You Call That Bank Reform?

Writing at the New Republic Alex Shephard bemoans Democrats’ reaction to the banking reform bill working its way through Congress:

The 17 Democrats who voted for the bill to proceed on Tuesday are either centrists or facing reelection in states that Donald Trump won in 2016. They have defended the bill on the merits, arguing that it will free up credit in rural areas and that it’s an overdue fix for Dodd-Frank’s flaws. There is also a sense among Democrats that this may very well be the best deal they can get on Dodd-Frank reform. But it’s also clear that they’re supporting the bill for performative reasons, hoping to show voters back home that Congress can do more than just bicker and that Democrats are willing to work with Republicans to get things done. “This is old-school legislating,” North Dakota Democrat Heidi Heitkamp told Politico.

But it’s not old-school legislating, not really. If it were, Democrats would participate in a give-and-take with Republicans. There would be parts of the bill that they could point to as significant Democratic wins. But as it stands, the bill is a giveaway to the banking industry in which consumers get very little. Even though it may be easier for some consumers to get loans, that comes with the tradeoff of a weakened financial regulatory system and fewer consumer protections.

Nothing in the bill bears any resemblance to my idea of the sort of reform that’s needed. If I were king I’d split up the big banks (including the investment banks), ban branch banking, and prohibit state-owned banks from doing business in the United States. But that’s just me.

I don’t think that fractional reserve lending is necessarily a problem. Size is the enemy not fractional reserve banking.

13 comments… add one
  • PD Shaw

    How does he know the Democrats didn’t have input in the bill? The bill has at least 12 Democratic co-sponsors. And its easy to see why Democrats outside of the major metros would favor relaxing requirements on smaller banks.

    And Democratic pundits should probably distance themselves from Elizabeth Warren, who “accused her colleagues of backing the legislation because of years of sustained bank lobbying in the wake of Dodd-Frank’s enactment.” She often sounds like the left’s version of Ted Cruz.

  • PD Shaw

    I have no idea whether the legislation is good or not, but an element of prairie populism always involved distrust of banks from New York City, not banks in general. They believed capitol flows were being controlled by people unfamiliar with local realities and federal banking rules favored or assumed the centrality of NYC. A bill that relaxes Dodd-Frank for smaller banks might just be broadly popular with Democrats in flyover country.

  • Bob Sykes

    Fractional reserve banking is how banks make money and stay in business. Without it, banks are impossible. In their place you would have mere depositories where you paid a fee for them to store your money. Very Medieval.

  • I’m aware that some of my readers disapprove of fractional reserve banking. I don’t agree. As I observed in the post I don’t think it’s a problem per se. I think there’s a problem when big banks are empowered to take extra risks because they’re confident that their mistakes will be underwritten by the federal government.

  • TastyBits

    In full reserve lending, depositor’s money is what is lent, and a bank cannot lend anymore money than has been deposited. Depositor’s are paid interest for the use of their money as loans.

    With fractional reserve lending, depositor’s money is the fraction that is kept in reserve, and a bank lends a multiple of the money that has been deposited. Depositor’s are paid interest for the use of their money as leverage. Money is lent into existence.

    (In reality, banks have capital requirements they must meet, and the reserves are lent to other banks.)

    Government backed fractional reserve lending is like morphine. It is addictive, and without sound banking regulations, it will always result in ‘too big to fail’.

  • TastyBits

    @Dave Schuler

    … underwritten by the federal government.

    There is no way to avoid this. The monetary system is backed by the financial system, and because the government is responsible for the monetary system, it is necessarily responsible for the financial system.

    The only way to mitigate the problems of fractional reserve lending is by separating commercial lending and investing. Since money is created through lending, commercial banks need to be strictly regulated, and investment banks need to be lightly regulated.

    Blah, blah, blah … Everybody knows where this is going.

  • In reaction to the financial crisis the federal government bailed out the big banks while sacrificing many small ones. The lesson is clear: when you’re a big bank you can do anything. The underlying message is equally clear: break up the big banks.

