The Cyprus Moment – a Shell Game Gone Wrong

“This is it! This is the sign!”  – Louis, Ghostbusters

Fractional reserve lending and the central banking cartel that backstops it are about to be put to a serious test in Europe. Fractional reserve lending is, of course, the process by which banks lend the same dollar out multiple times in order to leverage their returns and make huge profits on small margins. It is a dangerous game – as are all things that heavily leveraged – and the pain of the unravel will be something to behold.

The basic trouble with fractional reserve lending is simple. I deposit $10,000 with the bank, and they lend out $9,000 keeping back $1000 in “reserve”. But the borrower of that $9000 spends it, the recipient deposits it (perhaps at the same bank, though it doesn’t really matter), and the bank lends out $8,100 keeping $900 in “reserve”. So on and so forth until eventually there are $100,000 worth of account balances at the bank, and $90,000 worth of loans, but only the original $10,000 is cash on hand. What happens when everybody tries to withdraw their money?

Well, there are three things that  could happen when everybody takes their money out. (1) The bank runs out of money and the people lose the rest until the loan repayments slowly start to trickle in (which they won’t, because nobody buys anything when their bank accounts are gone). (2) The bank immediately demands repayment of the loans, which likely won’t work since the folks who borrowed money did so to buy something (this, by the way, is how the banks tried to handle things during the Great Depression … it didn’t work). (3) The central bank prints up enough cash to cover the difference and we all muddle along. So, either the depositors and the bankers take a bath (options (1) and by extension (2)) – or the “rest of us” (in the form of the holders of existing currency printed by the central bank) foot the bill.

On the one hand, I’m fundamentally fine with (1) and (2) – except for the fact that they confuse the various functions of the bank. If my checking account is a “demand account” then the bank should have no right to lend it out at all ever. They are just safe-guarding it, and I can demand it whenever I want. If it is an “investment account” then I must assume some of the risk of bad loans, and I might take some losses when loans are not repaid. In our current system, banks can freely claim that money is whatever form they choose and lend it out time and again. With that, the people who just put their money in the bank for safekeeping are unknowingly bearing the risk of loans that the bank is making (the bank, by the way, keeps any profits).

The idea behind the fractional reserve lending scheme is that the bank never really needs to have all of those deposits on hand. Surely it won’t be the case that everybody wants all their money at once, right? As long as the don’t all come calling, we should be fine. (By the way, current requirements in the US are 10% reserve on “transaction deposits” and 0% on everything else – and there are apparently loopholes by which banks can declare “transaction deposits” to be something else if they need to. Cash as a percentage of “money supply” tends to hover somewhere around 4.5%, so that is a reasonable notion of the actual leverage in the system.) The idea is sound … until it’s not.

If you’re going to run this sort of scheme, you need to take measures to ensure that the masses don’t all demand their money back at the same time. In America we have the Federal Deposit Insurance Corporation (FDIC), which guarantees to make up the difference for any losses up to $250,000. So, as long as you have less than that in the bank (ahem) you’ll be fine.

Another simple way to avoid mass withdrawals is to keep people from panicking. As long as people think their money is safe, then perhaps it is. A sort of “self-fulfilling prophecy” as it were. This won’t always work, of course. If loan defaults start piling up the money just won’t be there to support withdrawals. But if economic stresses don’t get too bad, and the people don’t panic, the fractional reserve system probably holds together.

One thing you don’t want to do in a fractional reserve system is tell the people that their money isn’t safe. Don’t give people reason to believe that if they went down to the bank tomorrow they couldn’t withdraw 100%. As soon as that gets out, there will be little that can stop it. Once the run starts, it will be tough to stop.

This is exactly what the European Union did this weekend. The banking system of Cyprus is insolvent. Too much money (a lot of it from foreign depositors) lent out to bad credit risks … it’s all coming undone. Somebody is going to have to foot the bill for the losses (see options (1), (2), and (3) above). The EU has decided that depositors should pay some of the pain and have offered to help with the rest. In exchange for a 10 billion euro bailout package, the EU has demanded a 6.75% tax on deposits under 100,000 euros and 9.9% on anything above that.

As you can imagine, the bank run is on.Cypriot banks are closed Monday and Tuesday for emergency voting in the legislature on the bailout package. But the ATMs have already been drained of their cash as nervous depositors try to get anything out that they can. It’s no use – the emergency measure is in place and the levy amount has already been frozen. The message is clear though: when a banking system collapses the depositors will be held to account for bad lending decisions of the bankers. (Again, if people were using banks as an investment vehicle, then this is fine – but if they are using the bank as a storage/checking function, it’s balderdash.)

