You are a free subscriber to Me and the Money Printer. To upgrade to paid and receive the daily Capital Wave Report - which features our Red-Green market signals, subscribe here. Really Fair, Really Quickly…We're going to talk about the modern banking system, why your deposit doesn't just sit in a vault, and why the whole machine only works because the government stands behind it.
Dear Fellow Traveler: I’ve now written over 1,500 articles here on Substack… and I went back… way back… to read the slop where it all started. The fifth article I ever wrote was explaining… what fractional banking is… And I thought… YEP! Better revisit this nonsense… Don’t Do This to Me, GarrettSorry… but a lot of people think banks take their money and lend it to someone else. That’s… well… partially right. But what actually happens is more dangerous than most people realize. Call it “fractional reserve banking” if you want the textbook term. In practice today, it’s broader than old-school reserve math. It’s a system where your ‘safe’ deposit becomes the base ingredient for a much taller tower of credit and rate risk. The classic version goes like this… You deposit $100 in the bank. Historically, the bank was required to keep a fraction of that $100 as reserves at the Fed or in cash and could use the rest to make loans. That’s the origin of the phrase “fractional reserve.” The idea was for a bank to hold a slice and lend the rest. Since March 26, 2020, the Fed’s reserve requirement ratio for transaction deposits at banks has been 0 percent. Yes… ZERO PERCENT. One more time for the people in the back… ZERO PERCENT. Every bank in America can lend as if the reserve requirement never existed. Today, banks aren’t limited by “must keep 10 percent in the vault.” But… this is important… Capital rules constrain them (Basel III ratios like CET1 and leverage constraints), liquidity coverage requirements, stress tests, and internal credit standards, not a fixed reserve ratio. But the multiplier effect still works the same way. Now watch the chain. The bank makes an $80 loan to Bob’s small business. In modern accounting, that loan doesn’t come from a shoebox of “your” $80. The bank creates a new $80 deposit in the system when it lends. Bob then spends that $80 on equipment from Sarah. Sarah deposits that $80 at her bank. Sarah now sees $80 in her account. Sarah’s bank can now make its own loan against that new $80 deposit, keeping only a small liquidity cushion. Say it lends Mike $64 for a down payment. Mike pays Dr. Johnson $64 for dental work. Dr. Johnson deposits the $64. Now look at the ledger:
The banking system just turned one original $100 of base money into a few hundred dollars of deposits that all spend like money. This is how traditional bank lending expands the money supply… And how I get a nosebleed every time I explain it. New deposits are created when banks make loans. But as I noted the other day, there’s a whole other world of banking that exists and the structure of it all is pretty deep and intensive and will make you dizzy… Why This Should Worry YouEveryone in that chain believes they have cash on demand. But the underlying “hard” money in the system (reserves, physical cash, Treasuries that can be repo’d for cash) is much thinner than the total deposits people think they can grab instantly. The only reason this tower of credit doesn’t collapse instantly is the explicit and implicit government backstop. That’s fine in normal times. It is not fine in panic. A bank run is just this math getting exposed in real time. If too many depositors demand their money at once, the bank can’t instantly produce cash for everyone, because a lot of its assets are loans and securities that can only be sold at a loss or over time. We just watched a modern version with Silicon Valley Bank. SVB took in huge, concentrated, mostly uninsured deposits. It then bought longer-dated Treasuries and mortgage bonds with that money because those looked “safe.” When the Federal Reserve hiked rates, those bonds plunged in market value. On paper, SVB still had “assets.” In reality, if it had to sell those assets fast to meet withdrawals, it would lock in enormous losses. (This is what happened to pension funds in England in 2022 as well, until the Bank of England had to step in…) Depositors figured that out and ran all at once. The bank couldn’t convert those assets to cash without blowing up. Regulators stepped in and guaranteed the deposits to stop contagion across the rest of the system. That’s not a glitch in the system… it is the system. The illusion of liquidity only works until someone tests it. And we experience the modern bank run… It wasn’t Bonnie-and-Clyde. It was a combination of duration risk and Twitter. Moral Hazard: Heads They Win, Tails You Pay Here’s the structural problem. Banks earn more when they take more risk. They can reach for yield, stretch maturity, buy longer bonds, and make looser loans. If it works, executives get paid. If it fails, there’s an