Distributed Economics

Viewed from a computer scientist’s perhaps somewhat jaundiced perspective, the history of Fractional Reserve Banking and the many changes that have been made to it over the centuries is one of neither careful design, nor careless conspiracy  - careful conspirators typically don’t publish their meeting’s minutes online. Rather it is a history of kludges.

Every time the banking system has blown up, either in the form of some kind of speculative credit bubble, or through a collapse in the value of money through general inflation, the proximate cause has been identified and “fixed”.  Almost inexorably, or so it seems, thereby setting the larger economic system on track for the next problem.

One of the classic problems acknowledged in the textbook implementation of the Fractional Reserve Banking System is the inherent problem in relying on statistical multiplexing of a small reserve to satisfy deposit demands. What happens if a Bank hits a statistical outlier, and more than 10% of the bank’s depositors turn up on the same day asking for funds?  The other 90% of the bank’s deposits is represented by loans, and not immediately available. The probability of this happening depends on a number of factors, but two obvious, and historically relevant ones,  are the size of the bank, and its geographic coverage. The smaller the bank in terms of the number of its depositors and loan recipients, and the more locally based its depositor base, the more vulnerable it is to external events. For example, a bank that takes all its depositors money and makes five large  loans with it, is much more exposed if one of them defaults, than one that makes one hundred.

As a side note, this also means that the stability of a fractional reserve based banking system itself, depends in part on the distribution of monetary tokens within the community. A society where all the monetary tokens are controlled by a small number of people, is potentially far more vulnerable to banking crises than one where ownership of monetary tokens is more evenly distributed.

The pattern of a large number of small, locally based banks, was especially the case in the 18th and 19th centuries, when there a much higher incidence of bank runs than even today. Customer demand for money that exceeded the available reserves could just happen  randomly, because at the end of the quarter money had to be transferred from depositors to lenders at different banks. Ludwig von Mises also mentions this problem occurring in the Austrian Banking system in The Theory of Money and Credit.  It could happen because some event acted to co-ordinate borrower’s demand for funds – say a local crop failure requiring food to be purchased with savings, which might also put pressure on the bank from both directions, if the crop failures also caused local  farmers to default on their bank loans. It could even happen because the owners of the town’s other bank started a rumour, in order to get customers to switch their deposits.

From the perspective of the people running the banks though, this is regarded more as an annoyance than a real issue with the system itself. After all the depositor’s money is out there somewhere  in the form of a loan which will eventually be paid back. If the depositors would only wait, then they could receive their funds. Silly people for not understanding modern banking concepts and panicking. This is what comes of letting the common people have bank accounts. Etc.

The solution that was found in Great Britain in the 19th century was to introduce the concept of a central bank, in their case the Bank of England, as the lender of last resort. If a bank didn’t have enough funds to satisfy instantaneous demand, the Bank of England would provide funds to do so, and the Bank could then repay the Bank of England when its loans came due. Problem solved.

From 1866 onwards there were no financial crises in Britain at least for the rest of the 19th century. The banking system in the United States of America on the other hand, which at that time consisted of a large numbers  of very small banks,  saw repeated local bank panics, and occasionally some non-local ones with their associated major financial crises. It wasn’t until the early 20th century, that the United States copied the British system and setup the Federal Reserve Banks to act in a similar role as lenders of last resort in 1913. Following the wide spread bank failures during the Great Depression there,  a further support in the form of deposit insurance was introduced to the American system (and subsequently copied in Europe), and since then, there have been remarkably few bank failures, at least until the Savings and Loan crisis in the 1980’s.

From a distributed systems perspective, these are both good and valid solutions to the problem created by excessive demand for instantaneous funds.  Essentially what both these changes did was to distribute the problem represented by instantaneous demand for funds that exceeded the available local reserves of a small bank across the entire banking system.  While the available funds/loan balance of  single  bank could be badly de-stabilised by a single customer with a large deposit moving their account to another bank say, within the context of the entire banking system, this is a non-event.

Unfortunately, either lulled into a sense of complacency by the absence of bank panics, or perhaps because it was something that was never explicitly acknowledged,  the Central Banks appear to have forgotten the other purpose the individual bank’s reserve requirement played in the monetary system.

Providing a limit on the total quantity of loans made available by all the commercial banks.

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cc Credit Crises, Fractional Reserve System, Lending