Sunday, 28 June 2015

Greece, Mini-bank Queues and Fractional Reserve Banks

People in Greece have been withdrawing deposits from their banks for some time now. With the recent referendum announced by the government following endless talks with the troika, deposit withdrawals are likely to gain further traction the coming days and weeks. People lining up at the mini-banks (ATMs) is a mini-version of a classic bank-run.

When people withdraw deposits from banks, they decide to store the money they own themselves instead of leaving it to the banks. The trigger for such an action is usually that people no longer trust the banks to safeguard their deposits nor make the cash available upon demand. When this happens, banks run into financial difficulties. But why?

Simply put, banks run into problems when people withdraw their deposits as banks use these very deposits to run their daily operations. In simple terms, banks don't keep all your money in a safety deposit box, only a fraction of it. This is why the banking system is called "fractional reserve banking". In real life, this means banks will only be able to pay out a fraction of the deposits, typically around 10%, if all depositors run to the bank to withdraw their funds. This is why banks are financially fragile. It's a flawed system, a house of cards, ready to collapse at any moment once confidence among depositors vanish. But where is the rest of the money customers deposited? It's tied up in assets like bonds and loans that are substantially less liquid than cash.

The current flawed system also explains why all sorts of capital controls and bank holidays likely will be implemented tomorrow and the days and weeks to come in Greece - the banks have been investing and lending, sometimes gambling, not just with their own equity capital (of which banks have very little), but also with the very customer deposits these banks are supposed to keep safe! Alas, that's why banking crisis keep popping up again and again in countries employing a fractional reserve banking system - it's inevitable by design. Sadly, most countries and all "developed" nations today operate in such a banking regime.

The case of Greece is therefore an excellent opportunity for more people to truly understand the misery brought about by fractional reserve banking.