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In  Defense  of
Private Banking

There are some who have heartburn over the fact that banks, which are private enterprises, are able to create money out of thin air when by issuing loans.   What's worse, they can actually earn interest on their loans, which must surely be a free lunch.  So why do we allow it to continue?

No Free Lunch

When a bank grants a loan, it credits the borrower's account with a new deposit which will soon be spent, usually by check.  As the check clears, the bank's reserve account at the central bank is debited by the amount of the check and credited to the payee bank's reserve account. 

If the borrower defaults on the loan, the lending bank may never see the money again.  Thus the bank would not grant the loan without charging a fee sufficient to cover the risk and earn a reasonable profit.  We use the term "interest" if the fee is paid at regular intervals but it is basically a service charge. 

Financial Needs of a Growing Economy

Every nation needs a mechanism to expand its money supply, consistent with the growth rate potential of the economy.  In fact the money must be available in advance to support new capital investment.  It takes time for a firm to produce capital goods, and people need to be paid while they are doing the work. 

The necessary funds might be acquired from the sale of shares, but more often they are borrowed.  Non-bank lenders such as finance companies provide the bulk of those funds.  However non-banks cannot expand the money supply.  Their lending simply transfers the ownership of existing bank deposits.  Only depositories such as banks and thrifts have the ability to expand the money supply through lending.

A System without Private Banks

In principle, there is no absolute need for private banks.  All of their functions could be performed by the government’s own central bank.  The central bank could accept deposits of individuals and firms, pay interest on term deposits, and manage the transfer of funds between transaction accounts as part of the payment system.

Equally important, the central bank could provide for the entire growth of the money supply by issuing loans and monetizing the debt through the purchase of Treasury securities.  However operating in this way means managing the growth of the economy from a central bureaucracy.  It doesn't usually work well, as the example of the failed Soviet Union has shown. 

Why Private Banking Makes Sense

Private banks operating in the community they serve, and working under the incentive of the profit motive, can do a much better job of allocating funds based on their knowledge of local needs and credit risks.  Banks, no less than non-banks, need to earn interest or fees on their loans.  Without such earnings, they could not cover their costs and would have no reason to be in business. 

Some banks do a good job, earn a good return, and grow their own capital along with the economy they support.  Others lend poorly, become insolvent, and drag their investor-owners down with them.  On average the profitability of the banking industry is comparable to that of the economy at large.  In the long run, banks can only grow apace with the growth of the real economy. 

Another View of the Banking System

Private banks in effect act as the lending agents of the central bank, using its credit and operating under its supervision.  They are regulated and none may lend more than a prescribed multiple of its own capital at risk.  Their profits depend on the efficiency and care with which they manage their business.  Any bank that doesn't play according to the rules can be disciplined or even have its license removed.

Some Problems with Private Banking

While the banking system today generally works well, some practices need to be curbed.  One is the tendency toward procyclical lending, i.e. lending too much during the up-phase and too little during down-phase of the business cycle, thus amplifying the cycle itself.  Also banks lend much too freely to financial institutions engaged in speculative ventures that offer no real economic benefit.  The central bank needs to do a better job in its regulatory role and be more aggressive in curbing financial excesses in which banks often play a significant part.

Finally, banks have too much political power because of their unique role and their close ties with Congress through the money channel.  Seen from a different perspective, the political influence of banks is the natural result of the corruption in Congress.  Banks are just one of many working the system.

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