by Tyler Watts
Larry, George, and Steve all live next door to each other in the quiet town of Ayr. As respectable men about town, they all endeavor to keep their houses neat, especially their lawns. Currently only Larry has a mower. One summer day, right after Larry cuts his grass, George comes over and says, “I’ll give you a cold beer if you let me borrow your mower.” “Sure,’ says Larry, “do whatever you want with it, but be careful! I’ll pick it up next time I need it.” So George takes the mower home, planning to cut his own grass in the next few days. Soon Steve comes over to visit George. Noticing the mower in George’s garage, Steve says “Hey George, I’ll give you a 6-pack if you let me borrow that mower.” George replies, ‘OK, just be really careful with it—it’s Larry’s. I’ll pick it up when I need it.”
It might be a little strange for a neighbor to re-lend a borrowed item, but assuming Larry is truly OK with it, would there be anything morally wrong with this arrangement? Would it be damaging to the economy, or helpful?
Replace “mower” with “money,” and you’ve got a bank: an institution that borrows “idle” financial resources from many “neighbors,” often paying them a small fee, with the purpose of re-lending to others who need them and are willing and able to pay a somewhat larger fee.
Of course this is much more practical with money, because every dollar is economically equal, whereas a brand new Honda mower is clearly superior to a 40 year old Lawn Boy. But the economic essence of banking—whether it’s done with mowers or money—is really no different from any entrepreneurial endeavor. The entrepreneur assembles resources in order to put them to a more highly-valued use; the increased value (or lack thereof) is revealed by the profitability of the business.
Yet some people will object to this kind of operation when it’s done with money—even if they have no qualms with my admittedly unlikely lawnmower example. The objections boil down to two main points: 1. It’s a fraudulent arrangement in the sense that depositors don’t know (and would not approve of) what the banks are doing with their funds; 2. It’s economically de-stabilizing, in the sense that it’s likely to not work out well for the original parties and/ or can have harmful effects on others.
I’ll admit I assumed away the first objection by indicating that Larry implicitly knew about and was OK with George’s re-lending. But what if he did not know, nor approve of, George’s business model? There’s a simple fix: he NEVER lends anything to George ever again (and perhaps seeks legal damages for the increased risk arising from George’s unauthorized actions). As for banks, the same remedy applies: people who don’t approve need not participate. At any rate, I don’t know of anyone accusing banks of claiming that they are holding depositors’ funds earmarked in a vault for safekeeping (safe deposit boxes notwithstanding). I’ll suggest it’s common sense—and common knowledge—that banks live by re-lending what the depositors, through their checking and savings accounts, have initially “lent in.”
The second objection has some teeth, due to a special kind of problem that could crop up for George’s business: what if Larry comes back for his mower while George has still got it loaned out to Steve? Worse yet, what if Steve ruins the mower, and/ or doesn’t pay his borrowing fee? Worse still, doesn’t George’s business increase the economy’s perception of the available quantity of lawnmowers, thus reducing their value in general? These situations could leave the three, not to mention total strangers, much worse off. Let’s consider in turn why these are unlikely to become systemic problems in a free market economy
The first situation—Larry needs the money back before Steve is done with it—is known as “illiquidity” in banking jargon. Several remedies are available. George could simply “call in” the mower from Steve, possibly increasing the payment to Larry in compensation for the delay (“have another cold one, and I’ll definitely get it back to you by Friday”). Better yet, seeing Larry coming to get his mower back, George could send his kids down the street to borrow yet another mower from yet another good neighbor (this time George might have to pay the 6-pack, due to the urgency). Better again, George could expand the operation, “borrowing in” mowers from, say, 100 neighbors, and making sure he only has 90 lent out at any given time, leaving 10 in “reserve” for just this contingency. George thus establishes the Mutual Mower Association of Ayr and makes it his business to put idle mowers to good use.
