Unit 1 Lecture Notes

The relevance of the question of fractional reserve banking and bitcoin is twofold: First, to understand whether a fractional reserve system can develop on top of bitcoin. Second, to understand how the current financial system can interact with Bitcoin.

Fractional reserve banking, in the institutional manner discussed in the old works of Mises and the Austrian economists, is no longer the serious problem it once was. As mentioned above, the tension between banking solvency and currency hardness was resolved in favor of the former. With time, the FDIC, and international equivalents came along to play the official role of lender last resort. Laws like Glass-Steagall act segregated banking from investment banking, and protected only the former with the protections of a lender of last resort. Supposedly strict lending criteria were implemented to prevent too much credit expansion, and the central bank would set the interest rate. This highly complex edifice of central planning of course did not work too well: the currency continuously lost value, and business cycles were a constantly recurring phenomenon, but for many major economies it did succeed in averting major crisis for many decades through putting some tenuous limit on credit expansion. But this tenuous arrangement is deceptively unstable, for its own stability sows the seeds of its collapse.

By placing a lender of last resort facility at the service of the banks, it is unthinkable that such an exorbitant privilege would go unabused. The banking sector may have ring-fenced retail banking into a highly-regulated industry to prevent bank runs, but they still branched out into other models of banking and finance. These institutions are known as the shadow banking system: financial institutions that engage in fractional reserve banking without having a formal lender of last resort like the FDIC. They include investment banks, mortgage companies, money market funds, repurchase agreement markets, asset-backed commercial paper, and securitization vehicles.

The shadow banking system is effectively government-subsidized by the guarantee of the central bank as a lender of last resort, in various explicit and implicit forms. First, these financial institutions can secure funding at a lower rate than other businesses, which is why financial companies began acquiring larger and larger sectors of the economy, and even non-financial companies resort to a large degree of financial operations, as discussed in The Bitcoin Standard. This implicit subsidy is itself a privilege to these financial institutions that allows them to engage in mismatched-maturity lending, since they have access to a lower rate than any outsiders.

Second, repeated episodes of the Federal Reserve bailing out financial institutions deemed too systemic to fail reinforced the idea that financial risk-taking was unlikely to be allowed to fail. As far back as 2004, in Too Big to Fail, Stern and Feldman warned of the pervasiveness of a bail-out mentality in the financial system, arguing that "not enough has been done to reduce creditors' expectations of [Too Big To Fail] protection".

Stern and Feldman outline several episodes that have, over two decades, fostered creditor bail-out expectations. The first was the bailing out of creditors of Continental Illinois in 1984, which was summarily followed by the comptroller of the currency testifying to Congress that policymakers would also protect creditors of the eleven largest banks in the country, since they were too systemically connected to fail. This incentivized banks to become too big and interconnected to fail, and to take excessive risks. Several other banks and Savings and Loans Associations failed in the subsequent years, and federal protection seemed to become more generous towards creditors and depositors with time, going beyond legal requirements under the pretext of guarding against systemic effects. Stern and Feldman argue that the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was insufficient to counter growing bail-out expectations. Further, increased bailing out of debtor countries, as well as the government induced rescue of Long-Term Capital Management (LTCM) in 1998, all contributed to heightened expectations of creditor protection. In time, these warnings have proved prescient.

Third, Yet perhaps even more important was the growing deployment of monetary policy as a means of rescuing failed institutions and forestalling creative destruction. Under what came to be known as "Greenspan's Put", former Federal Reserve Board Chair Alan Greenspan repeatedly lowered official Fed funds rates in response to asset price falls and solvency problems for large firms, allowing them to borrow on favorable terms to save themselves. The 1987 stock market crash, Russia's debt default, the collapse of LTCM, and the bursting of the dot.com bubble were all followed by the Fed cutting rates. Investors and creditors had found a way of privatizing their gains while socializing their losses. Straightforward solvency problems - market losses - were now treated as liquidity problems which a lender of last resort could alleviate, and in the Federal Reserve, the shadow banking system came to increasingly believe they had a lender of last resort upon which they could rely.

Fourth, the increasing political influence of the banking industry which succeeded in formally repealing Glass-Steagall Act, allowing retail banks to enter into investment banking. Rather than being the main culprit of this episode, the repeat of Glass-Steagall is more of a symbolic confirmation of the reality that had creeped over decades of government-enforced control of banking: A giant shadow banking system was now responsible for creating far more of the US Dollar money supply than the government or the formally regulated retail banking system. The shadow banking system's ability to increase the supply of credit is hard to measure or understand, as its many organs move in many different ways, and harder to regulate, since no formal authority has control over these banks, as in narrow retail banking. Instead of regulating it or controlling it, the US Federal Reserve has chosen the wholly submissive position of bailing out virtually unconditionally.

All of this means that today, the inflationary money creation and business cycles are not mainly being generated in the traditional or retail banking system as was the case in the eras of most Austrian economists' analysts. The analysis of fractional reserve ratios, lending criteria, and interest rates for depository institutions are becoming an increasingly quaint irrelevancy in the modern economic system, where far more money is being created outside the traditional retail banking system than inside it. The layers and degrees to which maturity mismatching and fractional reserve banking can exist in the shadow financial system is not easy for anyone to survey.

Now, if you thought fractional reserve banking was complicated when done with bank reserves, then that is nothing compared to the complexity of performing the equivalent of fractional reserve banking with all financial assets and instruments that are held by the shadow financial system. Stocks, bonds, commodities, and all different kinds of debts are now part of maturity mismatched lending, which effectively means the claims for ownership of these assets are larger than the assets. The 2008 financial crisis was merely the collapse of this fractional reserve shadow banking system. By bailing out the majority of financial institutions directly, and by letting them borrow at lower rates, the central bank played the role of lender of last resort, allowing these banks to profit from mismatched maturity lending in the financial markets, and to continue doing it.

The problem today is quite severe, as Ciatlin Long has been tirelessly repeating. Whether it is stocks, bonds, or collateralized debt obligations, the brokers and financial entities handling these financial assets are engaged in large amounts of rehypothecation, no different in essence, from what banks do with their reserves. Bitcoin is entering a world of shadow banking institutions engaging in mismatched maturity lending without a formal central bank, but with an informal central bank guarantee that bails them out. The amount of fraud and manipulation likely to take place in such markets is large, and many are concerned about what this might mean to Bitcoin. Would the maturity mismatched lending of the shadow banking increase the supply of Bitcoin-tracking financial instruments that provide exposure to the price of bitcoin without having full backing in bitcoin? Wouldn't that reduce the demand for holding bitcoin itself?