Weaknesses of fractional reserve lending

Voiceover: What we're going to talk about in this video are the negatives of fractional reserve lending. And the biggest negative of fractional reserve lending, and these are all related, is that it's fundamentally unstable unless you have a lot of engineering on the part of central banks and governments to make it more stable. Unnatural things have to be put in place to make it stable. And the reason why I say it's unstable is because all of these depositors have been promised that their money is safe and sound, that at any point they can come to the bank and get their money. It's on demand. But a good fraction of that money is being lent out. You can imagine, let's say that all of these banks are lending out the money responsibly, but let's say this bank something shady happens. It lends out money in a really bad way and it doesn't get it back, or maybe it's even worse. Maybe there's some type of fraud taking place where executives were embezzling money. Whatever. These are good actors within a fractional reserve lending system. This is a bad actor. It made a bad loan. Now all of a sudden this money is gone. If you don't have any support from central banks or from governments, now all of these customers are going to say, "Wait, I heard something shady happened at this bank." They're all going to show up at this bank all on the same day and they're going to say, "Give us back our money." Then it will be pretty clear that their money actually was not available, that it was lent out, some of it was lost. They will be very upset, these people right over here. It's not just bad for this bank. It's not just bad for this bank. It doesn't even have to be that this bank actually did anything fundamentally bad. If even rumors start to spread that something at this bank is a little bit fishy, you could imagine every one of these bank's customers showing up when that news report hits and says, "Give us back our money." They'll say, "Well I can give you back 10% of your money. "The other 90% has been lent out." That won't just affect this bank. As soon as these people try to go get their money and they're not able to see it, then the rest of the economy, all the other actors in it will say, "Wow, the banking system isn't as solid as I thought it was." So all of these other banks, and maybe there wasn't any news report written about them and they didn't do anything shady. All of their customers are going to start showing up. They're going to say, "Well, you promised me "that my money is available on demand, "well I'm demanding it right now." Of course they're not going to be able to get it because their money was being lent out. The situation that you have right here is called a run on banks. You know banks lent out 90% of the money and so really people cannot get access to it. You can imagine this is a very, very, very bad situation. You can have major bank failures. A lot of lending starts to be ... The whole banking system essentially has to unwind in some way and it would probably throw the economy as a whole into something of a downward spiral. So the way that governments attempt to address this issue and in particular it's usually the Central Bank, is they say, "Okay we'll insure banks." That's why you'll often see at the front door of a bank you'll see FDIC, which means Federal Deposit Insurance Corporation, which means that the federal reserve is insuring that bank. So for whatever reason, it's usually up to some amount of deposits, if one of these scenarios happens and the bank does not have the money on hand, the Federal Reserve will say, "Okay, we'll just make sure that you have the money." It's not an easy process and it takes some time but eventually the Federal Reserve will give them the money. But that by itself creates another problem. So that creates really the second problem is bad incentive, or nonmarket, I would say discipline. Bad incentives. Because in a traditional system if I was giving my money to someone and they were going to go and lend it to someone else, I would really care how they're lending that money. I would really care how they're managing their business. I would want transparency in terms of what investments they're making and how safe they are etc, etc. But in a situation where all of the banks have this FDIC insurance, they essentially are back stopped by the government. Now all of the sudden when customers go to the bank they're like, "You know what? I really don't "care what you do with my money. "I have FDIC banking so all I really care "about is if you have cute kittens on your "checkbooks and you have lots of ATMs. "You have very impressive looking buildings." They really wouldn't scrutinize the financials. So you don't have that market incentive anymore for banks to say, "Hey look, we are good shepherds "of your money. "Look at where your assets are being spent. "We want the market to scrutinize us onto "whether we are making good loans "or we are making bad loans." The third problem with fractional reserve lending is that because of fractional reserve lending, you're giving the private banking system a good deal of control over the money supply. If they lend more, so lending translates into more money in the money supply or the other way around, if lending were to go away, that would mean contraction of money in the lending supply. The problem with this is when the economy is weak. Let's say you have a recession, standard monetary policy arguments you would say, you want to increase the money supply. Maybe you want to lower interest rates so that people will borrow and start to consume or invest again. So you want during a recession, you want more money. What's going to happen? Central Bank tends to do that. When it is clear that it is in a recession, the Central Bank will attempt to print more money. But in a fractional reserve lending system, that's only part of the money supply equation. You also have the lending and when you're in a recession, lending goes back. So this is what you want. You want this. Central Bank might do it. That is what you want. The reality is in a recession the banks are going to get scared. They're going to see their loans go bad and you have less lending. It's going to essentially have the exact opposite effect of what you want. You're going to have less, and I should put money in quotes. It depends on how you define money but you have less money in circulation. The opposite happens in the boom. The economy is down and out in a recession. It's going to be even worse when that lending dries up. There's going to be even less money in circulation. It's going to be even harder for people to get access to capital. The opposite is true in a boom. I'm running out of real estate on my screen. In a boom when the economy is well heated or overheating, Central Bank will say, "Hey let me take a little "bit of that fuel out of the fire." So what you want is less money and Central Bank might do that by taking securities it owns, selling it in the open market and then it takes that cash and it could even discontinue that cash, and that's what Central Bank could do. Central Bank could actually act on this. In a boom banks get even more confident. They get less risk and start understating the risk and so the reality is you have more lending. It essentially puts more ... which is more money. More money in the system and essentially adding more fuels to the flame in an economy that is already getting overheated. So a lot of times this fractional reserve lending might lead to the money creation process going in the exact opposite direction that you want it to go if you really wanted to moderate the fluctuations in the economy.