Bank Limitations & Losses

What conclusions can we reach from these premises?

The Effects of Bank Limitations

Banking regulations set limits on the level of deposits that banks can carry and the amount of risk assets they can own. There are separate limitations for each of these; however, it remains important to understand the interaction of these limiting regulations.

Limitation on Deposit Liabilities

Traditionally people have thought that the expansion of bank reserves drives the expansion of deposit liabilities and therefore the expansion of the money supply. In fact bank reserves act as a limitation on the expansion of deposit liabilities and the money supply. In other words the Federal Reserve cannot create money without the help of banks.

Limitation on Risk Assets

People have frequently asked the question, "Why don't banks make more loans?" The answer to that question frequently exists in the bank's capital ratio. When a bank is at or near its minimum capital ratio it will be far more reluctant to make new loans — or bank regulations may prohibit it from making new loans.

Interaction of Limitations

Understanding the interaction of the limitations set by reserve requirements and capital requirements helps us to understand why banks react to the pressure to make new loans in the manner in which they do. It seems that people more commonly recognized the ability of banks to make more loans because of excess reserves, but they don't fully understand the limitation caused by the capital requirements.

I would argue that the reason banks don't make loans (and that the risk of hyperinflation remains low) results from the influence of bank capital requirements. When the current level of capital in banks restricts the amount of risk assets the bank can hold, the bank will not expand deposit liabilities (thereby expanding money) more than they are willing to (or capable of) taking on new risk assets.

The Impact of Losses

Loan losses have a much wider impact than just on the owners of bank capital. If the owners run a shoddy operation, they should lose some or all of their money. But the collapse of banks affects all of the bank's customers as well as the many people who rely on a sound banking system.

Deposit Liabilities & Money Supply

First, all banks teeter on a very small capital base. As I hope you've seen from this example, it takes a relatively small loss in the banks note portfolio to put it at risk of failure.

In the large scheme of things the deposits of each and every bank represent an important part of the nations money supply. To allow depositors to suffer any loss at all creates the very real possibility of people losing confidence in the US money supply. To have this happen could have catastrophic effects on the economy at large.

Confidence In Money

The confidence that people have in their banking system is a widespread influence on the stability of the monetary system. When one bank goes out of business, people frequently fear that other banks will do likewise. For this reason bank regulators try to make the closing of insolvent banks as invisible as possible.

When widespread bank failures occur they have the potential of leading to "bank runs." These sudden and an widespread withdrawals can topple a banking industry balanced on a very limited amount of capital.

Government Underwrites Deposit Liabilities

Second, it takes the sizable acquisition of risk assets in order for the inflation machine of the US banking system to distribute the vast amount of money produced for nothing. Without the support of the FDIC and the federal government they could not afford to take the huge risk they do with a large amount of deposit liabilities that they accumulate.

In chartering banks under a reserve banking system the government has allowed banks to be the creators of the bulk of our money supply. Because of the important role that the money supply plays in the stability of our economy, the government has taken steps to ensure the reliability of bank deposit liabilities. The FDIC amounts to simply a smokescreen to assure bank depositors of the soundness of banks. In reality the FDIC does not have the resources to cover large-scale bank losses. By default, to protect its own money supply, the federal government has underwritten the deposit liabilities of banks. If the FDIC cannot cover losses, the taxpayers most assuredly will.

Bailing Out Banks Bails Out Money Supply

The reason the FDIC and the federal government cannot let large banks fail is not to protect the assets of the bank nor its shareholders.

The government cannot let them fail in order to protect the veil that hides the basic insolvency of the banking system as a whole. In order to get another bank to take on the deposit liabilities the federal banking regulators must do something to protect the assets acquired by the new bank.

A number of people make big talk about allowing banks that make bad loans to fail, but this position cannot be defended within the current structure of our banking system. Allowing banks to fail could create potential risks to the entire nations money supply and the economy as a whole. Employing the free-market concept of "too big to fail" in our non-free-market system would represent an act of irresponsibility.