Forget too-big-to-fail Instead Kill the Fractional Reserve Banking System

By: Colin_Twiggs

Interesting discussion on Bloomberg about currency-backed deposits and equity-funded loans.

The fractional reserve banking system is the primary cause of instability and asset bubbles in the global economy, allowing banks to create money out of thin air. Credit expansion above the rate of real GDP growth has only two possible consequences: inflation or asset bubbles. Both do serious long-term damage to the economy.

Under the current system, banks create new money by making loans where they don’t have deposits. The recipient of the loan generally deposits the money back in the banking system, allowing banks to fund newly-created loans with newly-created deposits. The fractional reserve system enables banks to rapidly expand credit as demand grows, but at the risk of creating a bubble.

Requiring banks to hold 100% reserves against deposits — either government bonds and short-term bills or central bank deposits — would remove the risk of bank runs and the need for deposit insurance. It would also eliminate bank bailouts and the subsidy of too-big-to-fail banks by the taxpayer. Volcker rule restrictions on proprietary trading would become unnecessary, with banks no longer able to bet with their customers’ money.

Credit would be equity-funded rather than deposit funded. While this model may seem strange to the reader, it was successfully used by German banks to fund Germany’s industrial expansion in the early 20th century and is still employed by investment banks and private equity funds to finance major ventures today. Islamic banks follow similar principles.

It would be a fairly simple exercise to structure different tiers of equity – with commensurate returns — that participate in different levels of risk. Banks would not be restricted from issuing bonds, but the ratio of debt to equity and access to the retail market could be strictly controlled by regulators.

Fractional reserve banking is not an essential component of capitalism. All that we need is an efficient financial intermediary to channel savings into capital investment. When one considers the costs of the present system — especially the massive wealth destruction wrought by an unstable banking system — the alternative is a lot more appealing.

By Colin Twigs

http://www.incrediblecharts.com

Colin Twiggs is a former investment banker and author of the popular Trading Diary and Goldstocksforex.com newsletters, with more than 140,000 subscribers. His specialty is blending fundamental analysis of the economy with technical analysis of stocks, markets, commodities and currencies. Focusing on the role of the Fed and banking credit as primary drivers of the economic cycle, Colin successfully forecast the October 2007 bear market -- eight months ahead of the sub-prime crisis.

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