Quote of the Day: How Fractional Reserve Banking System Causes Bank Runs

Economist Tim Worstall writing at the Forbes eloquently explains how the central bank- fractional reserve banking system causes bank runs and originated the 2008 crisis or the Great Financial Crisis

To explain this we need to take a step backwards: we can usefully, if not wholly accurately, divide investors into two types. Those who invest with their own money, those who are unleveraged, and those who invest with borrowed money, the leveraged investors. Further, among the leveraged investors we would want to distinguish between the banks who are doing this (at least, in a fractional reserve banking system we want to) and the others. And the danger comes when those banks, those people working with the deposits made into the banks, invest in either illiquid or volatile assets.

Liquidity is a problem because those depositors can come along at any time and ask for their money back. And banks borrow short and lend long: the things they invest in are notably more illiquid than the deposits they take to finance them. That’s how we get bank runs: people turn up for their money, the bank says that actually, they lent it to someone to buy a house, and then panic starts and everyone wants their money back right now.

Volatility is a problem because they’re using leverage: if prices move so much that the bank loses its capital then it still owes the same amount to depositors but it is also bust. Cue bank run again. What happened to Lehman Brothers was this second, what rocked the other Wall Street banks was the first.

Bottom line: liquidity and volatility problems are mainly symptoms of imbalances from highly leveraged systems brought about by the central bank fractional reserve banking.