We continue our journey through the evolution of banking with
the rise of the clearinghouse association. First, let’s review the evolution of
economic development thus far. Imagine a world of scarcity where we have
instantiated agents. These agents own property and take action according to their
preferences. As agents interact, direct (barter) exchange arises. Each agent
trades some good or goods that he owns for some other good or goods that he or
she values more than the item or bundle given up. In each exchange, agents pays
only as much for a good or goods as they are willing. Sometimes, a good desired
by an agent can only be acquired by multiple exchanges. Imagine that agent A owns
an apple, agent B owns an orange, and agent C owns an avocado. Agent A is
willing to trade her apple for an avocado, but agent C will only trade her avocado
for an orange. It just so happens that Agent B would like to trade his orange
for an apple. Agent A, sensing an opportunity to attain her desired end, trades
her apple for agent B’s orange. Then she trades the orange for an avocado. This
is indirect exchange. Over time, some types of commodities, say oats, come into
use for indirect exchange. The commodity used for indirect exchange comes to
gain value for its use in indirect exchange. This value is its exchange value.
Eventually, one or several of these moneys comes to dominate
markets of indirect exchange. Money has developed whose price tends to reflect
its supply and demand. One interesting feature of a commodity money is
that its quantity is, in the long run, dependent on its supply and demand. If money
becomes dearer due to an increase in demand for it, its price will rise and
thereby increase the quantity of money supplied. A fall in demand will allow
the quantity supplied in a given time period to fall. Thus, the quantity of money
stock is self-regulated with respect to changes in demand.
Commodity moneys are costly for agents carry. If the
commodity money is not standardized, it may be difficult to measure. If it is
heavy, like gold or silver, it may be costly, or even dangerous, to carry on
one’s person. Owing, at least in part, to these reasons, agents find that they benefit from leaving their money entrusted
to a third party at a secure location. The agent will likely receive a deposit
slip in exchange which can be used as money. Thus we have the
emergence of fiduciary currency. Eventually, the agent or firm entrusted with
the gold realize that they might profit from lending out some portion of the
existing deposits. This allows the latent media to earn a return. This return
allows the agent or firm to pay interest on deposits. The cost of holding gold
is no longer borne by the agent who owns the commodity. Fractional-reserve banking
is born.
Any bank in operation chooses to keep on hand some commodities
whose value is equal to a portion of its reserves. This is needed in the case
that some depositors want to immediately withdraw their currency from the bank.
If too many depositors attempt to withdraw from the bank simultaneously, the
bank may risk being unable to make a repayment. Absent any institution designed
to aid the bank in such a crisis, the bank will have to borrow from another
bank in order to stave off hysteria. Of course, if no other bank is willing to
lend to the bank, it will have to close until it can acquire the funds. This
option is a last resort as it will certainly attract the attention of
risk-averse depositors. Bankers realize that they have incentive to minimize the
occurrence of this scenario as a wave of collapses may have repercussions for
the entire economy. It so happens that a clearinghouse association is an
organization in prime position to provide stability during a run.
A clearinghouse
is the location at which multiple banks may hold some of their reserves and
keep their records. By holding their reserves and records at a common location,
banks can clear debits and credits between one another and use the reserves on
hand to pay remaining debts between one another. The clearinghouse is also a
nexus for information concerning the creditworthiness of borrowers, thus serving
a role in risk mitigation. The clearinghouse might also mitigate risk by producing temporary
currency during a crisis. The clearinghouse has plenty of reserves on hand. During
a crisis the clearinghouse, ostensibly drawing from these reserves, can lend out
emergency currency. This emergency currency allows banks that consider
themselves to be at risk and that the clearinghouse deems to be only illiquid - not insolvent - to build up their reserves
without depleting the supply of available credit. Since credit is employed predominantly for business, a net decrease in available
credit typically diminishes the level of future production, and consequently, real income. Likewise, a collapse in the credit markets leads to a collapse in production until the
collapse reverses (assuming it reverses). A wave of banking failures, like the
one that occurred during the Great Depression, can turn an economic recession
into a depression. For the sake of self-preservation, the clearinghouse has incentive
to prevent such an extreme crisis.
Given the risk of a credit crisis, the clearinghouse also
takes on a proactive role in regulating the positions of its member banks. If
may, at random or on the suspicion of a bank’s malhealth, withdraw a large amount
of funds from a member bank in order to test its capacity to handle adverse clearings.
This serves to discourage excessive risk taking by member banks and represents
yet another means of promoting the stability within the system.
Having mechanisms that promote stability does not suggest that the system is itself perfect. Every system has bugs. There will always be some banks that take on excessive risk. There will always be failures. Irresponsible banks must fail or else they corrupt the whole system. The significance of the clearinghouse system is not that it prevents any instability, but that it places bounds on that instability. Regulation and stability are themselves properties of the system as entrepreneurs earn profit by finding ways to mitigate risk.
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