Is Fractional Reserve Banking Disintegrating?

March 30th, 2013

Peter Nolan

The Cyprus
deal as it has been widely referred to in the media may
mark the next to last act in the the slow motion collapse of fractional-reserve
banking that began with the implosion of the savings-and-loan
industry in the U.S. in the late 1980s. This trend continued with
the currency crises in Russia, Mexico, East Asia and Argentina
in the 1990s in which fractional-reserve banking played a decisive
role. The unraveling of fractional-reserve banking became visible
even to the average depositor during the financial meltdown of
2008 that ignited bank runs on some of the largest and most venerable
financial institutions in the world. The final collapse was only
averted by the multi-trillion
dollar bailout of U.S. and foreign banks by the Federal Reserve.

Even more
than the unprecedented financial crisis of 2008, however, recent
events in Cyprus may have struck the mortal blow to fractional-reserve
banking. For fractional reserve banking can only exist for as
long as the depositors have complete confidence that regardless
of the financial woes that befall the bank entrusted with their
deposits, they will always be able to withdraw them
on demand at par in currency, the ultimate cash of any banking
system. Ever since World War Two governmental deposit insurance,
backed up by the money-creating powers of the central bank, was
seen as the unshakable guarantee that warranted such confidence.
In effect, fractional-reserve banking was perceived as 100-percent
banking by depositors, who acted as if their money was always
in the bank thanks to the ability of central banks
to conjure up money out of thin air (or in cyberspace). Perversely
the various crises involving fractional-reserve banking that struck
time and again since the late 1980s only reinforced this belief
among depositors, because troubled banks and thrift institutions
were always bailed out with alacrity especially the largest
and least stable. Thus arose the too-big-to-fail doctrine.
Under this doctrine, uninsured bank depositors and bondholders
were generally made whole when large banks failed, because it
was widely understood that the confidence in the entire banking
system was a frail and evanescent thing that would break and completely
dissipate as a result of the failure of even a single large institution.

Getting back
to the Cyprus deal, admittedly it is hardly ideal from a free-market
point of view. The solution in accord with free markets would
not involve restricting deposit withdrawals, imposing fascistic
capital controls on domestic residents and foreign investors,
and dragooning taxpayers in the rest of the Eurozone into contributing
to the bailout to the tune of 10 billion euros. Nonetheless, the
deal does convey a salutary message to bank depositors and creditors
the world over. It does so by forcing previously untouchable senior
bondholders and uninsured depositors in the Cypriot banks to bear
part of the cost of the bailout. The bondholders of the two largest
banks will be wiped out and it is reported that large depositors
(i.e. those holding uninsured accounts exceeding 100,000 euros)
at the Laiki Bank may also be completely wiped out, losing up
to 4.2 billion euros, while large depositors at the Bank of Cyprus
will lose between 30 and 60 percent of their deposits. Small depositors
in both banks, who hold insured accounts of up to 100,000 euros,
would retain the full value of their deposits.

The happy
result will be that depositors, both insured and uninsured, in
Europe and throughout the world will become much more cautious
or even suspicious in dealing with fractional-reserve banks. They
will be poised to grab their money and run at the slightest sign
or rumor of instability. This will induce banks to radically alter
the sources of the funds they raise to finance loans and investments,
moving away from deposit and toward equity and bond financing.
As
was reported this week, this is already expected by many analysts:

Source Article from http://lewrockwell.com/salerno/salerno17.1.html