    1,000 small banks .1% the size of Citibank will not be bailed out. Heck, 100 banks 1% the size of Citibank won’t be bailed out. It’s the size that creates the moral hazard not the monetary system.

  • Guarneri

    What would the depositors interest rate, and the loan’s interest rate be in full reserve lending?

  • TastyBits

    Without changing the interaction between the monetary and financial system, there is no way to break up the big banks, or if broken up, they will always reassemble as bigger ‘too big to fail’ banks. It is inevitable.

    The banks are to the financial industry as the pharmaceutical companies are to the medical industry. Each industry must manufacturers more of their products to expand, but the economy can only grow if the money/credit supply expands (inflation targets).

    Traditional engineering is regulated by the laws of physics, but financial engineering is regulated by the laws of politicians. One is more flexible than the other.

    Financial engineering will always overwhelm financial regulating. Sen. Glass & Rep. Steagall figured it out, and they wrote a bill to mitigate the future damage. Sen. Dodd & Rep. Frank were not able to work out the problem, and they wrote a bill to guarantee future damage.

  • TastyBits

    @Drew (AKA @Guarneri)

    What would the depositors interest rate, and the loan’s interest rate be in full reserve lending?

    It depends. Full reserve and fractional reserve lending would be different using sound vs unsound money, and each money type functions differently. Sound money is a currency, an asset, and a commodity. Unsound money is only a currency, but it can act as an asset or commodity.

    Generally, full reserve depositor’s interest rates should be lower, and the loan interest rate should be higher. Fractional reserve lending would be the opposite. (In addition, sound and unsound money are both subject to independent supply and demand conditions.)

  • Guarneri

    Glass-Steagall was intended to prevent banks from engaging in risky underwriting and trading activities using the strength of depositors money to bolster their balance sheets. Specifically, it was targeted at stock speculation. Banks were supposed to make farm and C&I loans.

    It failed to prevent bank failures, as most of those were due to loan losses in very local regions due to local farming issues (weather) and local economies, not securities speculation. This is where Dave errs in the call for returning to a bunch of tiny banks. It violates principal number one: diversification.

    The same occurred in 2007/8. It was loan losses in mortgages and construction loans. We have someone here who likes to talk about liars loans. In fact, the two biggest lenders to fail: IndyMac and WaMu, both failed due to their ARMs and Alt-A’s which went bad. Loans made in response to political commitments to HUDS’s CRA goals I might add. Those evil banks in point of fact committed suicide, not a good business strategy. And it was poor underwriting and loan losses. It was not G-S repeal driven speculation in securities. (BTW – trading in government securities was allowed by G-S before and after 1999. Heh. The government excepted. Imagine that)

    Where I agree with Dave, however, is in the opposite size extreme of the Big 5. Those guys have reached regulatory capture/subsidy levels of size. Not right. As usual, some middle ground makes sense.

    As for loan economics, you can put a big red X through your last comment, tasty. A typical loan spread would be 3 pts. However, depending on class of loan and prevailing conditions, a 2 pt loan loss experience would not be atypical (See: St Louis Fed) That leaves 1 point, or $1000 on every $100,000 in loans to run the business. No chance. You got close to the issue when you mentioned leverage in an earlier comment, but that explodes your full reserve banking notion. Metered money lending rates would need to approach equity return rates.

  • My rationale for a return to small banks is not to prevent bank failures but to mitigate the risks when banks fail as they inevitably will.

    TastyBits is right such a policy can’t be a “do once” policy. We need to be willing to step in and break banks up on a regular basis. We should be doing that with all large companies, particularly those as dependent on government support as banks are.

  • TastyBits

    Full disclosure: I believe that unsound money and banking is bad, but I am no longer fully pro-gold standard or fully anti-fractional reserve lending. My existing position is that it can be positive, but it is dangerous. As such, it needs to be strictly regulated.