One has to wonder if the Spaniards, Italians and Greeks are paying attention. For that matter, what about the French? Best to get your money out before the officials place a levy on it. Better to have your money in a mattress than in a bank where it could get taxed at nearly 7%.

It would take very little at this point to spark a Eurozone-wide bank run. While I don’t know what the leverage and ratios are in Europe, one can imagine that if 5% of the deposits were taken away, the system would face collapse. (Ever wonder how much of the euro bailout would come from the US Federal Reserve?)

The Cyprus measure hasn’t been approved by the legislature yet, but one suspects the damage is done. If they vote to accept the bailout, they’ll be voted out at the next election (by a landslide). And who would ever put money in a Cyprus bank again? If they reject the measure, the banking system will still collapse because the panic precedent has been set (and the banks are insolvent).

I’m far more interested in what happens in Spain, Italy, and the rest. If things unravel from here, the European Union demand that depositors foot some of the bill will be the “Lehman moment” for the eurozone and the European Central Bank. Time will tell.

(Update: the currency markets opened with the Euro dropping down from $1.308 to $1.290. A 1.4% move in the currency exchange rate is nothing to sneeze at. The markets are jittery. Where to from here? Who knows?)

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2 Responses to The Cyprus Moment – a Shell Game Gone Wrong

  1. “Surely it won’t be the case that everybody wants all their money at once, right? As long as the don’t all come calling, we should be fine.”

    I think it’s fascinating to compare this “game of chicken” perspective with the corresponding situation with a finite-supply currency like gold or bitcoin. As we have discussed before, gold has no value other than its finite supply– ok, it’s shiny, but that’s about all it has going for it. (I remember a short story I read as a child, I can no longer remember the title, about a human who discovered a Lilliputian-like race of tiny people in some other land. The people complained about the soft, malleable quality of the metal they used to make their tools… their “annoyingly-low-quality-but-abundant-supply” metal turned out to be gold.)

    Anyway, we place value on gold because we all agree that it has value. Bitcoin makes this situation even more vivid: you agree to accept bitcoins from me as payment because we all agree that they have value… and they aren’t even shiny! 🙂 And because of their limited supply, I am motivated to save/hoard them, in the expectation that they will further increase in value with time.

    But what happens if the game of chicken ends, and we all realize that the bitcoins, or the gold, or whatever, are not, in fact, as valuable as we thought/agreed that they were?

    Of course, this is all speculation. Whether a deflationary spiral will in fact occur with bitcoin (or would occur with a return to the gold standard) remains to be seen, and advocates/opposers are equally insistent that they know what will happen. I don’t know– but it will be interesting to conduct the experiment.

    • nomasir says:

      I think the “game of chicken” takes on a very different nature in the case of gold or bitcoin. In each case the only “value” is the agreement to use as a means of exchange COUPLED WITH the fundamentally limited (or difficult to increase) supply. True, you can’t eat bitcoin or gold – and while you can use gold for some things, tools are not among them. Their only value is the fact that we all agree to exchange them (and if we ever decided they were worthless, then worthless they would be – or near worthless).

      The “game of chicken” is far worse in the fractional reserve lending scheme. Not only are dollar bills of no intrinsic value (other than the heat they produce when burned), but the system is built on the existence of some 20-times more “credited” dollar bills than actually exist. And, the maker of dollar bills can just decide to make more any time they want, meaning the ones we use for exchange can be rendered worthless at a moment’s notice. True of gold and bitcoin? Perhaps, but it would be OUR decision, not someone else’s.

      Interestingly, it is fractional reserve lending that got us into the mess of the Great Depression (in my opinion – and a lot of others’ too). Were we on a “gold standard” at the time? In name only. When the banks lent more money into existence than their was gold to back it up, we were in some serious trouble. What if everybody wanted their money (nee gold) at once? It didn’t end well.

      On the bright side, I personally think that the deflationary cycle can be one of choice still. That is, if we eliminate all capital gains (not a position I hold in and of itself, but for the sake of the potential deflationary collapse) then people would move dollars in and out of various asset classes at will in order to provide a “safe haven” for their excess production. This would be free from confiscatory policies by the government or the central banks … which is why I suspect it won’t happen … so bring on the deflation.

      As to the idea that we save/hoard gold/bitcoin because we expect them to increase in value over time, I would contend that the value of savings in terms of “stable money” is merely a representation of stored production. If I think my gold will “increase” in value over time, it can only mean that I think human production will increase significantly over time (and it likely will) and that my stored production from last year will be able to buy more consumption due to said increase. While production should increase over time, I find it hard to believe that the rates of increase are anywhere near the types of rates of increase that governments/central banks have pumped into their fiat currency systems. Even if this were mildly deflationary, it would be deflationary with hope, not fear.

      And deflationary with fear could be really ugly … as we may find out shortly.

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