With the exception of the Brown Brothers Harriman & Co. partnership bank in New York, substantially all other U.S. banks are insolvent. They would be unable to redeem customer deposits on demand, as promised, and would be forced to default if more than a small fraction of their customers demanded return of their funds.
Insolvency is an unavoidable feature of fractional-reserve banking, in which banks create money out of thin air. When customers make deposits in a bank, they are lending money to the bank and become creditors of the bank. From the bank’s perspective, a deposit is a liability – money it owes to a customer.
Banks keep only a small percentage of customer deposits – typically less than ten percent – readily available to meet the demands of depositors for return of their funds. They lend or invest the rest and account for these loans and investments as assets.
When a person deposits his paycheck in the bank, other than any portion he sets aside for saving, he expects to be able to redeem his deposit on demand to pay for groceries, rent or mortgage payments, utility bills, and the like. Typically these expenses will arise within thirty days.
The bank, however, will not keep those funds readily available, so that it can without fail and with utter dependability return them when its customer’s utility bill is due. It will instead lend most of the deposit to someone else to buy a car, or to purchase a copier for a business, or for some other purpose, or it may even speculate in stock of other financial institutions with those funds.
The bank cannot make the person to whom it lent funds to buy a new Corvette sell the car and return the funds on short notice, should the depositor from whom it obtained the funds to make the Corvette loan suddenly need them back to pay the electric bill. It will instead have to “borrow” funds supplied by another depositor or lender.
In essence, almost all modern, U.S. banks are legalized pyramid schemes. If people demanded return of more than a small fraction of their funds on deposit with the bank, the bank would fail.
Perversely, blaming bankers for operating the pyramid schemes that are their banks would be unfair. Regulators practically insist that banks operate as pyramid schemes. It is doubtful, in fact, that regulators would give a banking license to a new bank that proposed to operate only as an absolutely safe and reliable warehouse for the hard-earned money of its depositors.
Several years ago, I made just such an inquiry of banking officials in the State of California. Would it license a new bank that did not make loans and did nothing more than secure deposits with high-quality investments of matched duration? These officials told me that such a bank would not qualify for a license, because unless it were making loans, the new bank could not “fulfill its obligations to the community in which it operates.”
Regulators are appointed by elected executives, whether governors and presidents, and overseen by elected legislators, whether state or federal. So ultimately, the sorry state of modern banking is the responsibility of the people, and it will be up to the people to take the actions necessary so that they may enjoy the use of safe and solvent banks.