This of course is what banks actually do, and have been doing since the business of modern deposit banking originated in 17th century London. They borrow funds from a large pool of depositors, and re-lend them to entrepreneurs, homebuyers, and so on. Done properly, it generally works well. Depositors know that the bank is not literally holding the exact money they deposited, and indeed at any moment has most of this money lent out. Nonetheless, pragmatic bank management ensures that depositors can generally get their money out as needed. Bankers pay careful attention to data on daily inflows and outflows of deposits, the quality and liquidity of their assets, interest rates, and so on, and make appropriate adjustments to their cash reserves. The “fractional reserve” aspect of banking—the fact that more of the deposits are loaned out than could be repaid to the depositors at any given instant—is entirely normal to banking and not inherently problematic
This is not to be Pollyanna-ish about banking. All action in life is fraught with risks, and things could definitely go badly for any given bank (or the whole financial system). This brings us to the second “instability” problem: for the Mutual Mower Association, borrowers like Steve could ruin the mowers and/or not pay their borrowing fees; for banks likewise, many of the loans could go into default—“insolvency” in banking lingo. George will want to be careful in his lending practices, lest the mowers are lost, he earns no profits, and worst of all can’t repay the original mower lender-depositors as needed. No matter how prudent, mistakes and disappointments will be inevitable—in a world of inherent uncertainty, the optimal level of error is not zero. But as mentioned, well-managed financial institutions can take appropriate steps against disaster—holding adequate reserves (including loan loss reserves and large capital cushions), offering a flexible, contingency-based compensation schedule for depositors, maintaining good credit so as to be able to borrow from others in a pinch, and so on.
There are also forces outside of the bank that could amplify the risk of its operations—for instance, the government promises, implicitly or explicitly, to bail out over-leveraged, insolvent banks, whether with tax funds or the printing press. This will surely increase the level of risk that bankers are comfortable with, and make financial crises more likely and more damaging because of it. But note that, while some degree of risk is “naturally” present in banking—as in any entrepreneurial business endeavor—the fact that outside forces create a moral hazard, drastically elevating the risk, should impugn the destabilizing outside forces, not the basic business model of banking itself.
Finally, there’s the question of whether banks, by allegedly “issuing” more money than they have in reserve, increase the overall money supply, causing inflation and hurting everyone (not just bank depositors). The mower example is instructive here. In the Mutual Mower Association, it’s clear that George does not “create” more mowers by lending Larry’s mower to Steve. If George creates anything (other than “intermediation services”), it’s a temporary claim on Larry’s mower by Steve. In some sense, there are multiple claims on the same mower, and this can be problematic for reasons already discussed if George doesn’t follow sound practices. But the whole point of banking is to move money from where it’s currently not being used to where it can profitably be used. While bankers issue multiple claims on the same pool of reserves, the economic reality is that they are re-lending depositors’ money that, on net balance, is “idle.” Some may fuss that banks cause the money supply to go up—this may be true in a technical sense—but they’re missing the point. Banks can’t indefinitely expand the money supply. They can only extend claims to money, in the form of loans, to the extent they can get depositors to consistently part with their money in the form of deposits—George can only re-lend Larry’s mower because Larry was not using it.
And this brings us back to the main point: there’s nothing inherently evil in the basic concept of banking, or “borrowing to re-lend,” as long as all involved parties know what’s going on and voluntarily agree to it. In historical and modern instances of fractional reserve banking, depositors are aware that banks’ main stock in trade is lending the money out, not just warehousing it; this practice after all is what enables banks to pay interest and offer convenient services to their customers rather than charge them fees. There are risks to any credit-based business—which are greatly escalated when governments are expected to step in to “stabilize” the financial system—but we accept them and learn to cope because the financial industry has tremendous potential to generate economic gain by putting financial capital to productive use.
If you want to criticize banking, then, you’d be wise to focus on external forces that increase risk. There’s a lot to choose from: deposit insurance, government bailouts, privileged access to central bank loans, government-imposed devaluations from gold to paper money, central bank money printing (the true inflation culprit), etc. But please don’t malign the perfectly legitimate business of banking itself. In a free market, banking transactions are voluntary actions between consenting adults—the basis of a flourishing market economy.
Tyler Watts is an assistant professor of economics at Ball State University.