The Banking System at the Root of the Crisis

by Lydia Prieg originally published at the New Left Project

The eurozone crisis is once again dominating the headlines following the €100 billion bailout of Spain’s banking system over the weekend. The Spanish crisis perfectly illustrates not the financial irresponsibility of the feckless South – a popular misconception, particularly among the German public – but instead the inherent instability of a financial model, fractional reserve banking, which has been enthusiastically adopted around the globe.

Fractional reserve banking is a system in which the value of all the deposits and savings reportedly ‘held’ in a bank exceeds the value of all the cash actually held in that bank. This is because banks lend out more money than they have in their vaults  — an activity that relies on the assumption that only a small percentage of the public will request their money back at any one time. 

While many people are aware of fractional reserve banking, very few realise that it has a critical implication: banks can and do create new money. In fact, approximately 3% of the money in the UK economy is created by the Bank of England and the Royal Mint. The other 97% is created electronically by banks.

As the Deputy Governor of the Bank England puts it: “banks extend credit by creating money”. In other words, banks create new money when they lend, and the amount of money in our economy is therefore very strongly determined by banks’ lending decisions.

If banks lend more, then the amount of money in the economy increases, which can lead to an economic boom. Conversely, if banks stop lending, then the rate at which new money enters the economy slows, and the economy may fall into a recession.

Banks also have direct control over which parts of the economy get this new money.

Unsurprisingly, they have directed it into the types of lending that are most profitable from their perspective, such as mortgage lending. Banks favour this type of lending because the bank can take possession of a house if a borrower defaults on their loan repayments. International banking regulation further incentivises mortgage lending, as it mandates that banks must hold less capital aside against mortgages (to help cushion the blow from unexpected losses) than against business loans. (Holding capital aside is expensive, because it means that it cannot be invested elsewhere.)

Thus, banks are inclined to withhold funds from productive lending, and instead direct loans, and thus new money, towards speculation, which reinforces  bubbles in housing and other asset markets.

This is exactly what happened in Spain, where banks funnelled enormous amounts of new money into the property market, causing a bubble that later burst. These bad debts associated with the collapse of the Spanish property market are so substantial that they now threaten the solvency not just of the banking sector, but also of the entire Spanish economy and, by extension, the rest of the Eurozone.

In addition to poorly directing new money in an economy, fractional reserve banking is also inherently unstable as the public and institutional lenders may suffer a collective loss of faith in a bank, and all withdraw their money at the same time. But there isn’t actually enough money in a bank to pay everyone back at once, so confidence in the bank will collapse. This  will encourage more people to rush and withdraw their money. And so on and so forth, until, much like a Ponzi scheme, the system collapses.

Spain and Greece are both currently suffering from such bank ‘runs’, and the European community is frantically trying to diffuse the panic before the system unravels completely.

Deposit insurance schemes, whereby deposits and savings in banks are protected up to a certain point, are typically put in place to help ease concerns about the solvency of banks, and so reduce the likelihood of bank runs occurring. Such schemes are often theoretically funded by the banking industry; however, the reality is that they are often also underwritten by the state. For example, during the recent financial crisis, the UK government was forced to bail out the UK’s deposit insurance scheme to the tune of £19 billion.

Such state subsidised deposit insurance schemes mean two things:

(1) Banks are able to offer depositors a very low interest rate, as the public knows that, regardless of how a bank invests its money, deposits are essentially risk-free. This gives banks a large financial boost.

(2) Banks do not need to worry about depositors becoming concerned about the level of risk that a bank is taking on. So deposit insurance encourages banks to take on more risk than they would do in a truly free market. This is called ‘moral hazard’.

In the case of Spain and Greece, where the solvency of the governments themselves are in question, such national deposit insurance schemes have proven to be unable to halt the panic. Many people are now calling for a collective European deposit insurance scheme, and argue that nothing else can restore confidence in beleaguered Spanish and Greek banks.

So what’s the alternative?  The New Economics Foundation would instead prefer to see a move away from this inherently unstable financial structure. The crucial point is that the existing system is not inevitable, but a matter of choice. Systems for creating and managing a nation’s money supply has varied over time and various alternatives to the current system have been proposed.

For example, in a full reserve banking system, funds that the public want to be 100 per cent safe could be kept in banks for safe keeping (in exchange for a fee, obviously) and not lent out. This would render distortive subsidies, such as deposit insurance, obsolete. In full reserve banking, separate institutions would exist where the public could deposit funds that they are happy to be lent out. An individual could decide what level of risk they are happy to take on, and would be compensated with an appropriate level of interest. It would not be guaranteed that they would get all their money back.

Under such a system, banks would be lending out money that has been deposited with them, which is what most people believe banks currently do. They would no longer be creating new money when lending; they would finally be true ‘intermediaries’, as they are currently incorrectly perceived to be.

Let’s stop pussyfooting around with the banks. And, perhaps more importantly, let’s remember that the soaring government debt in Spain is a result of a banking crisis. The collapse of the bank-created property bubble led to a recession, higher unemployment, greater demand for benefits, and reduced tax revenues. However much the right would like to rebrand it as such, the Eurozone crisis is not the product of government spending run amok.  It’s time to take on the real culprit: fractional reserve banking.

Lydia Prieg is a senior finance researcher at the New Economics Foundation.


One response to “The Banking System at the Root of the Crisis

  1. Pingback: 121116 – New Taxes Coming | The Hyper Report·

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