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Comment by philwelch | Hacker News Reader

That's not how fractional reserve works; that's just fraud. With fractional reserve, a bank holds maybe 1/8 of account balances in cash and the other 7/8 in loans due to the bank. So if eight people each deposit $100,000, the bank holds $100,000 in cash and can make three mortgages for $200,000 each plus ten $10,000 car loans. Either way they hold sufficient assets to cover their deposits, just not all of those assets are fluid. (The bank earns enough interest on the mortgages and car loans that they can pay interest to their depositors and take some profit off the top.)

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Exactly. And for those unfamiliar I'll add that banks face a classic problem: their loans have long terms, but their deposits can be withdrawn at any time. That is normally not a problem, but there are issues and edge cases that we handle with things like bank capital standards, deposit insurance, and swift government takeover and resolution in the case of bank failures.

For those interested in this, I strongly recommend Sheila Bair's "Bull by the Horns". She was the head of the FDIC up to and during the 2008 financial crisis, and this is her memoir. She's a fiscally conservative Republican, but one who strongly believes in the value of regulation as a way to create a sound economy so that all citizens can thrive. The book was fun to read, and it gave me a much better understanding of the forces at play and why good regulation of banks is immensely valuable to us all.

> banks face a classic problem: their loans have long terms, but their deposits can be withdrawn at any time.

Borrow short and lend long - great work if you can get it. Of course, this practice is fundamentally unsound (it provides nasty game-theoretic incentives to participants), but it tends to work "well enough" in practice that no one really cares, especially when there is a lender of last resort who is able to print money at will.

What are some of the nasty game-theoretic incentives it provides to participants?

If you think a bank run is going to happen, you want to withdraw your money ASAP, before it's all gone. Everyone else does the same - so you can get a self-fulfilling prophecy, even if everything would have been fine if everyone had stayed calm. For personal banking, this is largely mitigated by FDIC insurance, because the Fed can print enough money to cover small bank failures without anyone noticing or caring. However, if you're fucking around with collateralized debt obligations (CDOs)...2008 happens.

I don't think the majority of bank failures work that way.

Now they don't. But bank runs were common in the past: http://en.wikipedia.org/wiki/List_of_banking_crises

The "Calculated Risk" blog reports on bank failure, and even in 2010 (11?) when literally hundreds of banks failed there were only a couple cases in which the FDIC had to pay anything out.

How does that reconcile with this article: http://online.wsj.com/news/articles/SB1000142405274870439650...

which states that "The fund had a balance of negative $7.4 billion as of Dec. 31, though that was an improvement from the $20 billion hole it was in at the end of 2009."

Banks actually pay insurance premiums to FDIC, which are held in a fund which is used to pay claims. If the fund is wiped out, practically speaking the Fed would cover it but that's not the normal method of operation.

To be fair, the lender of last resort isn't necessarily printing/creating money in the long term.

If it is simply a classic bank run, and everyone wants their money back now, the lender of last resort could take over all of the distressed bank's illiquid assets and, over time, recover some or all of the lent moneys.

In this case, what the lender of last resort is really doing is making all illiquid assets liquid.

It's justified via statistical multiplexing, just like when an ISP sells a total of 1 Gbps of bandwidth but only has a 256 Mbps upstream connection.

So long as only a low percentage of demand depositors ask for their money back at any one time it's not a problem. But when everyone decides to withdraw their money at the same time you have a liquidity crisis. Liquidity problems aren't so bad anymore though -- the Fed steps in an lends all the cash you need against your long term assets. The real problem is when those assets go bad. Now you don't have a liquidity problem you have a solvency problem. The only thing the Fed can do at that point is to simply give the bank money to make up for their bad investments. Which is exactly what they did and are doing, albeit in an obfuscated manner.

Great stuff. Although I should say that there's more you can do with bad assets than just give people money. My understanding is that classic resolution is where you create a "bad bank" [1], a holding company for all the bad assets. You then fire the bank managers, put less dumb people in charge, recapitalize the banks, and use the bad bank to slowly realize the value from the assets, which are often not totally bad, just part of a cyclical slump. And you also update regulations and capital controls so as to reduce the chance of a similar mess next time.

A lot of people are critical that after the 2008 crisis very few people got fired for FUBARing the world economy. I get why the US ended up doing that; people were scared of anything that looked like more instability. But I think it was a mistake.

[1] http://en.wikipedia.org/wiki/Bad_bank

The Fed can't do something like that. It usually takes the involvement of a bankruptcy court, though the FDIC has some powers it can exercise independently. A full Swedish style resolution would almost have certainly required new legislation.

All that said, I agree with your underlying point that just giving insolvent banks money wasn't a great solution at all, though it was minimally sufficient to prevent bank runs at least on formal banks. There were some runs on shadow banking institutions, though in at least one case -- money markets -- the government stopped one by guaranteeing them as though they had been insured banks. That too was a mistake in my opinion.

I was under that impression they could make loans of 72/8 of their account balances. I may very well have misunderstood, but I had thought banks could loan out a given dollar multiple times at once. No?

No. The reason there's a multiplier effect that gets talked about a lot is because the money you borrow from the bank then ends up in another bank account (of the person you were borrowing money to pay). The bank it's deposited in there can then lend out against that deposit.

But each bank loan is balanced, to the reserve ratio that bank operates at, to a corresponding deposit.

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