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YOU DECIDE: Do banks need backup?

December 26, 2008

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

Banks have lost billions of dollars in the past year and cut thousands of employees. At the same time, the federal government - which really means you and me as taxpayers - has put billions of dollars into the banking system to limit losses and prevent a widespread banking collapse.

Both of these situations are certainly controversial.

Some say banks lost money because they made bad loans, and should therefore fail. Others argue the government money sent to banks is a bailout that will cost all taxpayers either more taxes or higher inflation in the future.

So why are we helping banks?

There are two possible logical answers. One is that the banking system, by its nature, is unstable. This instability creates financial booms and busts, and while the benefits from the booms typically outweigh the costs from the busts, the banks need public help to keep afloat during the bad times.

The second reason is that the banking system is special: it is essential to the economy. If the banking system doesn't function properly, households and businesses - indeed, the entire economy - suffers.

Let's look at each of these reasons in more depth.

The idea that the banking system is inherently unstable is based on the "fractional reserve system" widely used by banks. Banks operate by taking money from depositors, loaning those funds to borrowers, and making money by charging the borrowers slightly more than is paid to the depositors. Banks act as a middleman between depositors and borrowers.

In this process very little (only a "fraction") of any deposit (also called a "reserve") put into a bank is kept in the bank's vault. The majority is sent out of the bank as loans.

Yet there's more.

Let's say you deposit $1,000 into Bank A, which keeps $200 in its vault and loans the remaining $800 to me. I take the $800 to my Bank B, which accepts it as a new deposit, keeps $160 in the vault and makes another loan of $640. The process continues over several more rounds.

Eventually, the initial $1,000 deposit, when combined with the additional deposits from all the loans, grows to $5,000. The fractional reserve system, in which only a portion of any deposit is kept in a bank's vault, has resulted in the creation of much more money.

The fractional reserve system is beneficial for the economy because it creates more spending, more buying from businesses and therefore more jobs. In other words, it creates an economic boom. And everything works smoothly as long as the loans are repaid.

But if enough of the loans fail and aren't repaid, then the boom can turn into a bust. Not only will banks suffer losses, but they won't have enough funds in the vault to meet the demands of depositors wanting their money. A "run" on the bank, during which depositors demand their money back from the bank, occurs.

In the 19th and early 20th centuries these periodic bank runs were devastating. If banks shut down, the entire economy can grind to a halt because even the best-operated business needs access to regular credit. Think of banks as the heart of the economy, pumping the economy's lifeblood, money and credit, throughout the system.

This central importance of banks, combined with the system's susceptibility to booms and busts, was the main reason the Federal Reserve System (the "Fed") was established almost 100 years ago. The Fed's role is to moderate the financial system's boom-and-bust cycle by reining in money and credit creation during booms, and stimulating money and credit creation during busts. Federal insurance of deposits (FDIC) was also added to head off bank runs.

We can certainly see the Fed trying to stimulate lending in the past year by lowering interest rates, making loans to banks, buying bad debt from lenders and simply printing more money.

But some ask where the Fed was earlier this decade during the economic boom. These critics question whether the Fed did enough to slow the vast expansion of credit, particularly in the mortgage market.

The condition of the banking sector is central to today's economic issues. Decades ago we decided banking was a special part of the economy which deserved special public backup.

You decide if it still is, and does.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at December 26, 2008 08:00 AM