Central Bank Authorized Fraud; Fractional Reserve Lending Problems Go Far Beyond "Duration Mismatch"

Keith Weiner at the Daily Capitalist purports to explain the Fractional Reserve Banking: The Real Story

Weiner makes a case that the problem with fractional reserve lending is one of "duration mismatch". If you don't understand the term "duration mismatch", please don't stop reading. I provide an easy to understand example below.

While "duration mismatch" is a huge problem, it is by no means the only problem. Thus Weiner misses the overall picture.

Fractional Reserve Banking Defined

Before we can state the problems and concerns with fractional reserve lending we need to define the term. Here is the meaning I use for my analysis:

Fractional reserve lending is the act of lending out more money than banks have ownership of. "Ownership" can be temporary.

Clearly, I cannot lend you $1,000 if I only have $1.98.

However, and this may surprise many people, banks can. Moreover, the fact that banks can lend more money than exists is at the very root of the financial crisis we are in today.

It is illegitimate to lend out more money than you have "ownership of".

Legitimate Right-To-Lend

The key question is what constitutes a "legitimate right-to-lend"? The answer involves banks' "right-to-use" deposited money.

CDs provide an easy to understand example of right-to-use. Consider a 5-year CD. A person buying a 5-year CD gives up the right to use his money for 5-years in return for an agreed upon interest rate. The bank then lends the money out for a higher amount of interest.

Keith Weiner complains (and rightfully so), about banks securing funds for 5 years, then lending them out for 30-year mortgages. That "duration mismatch" is certainly a problem, but it is not the only problem as discussed below.

First let's consider a 100% gold-backed dollar.

A 100% Gold-Back Dollar Would Not Stop Lending

Note that a 100% gold backed dollar would not stop lending. One can easily relinquish ownership of gold for as long as one wants (say 5 or 10 years), and at the end of that period the bank would have to return the gold to its owner, plus interest.

Thus a 100% gold-backed dollar would not stop lending as many misguided souls think.

Also note that the commonly attributed meaning of fractional reserve lending is complete silliness in that it fails to address the crucial issue of "ownership"

I suspect this is what led Keith Weiner astray in this admittedly very complicated issue, even though I agree on his central thesis that "duration mismatch" is a huge problem.

Duration Mismatch Schemes Guaranteed to Blow Up

Weiner states ....

Borrowing short to lend long, aka duration mismatch, inevitably implodes. This is not a matter of odds or probability. Like a geological fault line, one can try to assess probability of a destructive event in any given year, but sooner or later catastrophe is certain. When a business knowingly engages in an activity that is guaranteed to cause it to dishonor its obligations, that is acting in bad faith. Such a business has no intention of honoring its obligations over the long term, only in the short term when it is expedient.

Finally, fractional reserve banking is one of those issues where there is a deep misunderstanding in Austrian circles. This is compounded by the dearth of information about duration mismatch (I am only aware of Professor Antal Fekete writing about it, and of course some of his students such as myself) and the proliferation of misinformation about it.

Duration Mismatch Articles

For starters, I have written about Duration Mismatch 17 times since 2007 as the link in this sentence shows. Two of the articles are from 2011.

Here are some of the key posts.

February 16, 2011: The Next Borrow-Short Lend-Long Guaranteed to Blow Up Bank Lending Scheme; Citigroup, Chase, Bank of America CD Ripoff

Borrow-short lend-long strategies have caused more pain and grief than nearly any play in the book. They are virtually guaranteed to blow up given enough time if the duration mismatch and leverage is too great.

For those who do not know what I am describing, a couple of examples below will help explain. The first example is a look at "cost of funds" and guaranteed profits that banks can make. It is not a borrow-short lend-long strategy but will morph into such a scheme as I vary the parameters. ....

February 02, 2007: Central Bankers Cry Wolf

Key GSE Points Size and leverage of Fannie Mae and Freddie Mac is enormous.The Fed does not want to be responsible for a blowup at either company.Both pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch.Both hold long-term mortgages and mortgage-backed securities financed by short-term liabilities forcing them to synthetically create a duration match via massive amounts of derivatives.The stocks act as if there is implicit government guarantees. There are no such guarantees.The lack of market discipline is striking.The Fed can provide liquidity not capital.A crisis is not unthinkable. Those that think so need a course in economic history.

