied up in government bonds. ("[B]anks were induced
to monetize the public debt," he has written, "state governments
were encouraged to go into debt and government and bank inflation
were intimately linked.")
were reduced to 18% with the advent of the Federal Reserve System
in 1913 and stand at 12% today . Loans as a percentage of
assets are higher today than they used to be, however. And off-balance-sheet
liabilities – such as standby letters of credit, interest-rate
swap commitments, and futures-markets trading – are higher,
The rise in
the risks attached to banking prompts numerous questions about the
nature of lending and the credit cycle. How has the regulatory and
monetary climate of the 1980s affected bank lending? If, as seems
obvious, it has inflated it, what will be the consequences of it?
anything is new about banking in our epoch, it is the substitution
of federal guarantees for the liquidity of individual banks. It
is the policy that, in the case of the 11 or so largest banks, failure
will not be allowed and that, even in smaller institutions, depositors
will be protected. It is this regulatory sea change that distinguishes
the current debt expansion from so many earlier ones.
when weak banks suffered runs by public depositors, instead of seizure
by the Federal Deposit Insurance Corporation, a liquid balance sheet
constituted a competitive advantage. When James ("Sunshine
Jim") Stillman, National City’s dour chairman, correctly forewarned
his associates in early 1907 to prepare for a panic that fall, he
was able to anticipate a competitive silver lining:
me as most important is to go into next Autumn ridiculously strong
and liquid, and now is the time to begin and shape for it. If
by able and judicious management we have money to help our dealers
when trust companies have suspended, we will have all the business
we want for many years.
one’s institution is beyond failure, it hardly makes business sense
to build reserves against an unpredictable day of reckoning. What
it makes sense to do is lend, and so banks have lent.
has written a brief
ode in prose to the bank run:
It is a marvelously
effective weapon because (a) it is irresistible, since once it
gets going it cannot be stopped, and (b) it serves as a dramatic
device for calling everyone’s attention to the inherent unsoundness
and insolvency of fractional reserve banking.
Reserve Act of 1913 was hailed as a gift to the nation, in part
because it seemed to promise a run-free future. Because the reserve
banks would lend in times of crisis, commercial banks could afford
to become a little less liquid – a little more expansive –
in good times.
not work out exactly that way, and the 1930s saw a marathon of bank
runs. Rejecting conservative counsel, the Roosevelt administration
created the Federal Deposit Insurance Corporation to furnish still
more federal assurances to bankers and depositors. Over the next
several decades, the conviction took root that enlightened legislation
had eliminated the possibility of another national banking crisis.
has worked, and it hasn’t worked. There has been no great deflation,
no national bank holiday, and no prairie-fire run on the members
of the New York City Clearing House Association. On the other hand,
there has been the thrift snafu and the Third World crisis. Each
is an emblematic event, as each has lingered for years, not months,
and the cost of each is measured in the scores of billions of dollars,
nothing less. It is hard to imagine a free banking system getting
itself into scrapes like those in the first place.
on some of these trends some months ago was none other than the
Chairman of the Federal Reserve Board. Alan Greenspan delivered
an unusual speech at a remarkable time. The date was October 16,
1989, the Monday following Friday the 13th, and the audience was
the American Bankers Association. Greenspan proceeded to describe
the 150-year odyssey by which American banks have become more leveraged
and less liquid.
What was notable
was the chairman’s historical perspective (even if, for professional
reasons, he did not share Rothbard’s view that fractional-reserve
banking is a fraud). In banking and credit terms, Greenspan admitted,
the 20th century has been an age of relaxation. While not deploring
this trend, he did not ignore it either. "Although leverage
was important in the past, as now, the amount of leverage historically
was much less than we see today." Despite the addition of $14
billion in equity capital by national banks in 1988 and the first
half of 1989, "capital levels for the industry remain at the
low end of their broad historical range."
In other words,
by historical standards, the banks are loaned up. More than that,
they are stuffed (many of them) with loans that were once considered
inappropriate for the balance sheet of a commercial lending institution.
The most prevalent specimen of this class of dubious assets is loans
against speculative commercial real estate. As banks withdrew from
business lending, they turned to property.
Robert L. Clarke, comptroller of the currency, adopts a non-Rothbardian
worldview. He recently testified that
banking system is fundamentally sound. That conclusion is based
on a substantial increase in capital levels, especially equity
capital levels, relatively strong earnings, and an improvement
in overall credit quality among the majority of national banks
during the past 18 months.
rejects Professor Rothbard’s theory that a run-resistant, semisocialized,
fractional-reserve banking system is a house of cards.
What has been
lacking in American banking in recent years is the bank run. And
when it has not been lacking – as in the rescue of Continental
Illinois in 1984 – it has been frightening. With the wholesale
substitution of federal promises, actual or implied, for conservative
banking practices, the caliber of lending has inevitably suffered.
Sunshine Jim Stillman, were he to return to Wall Street for a day,
would very probably wish that he hadn’t.
Is the banking
dilemma eternal? It doesn’t have to be. We could desocialize credit
risk and let the bank runs take their toll. Absent federal meddling,
the bottom line would be simplicity itself. The proof that banks
have created excess credit would be found in the action of markets.
It would be a fascinating picture if not a pretty one.