expectation… especially for large or systemically sensitive banks… that the Federal Reserve, Treasury, FDIC, or some combination will provide emergency liquidity or backstop deposits to prevent wider collapse. So.. what do you think happens because of incentives? The incentive structure creates moral hazard. The upside is privatized. The downside, when it’s catastrophic enough, gets socialized. We all absorb it through bailouts, emergency lending programs, and monetary policy that ultimately bleeds into inflation and currency debasement. Didn’t the Fed Fix This? The Federal Reserve was created in 1913 after a series of brutal 19th and early 20th-century panics. The stated mission was to stabilize the system and act as a lender of last resort. What we’ve seen instead is a cycle… Especially post-1971, when we came off the gold standard… We’ve had credit booms, asset bubbles, crashes, rescues, and… well… repeat. Dot-com bubble. Housing bubble. Everything bubbles. Modern central banking suppresses interest rates, floods the system with liquidity, and implicitly promises rescue when markets crack. The Fed mainly steers credit through aggressive rate suppression and liquidity injections, not by toggling reserve requirements up and down every cycle. That rescue prevents total collapse, but it also encourages the next round of risk-taking. We call this “financial stability.” In practice, it’s a permanent intervention system... Meanwhile, most new ‘money’ isn’t even born in commercial banks… It’s in the shadow system of repo, money-market funds, and collateralized lending. That’s fractional banking without deposits, powered by leverage instead of savings. But that’s a drink for a different day… Defenders Will Say...Supporters of this structure will argue, correctly, that without fractional-style banking, you don’t get broad access to mortgages, business loans, payroll financing, and innovation. Of course, innovation is a pleasant way of saying “risk…” and “financial engineering…” I’ve always loved the scene in Margin Call, where Paul Bettany explains that no one wants the system to be fair. He explains that bankers - the masters of the universe - have their fingers on the scale to benefit mankind…  Best line of the film…
It’s a brutally accurate description of modern finance… and it’s the second best monologue of Bettany’s career… right behind this gem in A Knight’s Tale (underrated film.) If every dollar had to sit idle in a vault at 100 percent reserve, credit would be brutally scarce and growth would slow… (well… it would be a lot worse than that…) They’ll also say deposits are protected. In the U.S., standard bank deposits are insured by the FDIC up to $250,000 per depositor, per bank. That’s real. You are not powerless. All true. The system isn’t illegal. It’s not classic counterfeiting. It’s not a Ponzi in the “criminal scheme” sense. But it is inherently fragile. When your $100 deposit becomes the base for hundreds of dollars of credit and layered risk, you’ve built a machine that only functions as long as confidence holds and as long as the Federal Reserve stands ready to act as an emergency liquidity provider. Most days, that’s enough. But the days it’s not… well… the whole world gets really fair, really quickly… Stay positive, Garrett Baldwin About Me and the Money Printer Me and the Money Printer is a daily publication covering the financial markets through three critical equations. We track liquidity (money in the financial system), momentum (where money is moving in the system), and insider buying (where Smart Money at companies is moving their money). Combining these elements with a deep understanding of central banking and how the global system works has allowed us to navigate financial cycles and boost our probability of success as investors and traders. This insight is based on roughly 17 years of intensive academic work at four universities, extensive collaboration with market experts, and the joy of trial and error in research. You can take a free look at our worldview and thesis right here. Disclaimer Nothing in this email should be considered personalized financial advice. While we may answer your general customer questions, we are not licensed under securities laws to guide your investment situation. Do not consider any communication between you and Florida Republic employees as financial advice. The communication in this letter is for information and educational purposes unless otherwise strictly worded as a recommendation. Model portfolios are tracked to showcase a variety of academic, fundamental, and technical tools, and insight is provided to help readers gain knowledge and experience. Readers should not trade if they cannot handle a loss and should not trade more than they can afford to lose. There are large amounts of risk in the equity markets. Consider consulting with a professional before making decisions with your money.
|
Subscribe to:
Post Comments (Atom)
0 Response to "Really Fair, Really Quickly…"
Post a Comment