November 03, 2009: What is Money and How Does One Measure It?

Given there are no reserves on savings accounts, as much as $4.5 trillion people think is in their savings accounts is not there either. Moreover, the duration mismatch on savings accounts, sweeps, and likely even CDs is massive.

If even 20% of the people tried to get their money out the system would freeze up.

The banking system is clearly insolvent. Such is the folly of fractional reserve lending.

September 10, 2007: Duration Mismatch Causing Severe Stress Everywhere

Duration Mismatch and Leverage

Leverage is a wonderful thing when spreads are moving in your direction. It's now payback time for those who borrowed short and lent long. Short term borrowing costs are rising while the value of long term assets, especially mortgage debt is sinking.

See Duration Mismatch to Bankruptcy (in one week flat) for the saga that caused Sentinel to go bankrupt in short order once their mismatch mattered.

The issue is not whether it's absurd for Lehman or Bear Stearns debt to be trading at a discount to Columbia, the issue is how much leverage Lehman (LEH), Bear Stearns (BSC), Merrill Lynch (MER), Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS) are using as well as the timing and size of needed debt rollovers.

It was a huge mistake for corporations to assume they could perpetually roll over short term debt at good prices. If you stop and think about it, many homeowners over leveraged in homes have a similar mismatch problem. Incomes have not risen as expected but short term financing costs have gone through the roof with no way to roll over the debt.

Duration Mismatch Not the Only Problem

Fractional reserve lending go far beyond duration mismatch. Here are few key points.

Fraudulent lending (banks lending more than they have ownership of) pushes up assets prices and favors those with first access to cash (banks and the wealthy). The housing bubble was a result of such fraud.
The existing fractional reserve system allows lending of money that is supposed to be available on demand. Lending of money banks have no ownership of is outright fraudulent.
Excessive credit backed only by artificially inflated asset prices is simply another form of fraud. Moreover, such lending also sends false signals to the market about the true state of the economy.

In the ensuing and inevitable busts, the central bank inevitably punishes savers by artificially holding rates too low.

Central Bank Authorized Fraud

Point number two above involves sweeping of checking deposit accounts into saving deposit accounts by banks, unbeknown to customers, then lending the money out.

Greenspan authorized sweeps in 1994 as a way of allowing banks to put "idle cash" to use. There are no reserve requirements on savings accounts.

Thus, money that is supposed to be available on demand isn't. People think that money in their checking accounts is sitting in banks. It most assuredly isn't. It has been "swept" away nightly into savings accounts that banks can lend out. Bookkeeping says the money is there. Physically it isn't.

Lending of money in "available on demand" checking accounts is purposeful fraud. Greenspan authorized the practice, but that that simply makes it central-bank authorized fraud.

Savings Accounts Fraudulent as Well

With savings accounts, customers do relinquish control of deposits, at least in theory. For example, customers deposit money in a savings account and receive an agreed upon interest rates. Everyone understands their banks will lend that money out.

Nonetheless, should someone walk into the bank the next day and request to pull money out of "their savings", it will be given to them. Unfortunately, control of "their savings" was relinquished to the bank who then lent the money out.

It is illogical (and fraudulent) for money that is already lent out to be available on demand. Thus savings accounts are nothing but another form of "have your cake and eat it too" fraud.

Whether the loans are backed by assets or not is irrelevant.

Problems Measuring "True Money Supply"

It is this very savings account debate that has caused two Austrian economic camps to split into two camps as to how to measure "True Money Supply".

The TMS2 camp says that money in savings accounts is available on demand and thus needs to be factored into money supply figures. Meanwhile the TMS1 camp that I am in says that the right-to-use the money was transferred (whether it is fraudulently available on demand or not) and thus should not be counted in money supply figures.

For further discussion, please see Money Supply Divergence - TMS1 vs. TMS2 vs. M2 - What does it Mean?

The above link also contains a discussion of sweeps and how they distort money in checking accounts.

