Financial Innovation and the Fractional Reserve System. What is to Blame for the 2008 – 20?? Economic Recession.

I would like to start this post by bringing into the discussion an issue that seemed to be obscured in the debates that took place in the mainstream media regarding the current economic crisis : the fractional reserve banking system that is used in the current Western societies.

To describe it briefly, within this system the commercial banks basically pursue their activity on the basis of the money supply they themselves have created. The technical term for this process is called, hardly surprising,  money creation and it represents the banks’ ability to deliver loans that are uncovered in the majority of their amount by any counter-balancing value. The amount that is covered is represented by the fractional reserve that the banks must maintain (in fiduciary currency) in accordance with the regulations imposed by the central bank.

At a first glance, this process seems fully discretionary in the sense that it allows to much control and power to the private banking sector. It does; however there are some self-regulatory control leverage mechanisms – the most important of which being the risk management policies. The fear of bank runs and the perpetual pursuit of profitability act as key incentives for banks to keep their policies somewhat sustainable.

So, what did go wrong? The most rational responses in terms of expertise lead to the conclusion: systemic failure. Indeed, there was a systemic failure. The sub-prime crisis was at its roots an asset bubble. These  market anomalies (or failures) take place when poor risk management measures are conducted.

What happened was that in effect, an important amount of the money supply (which took the form of debt) was defaulted by the lenders. This lead to serious problems for the financial system in the US and the rest is history.

(Here is a brief visual description)

The financial instruments that were used by the system were blamed for the outcome. They were considered by many as to innovative in order for the bankers to assess correctly the risks.

The conclusions I was able draw are the following:

1. The systemic risk in represented at its origins by the fractional reserve system. Allowing private entities to create and distribute the wealth within societies based mainly on corporate risk management schemes is similar to riding a sports car without safety belts.

2. Financial innovation (FI) is a delicate issue. Unlike innovation in other areas, in the case of FIs the market mechanism of bankruptcy can’t act efficiently as a correcting measure.  And if it does, the social costs are huge. The problem becomes increasingly delicate when governmental bail-outs are de facto guaranteed – and moral hazard is created.

Thus, the only viable solutions can be in the following direction:

1. Strongly regulating the financial sector in order to limit money creation in accordance with risk;

2. Tightening control on the financial instruments in use and promoting sustainable innovation - which for FIs means the ability to generate an acceptable level of risk assessment.

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