Friday, March 29, 2013

How banks go bust...

How Banks Go Bust

by Murray N. Rothbard

The Case Against the Fed, Chapter 8, “Problems for the Fractional-Reserve Banker: Insolvency.” (Slightly edited for publication as a separate article.)

The fractional-reserve banker, even if he violates his contract, cannot be treated as an embezzler and a criminal; but the banker must still face the lesser, but still unwelcome fact of insolvency. There are two major ways in which he can become insolvent.

The first and most devastating route, because it could happen at any time, is if the bank’s customers, those who hold the warehouse receipts or receive it in payment, lose confidence in the chances of the bank’s repayment of the receipts and decide, en masse, to cash them in. This loss of confidence, if it spreads from a few to a large number of bank depositors, is devastating because it is always fatal. It is fatal because, by the very nature of fractional-reserve banking, the bank cannot honor all of its contracts. Hence the overwhelming nature of the dread process known as a “bank run,” a process by which a large number of bank customers get the wind up, sniff trouble, and demand their money. The “bank run,” which shivers the timbers of every banker, is essentially a “populist” uprising by which the duped public, the depositors, demand the right to their own money. This process can and will break any bank subject to its power. Thus, suppose that an effective and convincing orator should go on television tomorrow, and urge the American public: “People of America, the banking system of this country is insolvent. ‘Your money’ is not in the bank vaults. They have less than 10 percent of your money on hand. People of America, get your money out of the banks now before it is too late!” If the people should now heed this advice en masse, the American banking system would be destroyed tomorrow. [1]

A bank’s “customers” are comprised of several groups. They are those people who make the initial deposit of cash (whether gold or government paper money) in a bank. They are, in the second place, those who borrow the bank’s counterfeit issue of warehouse receipts. But they are also a great number of other people, specifically those who accept the bank’s receipts in exchange, who thereby become a bank’s customers in that sense.

Let us see how the fractional-reserve process works. Because of the laxity of the law, a deposit of cash in a bank is treated as a credit rather than a bailment, and the loans go on the bank’s balance sheet. Let us assume, first, that I set up a Rothbard Deposit Bank, and that at first this bank adheres strictly to a 100-percent reserve policy. Suppose that $20,000 is deposited in the bank. Then, abstracting from my capital and other assets of the bank, its balance sheet will look as in Figure 4...

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