Regardless of the "correct" measure of money supply, both the TMS1 and TMS2 camps generally believe the practice of lending of savings accounts while simultaneously making the money available on demand is fraudulent.

Reflections on "Legitimate" Right-To-Use

Some argue that as long as customers agree to these various banking schemes it is OK. That line of thinking says as long as it's in the agreement for banks to sweep money from checking accounts to savings accounts and lend it out, then it's OK for banks to do so.

However, it's not OK because such lending is nothing more than a gigantic kiting scheme. Moreover, it affects others by cheapening the value of money, pushing up asset prices for the benefit of those with first access to money, the banks and the wealthy.

Logically, two people cannot have the right to use the same money at the same time, whether they agree to such a scheme or not!

Money Multiplier Theory

Compounding the issue, money that is lent out then redeposited in another bank, can be lent again and again and again. In theory, the same money can be lent an infinite number of times (10 times if you prefer, with each bank keeping 10% in reserves). This is the "money multiplier" theory of fractional reserve banking.

However, such analysis is further complicated by the fact that in a fiat-credit based banking system, lending comes first and reserves come second.

Thus, money multiplier theory as commonly understood is simply wrong.

For a discussion of the "money multiplier" issue please see Fictional Reserve Lending And The Myth Of Excess Reserves

Complicated Issue

Clearly, money is a complicated subject involving numerous competing definitions of money. Fractional reserve banking and invalid money multiplier theories greatly compound understanding.

Unfortunately, Weiner adds to the confusion with analysis that suggests that duration mismatch is the only issue in regards to fractional reserve lending.

Fractional Reserve Lending is Fraudulent and Must Stop Entirely

Lending what you do not have "ownership of" is the issue. Duration mismatch is a form of that problem, but it is not the only form of that problem. Numerous complications arise when multiple people have immediate access to the same money at the same time.

Housing and credit lending bubbles constitute unmistakable proof that fractional reserve lending in any form is fraudulent and must stop entirely.

The solution is to abolish the Fed, institute a 100% gold-backed dollar, and disallow banks to ability to lend money they have no legitimate right-to-lend.

Addendum:

At the Suggestion of James Turk I made a quick change to my definition above

From Fractional reserve lending is the act of lending out more money than banks have a legitimate right-to-lend

To Fractional reserve lending is the act of lending out more money than banks have ownership of.

That was the way I originally wrote it, but changed it at the last moment. "Ownership" of course can be temporary. I made a few other changes of "right-to-lend" to "ownership" as well to make it more clear.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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The Duration Paradox (Part Two of Two)

03/13/11 London, England – If Treasury bond yields do not currently provide investors with fair, market-determined compensation for the growing risks of inflation and dollar devaluation, what are investors to do? There are several potential options.

First, investors can hold cash instead of bonds. But if price inflation begins to pick up–at present it shows every sign of doing do–sitting in cash for a long period of time begins to look rather unattractive. Moreover, cash does not protect investors from the risk of a weaker dollar which, with an uncertain magnitude and time lag, is going to push up inflation and erode purchasing power.

Second, investors can hold foreign instead of domestic bonds. The Japanese and euro-area bond markets are comparable in size to that for US Treasuries. But interest rates are also so low in both Japan and the euro area that the Duration Paradox is also in effect, holding down long-term yields. So while there might be some diversification benefits to be had in this way, investing in these bonds does not get to the root of the problem.

Third, rather than hold bonds, investors can hold equities. Indeed, it would appear that, in late summer 2010, as the Fed indicated that it would be implementing QE2, global equity markets received a boost. But is this likely to continue? We have written recently about the equity market and have concluded that it appears substantially overvalued in any reasonable historical comparison. Moreover, there is growing evidence of a severe margin squeeze or ‘crush’ now underway which is highly likely to hurt corporate profitability in the coming quarters. The combination of high valuations and disappointing profit growth could be particularly nasty for equity markets in the coming months.

