Fractional reserve banking and its effect on maturity mismatching

 

The following is an excerpt from my presentation at the 3rd International Student’s Conference: Time to Rethink Economics, Beyond Frontiers that took place in Zagreb, Croatia in June, 2011. The title of the working paper is: Dangers of maturity and currency mismatching in a fractional reserve banking system with the example of Iceland and a look at alternative banking models.

Fractional reserve banking and its effect on maturity mismatching

For one to understand modern banking, history is an essential backbone unto which the pillars of modern financial intermediation are to be analyzed. The first and foremost example is Ancient Rome and the introduction of Roman Classical Law. In the time of great advances in philosophy, the beginnings of primal government structures and other forms of key institutions, a form of so-called jurisprudence evolved. Jurisprudence came about from the nature of societal and human understandings championed by Roman scholars, as” […] they embarked on an interpretation of legal customs, exegesis, logical analysis, the tightening of loopholes and the correction of flaws; all of which they carried out with the necessary standards of prudence and equanimity.“ (de Soto, p. 24)

The work of the jurisprudence was subsequently archived thanks to Emperor Justinian during the middle of the six century, as to be later on compiled into one monumental book, the Corpus Juris Civilis. Roman legal scholars, as part of this jurisprudence came to a conclusion that haunts modern banking to this very day. The pivotal conclusion regarding not only banking, but the core social edifice of society, but in the realm of banking, was the distinctive and fundamental difference of demand deposits which represent a sum of money deposited at a depositary institution, receiving the name of a monetary irregular deposit (to be shortly explained) also known as a tantundem, and a loan contract, under which an individual relinquishes his/her monetary sum for a distinctive period of time, at interest, also known as a mutuum contract.

A monetary irregular deposit stems from the notion of fungible goods deposited at a depository. This means, that if someone wishes to place a certain good at a bank for safekeeping, for example, oil, grain and so forth, it is in the depositories obligation to immediately relinquish this good at the demand for the depositor. Since grain and oil are by nature fungible, it is economically inappropriate to keep these goods separated or compartmentalized for the marginal cost would be too great. Therefore, grain and oil are kept together, since no qualitative or quantitative standards are violated.

Moreover, this fungible asset is, in its essence, a demand deposit. Any failure of delivery results in a law suit against the depository not being able to bring about this demand to its rightful owner. “In other words, the owner of the grain warehouse or oil tank can use the specific oil or grain he receives, either for his own use or to return to another depositor, as long as he maintains available to the original depositor oil or grain of the same quantity and quality as those deposited“. (de Soto, p. 59)

A demand deposit is not relinquished for any time. It does not represent a transfer of present consumption for future consumption, unlike a loan (mutuum). A loan transfers present for future consumption, in line with consumer preferences. One of the key roles here is the charging to interest.

Why banks grant interest payments to depositors? There is clearly no transfer of consumption patterns when a deposit is kept for safekeeping. A monetary loan on the other hand signifies a transfer of ownership where a demand deposit does not. In that case, banks are obligated to maintain a 100% reserve requirement for demand deposits.

However, fractional reserve banking manipulates this legal and economic understanding of not only ownership transference, but time transference of funds. Notable examples of this misconception derive all the way from ancient times to modern day banking with the clear deviation from logic, adopted in Anglo-Saxon Law. The practice of loaning out demand deposits and concealing them as loans is a concept known in the Middle Ages as depositum confessatum.

Under this veil, banks had the ability to pay out interest to depositors, even though it should be reversed, the depositors for various reasons, decide to safe keep their funds, and must pay a service fee, not the other way around!

Economic activity is therefore altered, for confusion enters the market, and one doesn’t know if funds are genuine savings, as in loaned out, or funds are safe-kept, to be instantly used. Primary examples include the government sponsorship of these actions in the past, so-called ius privilegium. Under such circumstances, banks were allowed to create credit out of nothing, loaning out deposits that should have been backed by a 100% cash reserve.

