Banks: The Faults of Factional-Reserve Banking

Topic: Banking
Words: 606 Pages: 2

The stability of the financial system of a modern country heavily depends on the proper functioning of the banking system. Banks are often referred to as “financial intermediaries” as they lend money to companies, individuals, and sometimes governmental agencies (Kling, 2013, para. 7). Some of the major functions of banks include loans, deposits, and investment. Properly operating banks ensure the stability of the economy as they lend money to companies that may need investment to support their growth and expansion (Siegel, 1998). This paper includes a brief analysis of the benefits of commercial banking, as well as associated risks.

As mentioned above, banks play the role of intermediaries, which is supported by the intermediation theory. According to this framework, banks do not produce assets but simply provide loans or attract deposits. In addition to the function of the financial support or even background of the economy development, commercial banks can also contribute to liquidity balance. Individuals and companies can deposit funds and access loans from commercial banks whenever they might need it. In order to operate effectively, banks have to make sure that their reserves are sufficient for meeting the demand of their depositors.

Some of the serious issues banks have to face are information problems of finance. Banks have to provide reliable data on their cash flow and liquidity, which is now regulated by the Federal Reserve and a set of regulations. Banks need to report on their activities that are also placed in certain boundaries. For instance, the banks’ ability to invest in nongovernmental securities is minimal (Siegel, 1998). In order to reduce their excess reserves and increase their profit, commercial banks tend to create derivative deposits. When banks are short of money and have difficulties with meeting the demand of their depositors, these institutions lend from other banks or the Fed. At that, Federal Reserve banks monitor the activities of commercial banks and try to make sure that banks do not lend excessively.

One of the possible reasons for disbalances in banks’ assets and financial constraints can be banks’ issuing demand deposits and turning them into illiquid loans. Banks do not have sufficient funds to maintain their functioning as they do not have the necessary liquidity to satisfy the needs of their depositors that might want to withdraw money. Apart from trying to invest in high liquidity assets (demand deposits or government securities) and avoid illiquid loans, banks can and often do lend from other commercial banks and the Fed. However, this lending is not limitless and can result in bankruptcies and even major financial crises. Kling (2013) illustrates such a situation when the government had to fund major banks that were referred to as too big to fail. Polleit (2010) states that the Austrian school offers an effective solution that can ensure the stability of the financial system. This suggestion implies the absence of central banks and the abandonment of the fractional-reserve banking.

To sum up, it is necessary to state that the modern banking system is associated with strengths and weaknesses, and it is beneficial for the stability of the economy but can also pose considerable threats. Irresponsible activities of banks who do not ensure their assets liquidity and proper balance overload the financial system leading to the creation of diverse bubbles. The crisis of 2008 can be seen as the most recent illustration of the major turmoil caused by irresponsible management and information provision. Central banks serve as mitigating factors in such cases, but their role and very existence are often criticized as it deemed as excessive. It is possible to note that the modern financial system needs certain improvements.

References

Kling, A. (2013). What do banks do? 

Polleit, T. (2010). The faults of fractional-reserve banking

Siegel, B. N. (1998). The banking business: Fundamentals. In G. A. Selgin (Ed.), Readings in money and banking (pp. 109-130). D. S. Brewer.