Quote:
Originally Posted by Double Ice
Suppose 100 people each own a $200k home free and clear. They want money so they each go to ABC bank and the bank trades the title for a 100k line of credit with interest, crediting debtors 10 million total and starting to spin up interest. But say ABC bank doesnt have 10m cash, they just have titles to homes. But part of lending 10m is that they have to make the cash available on demand. I agree that right now the bank has about 20m in titles so its true that their assets can usually meet their liabilities if given time to liquidate.
So, if I understand you correctly, you say its no problem because ABC bank can always meet their obligation. But the problems I see are: unfairness and hazards.
Unfairness: Basically with only say 1m in their vault, they are able to spin out interest as if they owned 10m, earning 10 times as much. And even though they can get other lenders to help with this [and if it is really bad, the central bank], overall I feel it is unfair that the government backs these private businesses. Like take deposit insurance. I guess most people only care about whether they get paid back and when they are assured of that, their problems end. But I think it is a serious problem and it is unfair that banks can spin more money in interest than they hold liquid.
For example 5 people deposit their gold bar at my place. I print 5 receipts and then go use the 5 gold bars to invest and spin up interest. When anyone wants their gold bar back, I go buy a new one. I find this to be fraud because the agreement with my customers are that I am supposed to hold their gold bar, not make investments with it. If my investments go sour a small % of the time I just default. And it doesnt matter if the government guarantees my ability to always make good, infact its worse because it makes my risk tolerance way higher. I mean I guess its really good for me, because the depositors have no risk since the govt backs me, and I just spin up free interest from the deposits. But thats unfair.
Hazards: Basically even though the bank has 20m in titles and only 10m cash outstanding, maybe a tornado hits and their 20m in titles become nothing and they cant pay. Of course in reality they have insurance. But the point is the deposits arent backed by cash. Out of the 10m in the banks deposits, only a fraction of cash is there. And the government insures banks from failure, why is this? When I play on pokerstars all the player deposits are held in a separate account. That way when the **** hits the fan everyone gets paid. Why arent banks held to the same standard?
I am not saying I am right and admittedly I am not well versed on this subject, but can you explain these problems to me?
Your point about FDIC and government backing deposits is correct. It is an intrusion into the banking market which helps banks make more money without any risk (gov't pays if they lose). This is a separate issue, but you are correct.
The other issue is that they "don't have enough cash to pay their debts," and "loan out the gold to earn interest." These are complaints that only arise because you are viewing banking as a storage service. Banking is both a storage business and a liquidity-generating business, but in both cases they are making an agreement that they plan to keep.
In the case of the storage business, imagine you hand your friend a $5k chip at a nightclub as he is leaving to go home, because you don't want to lose it at the Rhino. He agrees and when he gets home, throws it in the hotel safe along with all his other chips and cash. The next day, he plays in a big game and ends up putting all of his liquid cash on the table (at risk), but he is a millionaire; he has a lot more in the bank, real estate, other assets. If he loses that money he is still good for the $5k, and is still going to return it to you upon request. You would not fault him for putting the chip on the table.
Banks do the same thing, but have government insurance that backs up a huge amount of it, which is like the government telling your friend that he can lose up to $250k and they will pay. It's unfair to taxpayers.
The second part of a bank's business is liquidity-generation -- taking large blocks of illiquid assets and "chopping" them into smaller blocks. This would be like taking the title to your car and handing you $20k in poker chips. The service is accepting ownership of the large, illiquid (hard to sell) asset in exchange for small bits of liquid wealth (cash, poker chips).
These are two separate parts of banking. You should also realize that while your friend, (or the bank) holds the $5k, he owns the $5k and holds a debt, an agreement with you to repay the debt. He is free to do as he pleases with his assets, including money he owes to other people. It's a mistake to think that money sitting in a bank is "yours." It isn't yours; the bank owes it to you. There is a big difference there.
If the money were still yours, the friend might say "I'll hold this chip for you and in good faith protect it from loss, but if I am robbed or if it falls out of my pocket I am not liable; it is still your chip." But he didn't say that, he accepted ownership of the chip and gave you a debt in exchange for ownership, and because of that he is free to do as he pleases with the chip, knowing that owes you $5,000.
Last edited by Lyric; 08-30-2011 at 02:34 PM.