There are also other potential negatives for equity markets at present. China, India, Russia, South Korea, Indonesia and other relatively dynamic economies are all raising interest rates to slow growth and get inflation under control. Last week, even the European Central Bank (ECB) indicated that it, too, is about to begin raising rates. Another potential negative, although difficult to quantify is the increasingly hostile tax and regulatory environment in the US and to a lesser extent elsewhere. So-called ‘regime uncertainty’ tends to weigh on equity valuations. We don’t deny that, according to history, equities tend to outperform bonds in an inflationary environment. But from the current starting point, the potential relative outperformance might not be that substantial. Indeed, the performance of both bonds and stocks could well be negative for a period as financial markets adjust to what is a historically unusually hostile environment for financial assets generally. (Incidentally, one of the most famous bond fund managers in the world, Bill Gross, appears to hold this view.)

If financial assets in general currently fail to provide investors with attractive ways in which to protect their capital, what are the alternatives? Historically, real assets, including property, have held their value in inflationary periods better than financial assets. One rather obvious problem with property today, however, is that a bubble in property valuations in the US and elsewhere was a key ingredient in the financial crisis of 2008 and there remains a legacy of oversupply of various forms of property on the market. (While the US residential property bubble may now have been somewhat deflated, there is less evidence that this is the case with commercial property, in particular retail space and office space in major financial centers.)

Historically, precious metals have offered investors an alternative store of value. Indeed they have served as money itself.  While metals (and other commodities) do not provide investors with an income, in that they are not productive assets producing either rent (as with property) or other economic goods (as with capital goods), that is precisely the point: When financial assets in general are overvalued in historical, purchasing-power adjusted terms, and even property is still de-bubbling, the best way to protect wealth is to eschew cash flows entirely. Looked at from another angle, if economic activity is being artificially stimulated in various ways by soaring government deficit spending and highly expansionary central bank monetary policy, do investors really want to chase cash flows when those cash flows are demonstrably distorted and necessarily unsustainable?

But the alternatives do not end there. Global commodities markets can provide investors with far greater liquid, real asset diversification alternatives. Gold, silver and mining shares are normally highly correlated with each other, limiting diversification potential. Yet in a highly uncertain world, diversification is of paramount concern. Investors should be after all they can get. As such, the world’s most widely traded commodity, crude oil, with only about a 65% correlation to the price of gold, is an obvious place to look. Oil distillates, such as unleaded petrol and heating oil, have an even lower correlation to the gold price. Industrial or base metals also trade widely. That said, they tend to be more highly correlated to global equity markets and, as such, are likely to decline in price in the event of a major equity market correction.

Historically, the greatest diversification benefits are provided by agricultural and so-called ‘soft’ commodities. The prices for these are driven by random factors such as the weather. These commodities have correlations with gold and silver of only around 30% or so. That said, some of them are quite expensive from an investment standpoint, due to their perishable nature and commensurately high storage costs. As an alternative, investors could consider a diversified basket of agricultural equities, which would pay a modest dividend.

As the unsustainable sovereign debt burdens grow alongside massive worldwide money supply growth, preserving wealth is not going to get any easier. The pure uncertainty associated with debt and monetary crises continues to grow as policymakers stumble from one unsustainable policy to the next. History demonstrates that this is not going to end well. But end it will. When it does, those who have managed to preserve at least some portion of their wealth will be in an excellent position to exploit what are likely to be the best investment opportunities for at least a generation and possibly several.

Faced with growing adversity at home, peoples have occasionally sought to migrate to more promising lands, notwithstanding the tremendous uncertainty of doing so. Why? Because high uncertainty elsewhere is better than certain suffering at home, however familiar. Before doing so, they gather together into an ark or wagon their most precious possessions and, of course, necessary supplies for the risky journey ahead. Some possessions are going to be lost along the way and most supplies consumed, hopefully not to run out entirely.

The so-called ‘49ers’ of American lore needed to ford dangerously fast, near-freezing rivers and traverse high mountain passes to make it to California. Many lost everything along the way, including friends and family members. But those who made it in one piece found a vast, lush, mineral-rich land and many great fortunes were made by those who had nothing left on arrival but the shirt on their back. There is a lesson there.

It is hard sometimes to be optimistic, but we do try.

Regards,

John Butler,
for The Daily Reckoning

[Editor's Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.

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