Forbes: Modern Central Banking Is More Vulnerable Than We Think

Article by John Mauldin in Forbes

Banks are a place where you store your cash, right? Not exactly.

When you deposit money in a checking or savings account, you aren’t just letting the bank hold it on your behalf. You are lending the bank that money and the bank is borrowing it. That’s why deposits show as a liability on the bank’s balance sheet.

We think of banks as lenders, and they are, but they’re also borrowers. They make money by lending at higher rates than they pay as borrowers, and by leveraging their deposits via fractional reserves.

Modern Central Banking

This is obvious if you think about it.

How can your bank simultaneously a) promise you can withdraw your cash on demand and b) lend that same cash to someone else?

That’s possible only because they know only a few people will want their cash back on any given day. And if cash requirements are more than expected, they can borrow from other banks or the Federal Reserve, as needed.

Now, the system can be shaken up if too many people decide to hold physical paper money, or they transfer deposit money into other instruments banks can’t leverage as easily.

Central bank reserve requirements also play a role. The banking system is far more elaborate than the most complicated Swiss watch but it just keeps on ticking… until it stops.

Something weird happened in September, for reasons that remain a little murky. The repurchase agreement or “repo” market seized up.

We had a string of similar hiccups in 2007–2008. All were manageable but eventually they added up to something much worse. So, this wasn’t a good sign for market stability.

That’s the problem with unconventional monetary policy. It may solve your immediate problem but create bigger ones later.

To read this article in Forbes in its entirety, click here.