Mike Shedlock

Reader "Nate" noted that Bloomberg columnist Megan McArdle stated that banning Fractional Reserve banking won't work.

Nate asked "What would a future without fractional-reserve banking look like?"

Let's start with a look at Megan McArdle's article: Banking Without Risk Is Impossible.

The fundamental fact of a banking crisis, which is different from a crisis in any other industry, is that if people believe a financial institution to be bankrupt, it actually is bankrupt.

As Arnold Kling puts it, banks exist to reconcile the desire of households to lend short and borrow long -- we want to have bank accounts we can empty at any time we want, but we want mortgage loans that carry fixed payments and last for decades.

This creates a vulnerability at the heart of modern banks: If too many depositors try to turn their bank accounts into cash at the same time, the bank will be insolvent, because it cannot liquidate the mortgages fast enough to pay the depositors. And when are you most likely to get a flood of people trying to empty their accounts? When they think the bank is insolvent.

So why not build a banking system where this can’t happen? Well, alright. How shall we do that? Are we going to forbid the structure of modern banks (“fractional reserve banking,” for those who are interested in the technical term).

Leave aside the irony that outlawing a practice engaged in by millions of upstanding Americans is not, at first blush, a particularly libertarian solution.

I’ve heard arguments that you could fix this by allowing banks to freeze withdrawals in the event of a liquidity crisis. But I’m unpersuaded because during the Great Depression many places did freeze withdrawals. ....

Mike Shedlock

Mike Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management.