BANKING SYSTEMS: ARE THEY A PONZI SCHEME?

The recent failure if the Silicon Valley Bank and Signature Bank–coupled with the UBS-Credit Suisse merger on an emergency basis is unsettling to say the least. We saw how bank failures previewed the Great Depression so it’s natural to worry a bit when banks start failing. The fact is that the world’s economy and all it produces depends on the availability of funds. When banks fail and the availability of money is diminished economic activity shrinks. If the world’s economy is expected to grow constantly to provide goods and services to a growing population it stands to reason that the money supply needs to grow with it. Where does this increase in money supply come from? It comes from you and me as we deposit funds in savings and checking accounts. Because of banking regulations a lending institution is required to maintain only $.20 for every dollar of deposits. Banks can lend the other $.80 and so we have what is called “the multiplier effect”. Said another way, every dollar banks take in can result in $5 of loans. But-what happens when all those depositors lose confidence in the bank’s solvency and demand their deposits back? The bank simply does not have adequate currency on hand (that is “liquidity”) to return these deposits in the short run because 80% of the deposits are invested in various securities or commercial projects. Their failure to return deposits only exaggerates the problem because news of a bank’s inability to return deposits spreads quickly–causing others to run to their banks in fear. That said, a Ponzi scheme is defined as “a fraudulent investing scam which pays existing investors with funds collected from new investors”. The comparison with the banking system is not the fraud part; it is that existing depositors who demand their funds cannot get them unless new depositors bring money into the bank. This is the banking cycle throughout the world. It is not illegal but it is–at times–inconvenient and unnerving. The point: don’t panic when your bank cannot return your deposits immediately unless there are obvious signs that your specific institution has a specific problem. Faith in the banking system is the true currency that every nation runs on.