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Ashish's Niti

Niti in Sanskrit means policy/strategy/vision. This blog hosts my political views, along with news and commentary. This blog has moved here.

Monday, July 26, 2004

Move to 100% reserve banking to avoid bank runs and costly bailouts using taxpayers money

Yet another bank (GTB) has broken the public trust and Govt. has emabarked on yet another bailout at the expense of tax-payers!

The reason given for the riskiness of banks is low equity held by banks. Govt. is thus needed to monitor the risk undertaken by banks. But this is nonsense as the reason low equity is held by banks is because Govt. allows them to get away with fractional reserves.

Anatomy of The Bank Run explains clearly how a bank run happens. Basically, banks have to maintain only fraction of their depositors money at hand, even though they promise to redeem to the depositors his/her entire deposit balance on demand. Thus banks depend on the assumption that not all of their depositors will demand all of their deposit at any given time!

Now if banks have to maintain only fraction of their depostitor's balance, that means, they can loan the rest of the amount to their customers. Imagine, for every 100 Rs. of deposit at the bank, they keep only, say, 25 Rs. while loaning 75 Rs. to their customers. And this all the while promising to you that entire 100 Rs. is available on demand. Isn't this a fraud? A few bad loans and resultant loss of confidence in the bank will cause a "run" on the bank as depositors flock to the bank demanding their money back!

So, Govt. first creates this monster problem by allowing banks to hold only fractional reserves and then claims power and responsibility to regulate the banks in order to control the risks undertaken by them! Not to mention put taxpayers money at risk by constantly bailing the failed banks. If Govt. instead enforces 100% reserve requirements on banks there would be no need to regulate banking. No need to control the loan portfolio of the banks as depositor's money will always be backed by full 100% reserves.

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