Why Banking is an Illegitimate Business

Wyatt Investment Research

In the old days, say a decade ago, we could look forward to a bank-driven economic meltdown every five to seven years. Today, the interval has been reduced to every five to seven weeks. It's like Moore's Law (microchip performance doubles every two years or so) in some perverse alternative universe. 

Whenever I read stories on the dire straits of banking (a daily occurrence) in Cyprus, Spain, Italy or even in our own United States, either Einstein's quote on insanity comes to mind – doing the same thing over and over again and expecting different results – or the plot line in the movie Groundhog Day.

Banks everywhere are destined to screw up, screw up repeatedly and screw up on a monumental, crisis-inducing scale. As the patient lies prostrate and prone, triage – the central bankers – arrive to stem the hemorrhaging of money, re-liquidate the patient, and after a period of recovery send him on his merry way.

And by simply sending the patient on his merry way, we are thus assured another screw-up is just over the horizon. After all, it took JPMorgan Chase (JPM) only a couple of years to lose a few billion dollars on a “risk-management” trade that went sour. So much for contrition … and so much for lessons learned. 

Banking, as I'm sure you know, is unlike any other business. First, no other business is so dependent on confidence. Central bankers and government regulators will frequently parrot the need to perpetuate confidence. They parrot for good reason: no other business can bring an economy to its knees if confidence is lost. 

Banking is unlike any other business in another way: Banks can lend what they don't have. 

I say this because banks are permitted to engage in fractional-reserve lending, where only a fraction of a bank's demand deposits are kept in reserve, while the deposits themselves can be lent at a multiple much higher than one.

This nifty benefit allows banks to create money out of thin air, as I'll explain by way of example.

You find $100 in an old jacket pocket. You take your found money to your bank and deposit it in your checking account. In doing so, you've given your bank a profit opportunity. With a 10% reserve requirement, your bank has the ability to create up to $900 in new loans on your deposit.

Let's say the bank makes a $900 new loan. This new money didn't "come from" anywhere; it existed as soon as the bank changed the numbers on the ledger. The borrower went from having no money in his checking account to having $900 with a few keystrokes.

Fractional reserve banking expands credit, and therefore expands the money supply (demand deposits and cash). The broad money supply (deposits created via loan issuance plus cash) is a much larger multiple than the amount of "real" paper currency created by the central bank.

To be sure, the money supply is reduced when the $900 loan is repaid, but the bank earned interest on $900 instead of your original $100. (In a full-reserve banking system, you'd forfeit use of your money for the duration of the loan, and only the $100 could be lent.)

You might see where confidence is essential to fractional-reserve banking. You've deposited $100 in your bank. At the same time, a borrower has use of the $900 pyramided on your deposit. If enough $900 loans go bad and depositors lose confidence, bank runs ensue for money that doesn't cover all deposits, and the whole edifice collapses. 

Cyprus provides a valuable wake-up call to not only the dangers inherent in fractional-reserve banking but to the dangers of putting your full faith in political operatives. In Cyprus, deposits above 100,000 euros in the two principal banks – state-owned Cyprus Popular Bank and the Bank of Cyprus – will be frozen and used to resolve the former bank's outstanding debt and to recapitalize the latter bank.

The lesson is that once the equity and debt capital is exhausted, deposits are in line to settle the deficits. Cyprus' larger depositors are expected to lose at least 40% of their deposits. 

With that said, fractional-reserve banking doesn't prove banking is illegitimate. The illegitimacy is derived from government and central bank support, both of which promote moral hazard and reckless business practices (i.e. leveraged proprietary trading, unsound lending, etc.)

If banks were completely private with no federal guarantees and no central bank backup, bankers would be motivated to be more cautious in their lending and trading. Depositors, in turn, would be equally vigilant to monitor the banks that held their money.

To make banking a legitimate business, the Federal Reserve's role as lender of last resort must be abolished. Private bankers could easily take over the Fed's clearinghouse functions. As for serving as lender of last resort, these private bankers would offer their services only to banks with solid balance sheets that are merely experiencing a temporary cash shortfall.

Deposit insurance should be similarly privatized. Either the bank, as a service, or the depositor would buy insurance from private insurers. The insurance companies would monitor the bank's risk, and charge premiums accordingly.

For banks to become legitimate businesses and return to their original role as worthy financial intermediaries, bankers, their investors and their depositors must be willing to bear all the risk associated with fractional-reserve banking. 

Unless my recommendation occurs in the near future, I expect we will be discussing Greek, Italian and Spanish banks six weeks hence like we are discussing Cyprus banks today. Either that, or a large U.S. bank will have made the wrong directional bet attempting to “manage risk” only to post another multi-billion dollar loss.

Given my views on banking, you probably understand why there aren't any in the High Yield Wealth portfolio.



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