Our banking system is broken

Conventional banking plays a vital role in any economy. In a strictly technical sense, banks do create money. Here’s how it works: Banks are required by law to hold a certain percentage of their liabilities (deposits made by you and me) as actual cash reserves. This is so that we can draw  cash at the ATM when we need to, or move our money to another bank if we so choose. We’ll assume a nice tidy figure of 10 percent (the actual requirement is usually lower). Now let’s say you come into some money; maybe through a relative’s will, or whatever; a sum of €100000.00. In a state of bliss you deposit the money at your local branch. Does it all just sit there, waiting for you to draw it out again? Nuh uh. The bank only has to hold onto €10000.00, they can lend the rest to somebody else. So €90000.00 goes to the local shoe store as a loan to buy stock. As soon as they pay for the stock, another bank somewhere else has an additional €90000.00 in deposits, they keep €9000.00 and loan out the other €81000.00. And so it goes on; taken to it’s limit with an infinite number of rounds, we can calculate that the deposit multiplier is equal to the reciprocal of the required reserve ratio. In this case:

M = 1/10% = 10.

Your initial deposit of €100000.00 has enabled lending of €1 million. Congratulations.

But you might also notice that the system only works if banks are actually lending. What is happening at present in Ireland is that banks are not lending. In the first place, people are reluctant to deposit money with Irish banks, and money that is there is not being circulated, which is how a normal economy functions.

How do we remedy this?

  • just like in any other market (this being the market for credit), deal with the demand issues. The government is addressing this in their Action Pan for Jobs 2012. Supply always follows demand.
  • Simplify the business of banking. It’s too complex, to the point that we still don’t even know how deeply in the dwang we are with Anglo Irish Bank, more liabilities keep popping out of the woodwork. This is a direct consequence of the neoliberal emphasis on transaction for transaction’s sake. Banks must shed peripheral “business” (which is no more or less than financial alchemy) and do the only thing they do well – take deposits and make (sensible) loans. The personal relationships between bank managers and their customers must be re-instituted as a matter of urgency.
  • Allow the failed banks to fail so that they stop bleeding us dry. Sounds simple enough (you’d think). Allow other players to enter the market, you know, banks that actually want to conduct the business of banking here.
  • Large-scale debt forgiveness / reductions for those in negative equity or labouring under heavy business debts as a result of the recession. Stop throwing around stupid phrases like “moral hazard”. There’s nothing immoral about having bought a house that’s now valued at a fraction of what the mortgage is.

I have more to add on morality and economics in general, but that will be for my next post.

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