Wednesday, 27 Mar 2013 08:18 AM

By Patrick Watson

The European eggheads who attempted last week to seize insured bank deposits in Cyprus did us all a favor. Their ham-handed money grab exposed a near-fatal flaw — a flaw present in every bank worldwide, and even here in the United States. Today I’ll explain how their legalized trickery works.

Let’s say you have $1,000 in paper money. You’re afraid someone might steal it, so you go to the bank and open a checking account. Your cash is now safe. It’s also accessible: you can write a check or visit an ATM.

Walking out, you run into your friend Jack. He wants a new $1,000 motorcycle and came to the bank for a loan. You wish him luck and go on. Minutes later, Jack walks out of the bank with the same cash you just deposited.

Now assume you and Jack are the bank’s only customers. You represent all the depositors and Jack represents all the borrowers. Consider what just happened. The bank took your $1,000 cash and promised you can always get it back. Then it gave $1,000 to Jack, who bought a motorcycle. How, since your money is now gone, can the bank also return it to you as promised?

The plot thickens. You go back the next day and ask for your $1,000. They give it to you. Minutes later you see Jack on the motorcycle. Obviously the bank didn’t repossess it. Where did the bank get the money that is now in your pocket? Answer: they borrowed it from the Federal Reserve. How did the Fed get the cash? They created it from thin air.

In just about any other context, we would call this “counterfeiting,” but for banks it is perfectly normal to sign contracts they can’t fulfill. They simultaneously promise depositors instant liquidity, then immediately lend the same money to someone else. They get away with this because they know only a few depositors will try to withdraw cash on any given day.

The bank also knows at least some of the money they lend will come right back. Jack’s motorcycle dealer probably put the cash in his account the same day. And if necessary, they have the Fed as “lender of last resort.”

This massive confidence game works very well as long as everyone believes the bank will keep its end of the deal. When too many people call them on it — by asking the bank to actually do what it agreed in the depositor contracts it signed — you have a “bank run” like the one in Cyprus.

Could such a run happen to U.S. banks? Probably not, though it is possible in theory. My point is that “fractional reserve banking” is a fundamentally dishonest business model. The rest of us have to keep our end of the contracts we sign. Banks should keep their promises, too.

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