The Theory of Money, Part 19

Image credit: Roberto Machado Noa

Last week in Part 18, we looked at the financial details of Indie Bank to understand more thoroughly how a bank run was triggered by the farmer’s bad crop. It was originally a pretty discombobulated post, so I just went back and edited it for clarity and flow. Check out the new version if you want, or just read this quick recap of what I was trying to convey:

  • Our fictitious society’s 5 banks are simplified banks with only one source of revenue: the interest they earn from lending out the money they created through fractional reserve banking
  • These banks have fixed costs (building maintenance, wages, etc.), which need to be paid for with the interest income they are getting
  • If a bunch of borrowers default at the same time, their revenue may drop below their costs, which would mean they are stuck trying to pay their costs either with even more newly created money or by paying directly with specie they have in the vault, both of which result in the same problem–even lower reserve ratios/even more severely depleted stores of specie
  • Depleted reserves trigger bank runs when word gets out and people get scared

All right, it’s finally time to see what the banking leaders do when they see the long line of people trying to exchange their Indie Bank Goldnotes for specie. Remember, they know perfectly well that Indie Bank will run out of specie before the day is through and that it will have to declare bankruptcy if they don’t do anything to stop it.

First, they organize an emergency meeting. The leaders of all 5 banks are there, although the leader of Indie Bank is in the corner playing a melancholy song on a lute.

They other four leaders initially talk about allowing Indie Bank to declare bankruptcy and then spinning this to the public to convince them that Indie Bank was the only imprudent bank and that all the rest of them are very safe. Their hope is that a strong and widespread PR campaign will prevent generalized distrust in the banking system after Indie Bank goes bankrupt. They would then have to prove how safe they are by being a little more conservative (at least for a while) with their reserve ratios and loan risk.

But after discussing this idea for a while, they are not convinced it would work. Even with a great PR campaign, there is still a reasonable risk that the panic will spread to the other banks, and they know none of them would be able to weather that storm. And they can’t let that happen–think of how disruptive to society it would be if everyone loses (the rest of) their savings! For the sake of the people, they tell each other, it is their duty to find a better option.

So, they hatch an ingenious solution. The society’s original goldminer-turned-banker, the proprietor of Pepper Bank, has a thoughtful look on his face for a while and then says, “What if . . . hmmm. Hear me out on this one because I just had an idea that sounds a little crazy but might work. You see, us other four banks still have gold coins in our vaults, right? What if we lend Indie Bank some of those gold coins–just for the short term–to help them avoid bankruptcy. We could make a big show of delivering cartloads of gold to Indie Bank. The people in line will see all that gold, and they’ll see the people at the front of the line walk away one by one with all the gold coins they requested, and eventually they’ll start to second guess their decision to wait in line when it seems that there are enough gold coins for everyone. Eventually, their panic will subside enough that the line will dissolve. We can then think of a clever marketing campaign to explain how what happened was pure unfounded public hysteria and reassure everyone that the banking system as a whole is rock solid.”

Eyebrows were raised, and then two concerns were also raised.

The first concern was that this could make one or more of the other four banks run out of specie. This concern was overcome easily by clarifying how much each bank could afford to lend and by realizing that the loan to Indie Bank would probably only need to be for a very short term, maybe even just for a day or two.

The second concern raised was more difficult to overcome. Someone pointed out that if they bail Indie Bank out like this, it will create bad incentives for all banks. It would essentially be taking away the consequence for too-risky lending and too-low reserve ratios, so all the banks would then have an incentive to engage in risky behaviour just like Indie Bank had been doing, knowing that they can get away with high risk and high rewards and, if anything goes wrong, they’ll simply be bailed out. But there may not be enough reserves in other banks to bail them out if everyone is behaving in such a risky way like this.

So they decided that there should be a price associated with needing to be bailed out. They would charge a high daily interest rate on any specie lent from another bank. This solution would actually turn out to be a win win because it alleviates the bad incentives while generously compensating the lending banks at the same time.

In the end, they collectively agreed to this solution and put it into writing. They then immediately sent word to the other four banks to start carting gold coins to Indie Bank. Within hours, their scheme had worked and the panic had dissolved. Crisis averted. Phew, that was really close to a societal default!

This solution was pretty tricky, right? The bankers just invented something new. If you’ve heard the term central bank before, you should be aware that I don’t like that term because it refers to multiple things; it’s not specific enough. So I will call this solution they came up with a reserve-sharing central bank. We will encounter the other kinds of central banks soon.

Where is our fictitious society now? It still has fractional reserve banking, and now it also has a reserve-sharing central bank to help the banking system continue to milk the cash cow that is fractional reserve banking.

Next week, we’ll look at how societal leverage contributed to this situation, and we’ll also talk about societal diversification as a means of reducing the risk of a societal default.

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