Fractional loaning of demand deposits, therefore, when visualizing from an accounting perspective, transfers leverage and unjustified profits from society to banks practicing this form of intermediation, creating a profound and unjustified act of usury.

Living off the global taxpayer

As mentioned in one of my previous blog entries that the government largesse is visible in the domestic economy, it is even more perverse on the international scene.

In What I mean by hazardous government rhetoric I wrote about the perverse incentives that the government implements to keep people from leaving government, this next piece is just as amazing.

According to the Guardian:

“As an official of an international institution, Christine Lagarde’s salary of $467,940 (£298,675) a year plus $83,760 additional allowance a year is not subject to any taxes. […]

The same applies to nearly all United Nations employees – article 34 of the Vienna convention on diplomatic relations of 1961, which has been signed by 187 states, declares: "A diplomatic agent shall be exempt from all dues and taxes, personal or real, national, regional or municipal."

According to Lagarde's contract she is also entitled to a pay rise on 1 July every year during her five-year contract.”

That’s right. When you or me seeks employment, we are forced into progressive tax brackets, while the “elite” get away with a free lunch. The masses endure financial repression and a fall in living standards, but the IMF chief gets a get-out-of-tax free card.

People should also check out the other “privileges” these people have, straight from the UN website:

1. Rental subsidy if newly arrived at the duty station your rent represents too high proportion of the total remuneration.
2.Dependency allowances if you have an eligible dependent spouse and/or child
3.Under certain conditions an education grant if you have eligible children in school.
4.Travel and shipping expenses when you are moving from one duty station to another.
5. Assignment grant to assist you in meeting initial extraordinary costs when arriving at or relocating to a new duty station.
6. At some duty stations, a hardship allowance linked to living and working conditions is paid and where there are restrictions on bringing family members, a non-family hardship allowance is also paid.
7. Hazard pay and rest and recuperation break when you serve in locations where the conditions are particularly hazardous, stressful and difficult.

The last one and first one is just brilliant. I have only one thing to say: Dear Christine, take a hike and get a real job.

Silent debt monetization in Croatia

 

Every week, a new news headline comes out of the Croatian business press that our Finance Minister has successfully indebted the Croatian people by a smaller interest rate. Most of this funding is being done on a short term basis. The main problem however is that these treasury bill purchases are being financed in most part by the Croatian banking system.

The headline reads:

“Banking institutions and other investors have submitted offers worth HRK 2.583 billion and 57.4 million euros. Ultimately, the auction of treasury bills was entered in the value of 1.309 billion and 51 million euros.”

Since banks are battling with foreclosure issues and the inability of the masses to repay their loans tied to the Swiss Franc, it is somewhat surprising that they are flush with a surmountable amount of cash to absorb this kind of auction. Banks had an appetite for nearly double the amount they received signaling that a flight to safety is still intact. My question is: Where are the banks getting all these funds?

Maybe, its because that on April 4th 2012, the Croatian Central Bank lowered the reserve requirement from 15% to 13,5%.

The headline from two months ago goes as:

“Banks get a release of about 4.1 billion kuna, and more than 110 million in foreign exchange”.

Banks, flush with cash aren’t loaning to the business community; mostly to do with the fact that the private sector hasn’t yet deleveraged and the growing uncertainty of outstanding loans, unions contracts and a negative economic outlook.

So, the government is high fiving itself for managing its debt burden with printed money. We will just wait and see what happens when all this “shadow liquidity” hits a certain part of the economy and its perverse effects it will have on the capital structure of the economy.

It’s a shame that, unlike most Western European countries, we don’t have a yield curve that might show how the effects of expansionary monetary policy has on the economy.

A True “Austrian” Money Supply measure (TMS) would also help in seeking out where the next peak is going to be, and from historical data draw the time from peak to through to figure out when the cleansing of the system of malinvestments might occur.