    First, the blah, blah, blah …

    Under full reserve banking, deposits = cash + loans. Money lent is not available to be lent. What is described as fractional reserve lending is actually fully reserve lending. Fractional reserve lending allows a bank to owe more money than it has. In other ways, it is bankrupt.

    Joe deposits $100 into Bank A, and Bank A lends $90 to Sue. Bank A has $10 in cash & $90 in loans, and Bank A cannot lend any more money than its deposits. This is full reserve lending. (A fraction of deposits remains as cash.)

    Jane deposits $100 into Bank B, and Bank B lends $900 to Dick. Bank B deposited $900 into itself to counterbalance the $900 loan, and Bank B lends more money than its deposits. This is fractional reserve lending. (Again, a fraction of deposits remain as cash.)

    For cash withdrawals, banks borrow from each other, but under the Federal Reserve System, the Fed uses fractional reserve lending, also. The amount of debt dwarves amount of money, and this is possible because of the Federal Reserve System. Simply, the Fed legitimises fractional reserve lending and provides the cash needed for withdrawals.

    @Drew (AKA @)

    […] Specifically, it [G-S] was targeted at stock speculation. […]

    Sorta, but …

    If I am not mistaken, Federal Reserve Banks have never been able to make risky loans, and this was true before and after G-S. Before G-S, Federal Reserve banks could lend to investment banks. I believe it was through overnight lending, but it was short term at most.

    G-S was designed to stop this. Commercial banks can make as risky loans as long as they do not provide a systemic risk to the bank. This steers them into farm and C&I loans rather than non-creditworthy borrowers.

    This was only part of the Banking Act of 1933, but it allowed the creation of the FDIC. The FDIC provided an amount of safety for depositor money, but FDIC banks were limited in the amount of risk they could take.

    Between 1933 and 1998, all parts of G-S was being chipped away, and some things that weakened it were not subject to it. LJB removing the Gold Cover and Nixon ending Gold Convertibility (gold window) were two events.

    Because the monetary system is backed by the financial system, there is no way to fully separate commercial and investment banking. Commercial banks will always include some highly risky investments.

    Dodd-Frank was not an updated Glass-Steagall, and it will not stop another financial collapse.

    […] It failed to prevent bank failures … […]

    G-S was not designed to prevent bank failures. It was designed to provide Federal Reserve Notes to Wall Street. This causes commercial banks to more sound lending, but as you well know, there is no risk-free loan.

    I need to think more about our host’s small bank proposal. It may be needed, but I think it small/ regional banks increase under an updated G-S.

    For the newcomers, I am not the liar’s loan guy. ARMs, Alt-A, and securitization pre-dated the 2007 Housing Crisis and 2008 Financial Collapse. Even with the repeal of Glass-Steagall, none of this alone could cause a housing bubble or financial engineering needed to support it, and not even, HUDS’s CRA goals would add enough to get to 2007/2008.

    In order to get to 2007/2008, the Government Sponsored Enterprises (GSEs) were required, and as we know, Freddie and Fannie were purchasing as much MBS paper as possible. More importantly, riskier was better.

    I do not think that there have been any public fully reserved lending institutions for some time. We could compare an FDIC commercial savings account with a non-FDIC money market fund investment, and I believe that the money market fund investment pays higher interest. (I believe a money market account is FDIC backed.)

    […] loan spread […]

    I might have misunderstood your original question, but even though no full reserve lending exists, I think you have proved my point. A full reserve bank must pay a lower interest rate and charge a higher interest rate than a fractional reserve one, but I have no idea of what the actual numbers would be.

    Possibly, you were trying to prove that full reserve lending is not profitable enough for a bank to stay in business, and in the existing monetary/financial system, I agree. In a non-fractional reserve lending system, it would be possible, but it would be more costly.

    As I noted at the top, I now realize that fractional reserve lending and a credit backed currency can be useful, but it needs to be limited. Yes, full reserve lending loan rates would need to be much higher, but because fractional reserve lending rates are lower, more risky loans will be made.

Leave a Comment