By Hema Senanayake –
Sri Lanka is at the edge of the explosion of severe economic crisis. This is a government made crisis which might begin with a full-blown banking crisis unless corrective measures are not taken immediately. The obvious sign of this crisis appears from the recent advertisement of the Bank of Ceylon (BOC). The advertisement says that the BOC has three trillion assets. The other sign, as reported by media, was the restriction imposed by the Central Bank preventing commercial banks to declare profits until accounts are audited. The intention of this action must be to postpone the revelation of weaker performances of banks if there are any. None of these measures cannot prevent the collapsing of banks under the current practice of Fractional Reserve Banking which we practice at present if depositors lost credibility on banks. If I give you an example to understand the vulnerability of this present banking system, I will say, if depositors withdraw just 10% of their deposits within a day from a particular bank, the next day the bank has to close its doors for business. We live in a crisis that the collapse of one designated commercial bank which participate in the Fractional Reserve Banking system with the Central Bank, would make havoc quickly in the entire commercial banking system. The crisis is so serious. Unfortunately, there is no solution within our boarders to this impending crisis.
Government’s recent policy approaches contributed to this situation. Out of these policies two policy approaches are deadly. One policy is “austerity by import controls” and the other is the “mega infrastructure development.” Who put the government into this mess? Economic pragmatism is the philosophical culprit who put the government into this crisis. The government think that moving with the policy of Professor Lakshman’s “austerity by import control” helps the government to find a solution to the problem of severe foreign exchange reserve crisis and this is a mistake. Next, the government thinks that by undertaking mega infrastructure projects with government’s financing or with financing of foreign investors under BOT (Built Operate and Transfer) arrangement, the government can boost the economy and this thinking is a real blunder. That is why I say silly pragmatism does not work in economics as in many other scientific disciplines. I will discuss these issues in a separate article. In this one let us focus on the impending banking crisis.
Commonly, economists identify the modern monetary system as ‘elastic.’ This elasticity is arising from a unique practice of the banking system, and it is called Fractional Reserve Banking which system is facilitated and regulated by the Central Bank. Basically, there are two banking systems; one is fractional reserve banking, and the other is Full Reserve Banking System. Economists recently began talking about another variant of fractional reserve system call ‘fractional reserve free banking system’ which can be operated without a ‘lender of last resort’ (i.e., central bank).
Today, as I mentioned earlier our core banking system is known as “Fractional Reserve Banking (FRB)” system. It is a very peculiar banking system and is difficult to understand. Therefore, economists are not unanimous in explaining the concept of FRB system.
The monetary system that is being practiced today globally, is fractional reserve banking. But this is a highly vulnerable, crisis-prone system. At the same time, it is also a highly flexible system to run an efficient “elastic” money system, if managed properly.
The unique feature of the fractional reserve system is that it allows designated commercial banks to create more credit out of a fairly small incoming deposit, for an example if the incoming deposit is Rs. 100 the bank can loan out Rs. 900 or so under the existing rules of fractional reserve system. If someone gave you Rs.100 and if you want to lend it out to a borrower, the maximum you can lend out is Rs.100. But under the fractional reserve system, the bank could lend Rs.900 or so out of an incoming deposit of just Rs.100. The vulnerability of the banking system during a crisis arises due to this particular banking operation. Explaining this phenomenon is a bit difficult.
Sometimes difficult phenomena could be best explained through stories. As such following story is useful in understanding the Fractional Reserve System.
It is believed that in the middle centuries, goldsmiths started the practice of so-called fractional reserve system. In those days people deposited part of their gold with goldsmith for safekeeping. The goldsmith then issued a note to the depositor mentioning the number of coins deposited with him. The goldsmith returned any person’s gold upon surrendering his note. Sometimes he charged a small fee for his service.
When people wanted to borrow, they too came to goldsmith. Goldsmith had deposits of other people’s gold and knowing that everybody would not withdraw all the gold coins deposited at any one time he could lend gold from the deposits in his custody. Accordingly, the maximum he could loan out was the deposits he had. However, he had to keep a fraction of the deposits as a precautionary measure to return to any depositor whenever a depositor came to withdraw his or her deposit. With his past experience, he gradually understood that at the remotest possibility only ten percent of deposited gold coins were withdrawn. The balance ninety percent could be loan out safely. Taking this into consideration, the goldsmith could lend only ninety gold coins, if he had to lend in gold at any given time.
Since the note issued by goldsmith against deposit was honored by goldsmith, sometimes people used the notes to settle their payments among themselves. Now the goldsmith understood that people would not withdraw their goal at any one time, and his notes were considered as money – the gold – in executing transactions among people. Given this understanding he decided to issue a note when people came to borrow gold to pay their debt or make payment to another since the note was exchangeable for gold when it was presented to the Goldsmith and people trust the system. Goldsmith’s note was just a piece of paper, and he could create any amount of them. So, he could lend any amount to borrowers in the form of notes, however there were certain limits. Look at an example to understand this process.
In this example, people deposited 100 gold coins with Goldsmith. He issued 100 notes certifying the deposits. Then, when borrows came to borrow goldsmith he did not issue gold to borrowers, instead he issued a note because the note was honored by goldsmith when it was presented to him by the borrower or any other person. In this arrangement, he was not required to lend gold, so he kept the total deposit of 100 gold coins. From his past experience he knew that only 10% of noteholders could possibly come to withdraw gold at any given time period. Since he had 100 gold coins in his custody, he knew that it should be equal to 10% of total notes issued. So that he can calculate how many notes he could put into the circulation. Since he should issue 100 notes to depositors of gold coins and if he issued another 900 notes to borrowers now there would be 1000 notes in circulation out of which only 10% of notes would return to the goldsmith by holders of notes to withdraw gold at any given time. Ten percent of 1000 is equal to 100. This means if 1000 notes were in circulation the goldsmith has to have actual gold coins amounting to 100 only. Since he did not lend any coins, the goldsmith had 100 gold coins in his custody, and he could honor withdrawals without any problem. In fact, he lent money he did not have and during the act of lending he created a kind of ‘virtual’ money. The total system depended on the trust people kept on the goldsmith. In this system he had only a fraction of deposit as reserves to honor the withdrawals and is very similar to modern fractional reserve system even though nowadays it is regulated by the Central bank. But this system is highly vulnerable. Why?
Again, imagine that the goldsmith kept 100 gold coins and he put 1000 notes into circulation. He operates with a mandatory reserve ratio of 10%. Until depositors trust the goldsmith the system is fine. But if the depositors think that goldsmith is virtually bankrupt, they might come to withdraw their gold coins (money) by returning the goldsmith’s notes. Immediately after the withdrawals exceed 10%, the Goldsmith cannot honor the rest of notes he has issued to his customers. The system gets bankrupted within a day. This happened in the United Sates in 2008 during the Great Recession of 2008-09. This is the reason for BOC’s new publicity campaign and directing banks to delay revealing their financial performances. These actions create suspicion not credibility. Severe financial and banking crises take place not slowly, but suddenly as similar crises happened in Argentina in 2001 and recently in Lebanon. Under the present crisis, Sri Lanka is no exception. I again urge the community of entrepreneurs of Sri Lanka to pay serious attention on this matter before it is too late.