Poor Chuck Schumer... He had the unmitigated gall to point out the obvious fact that IndyMac Bank was in serious trouble. During the following 11 days, depositors withdrew $1.3 billion, effectively destroying IndyMac and forcing the FDIC (Federal Deposit Insurance Corporation) to take over the bank. Depositors with deposits within the insured limits will be made whole. Others will probably not.
Well, the thing is, Schumer was right. But he was right not just about IndyMac, but about every single U.S. bank. Every one of them has the same basic problem. Every one of them operates as a fractional reserve bank. They all lend out almost all their depositors' money, while at the very same time promising to repay any and all depositors at any time. So they are promising to do what they cannot possibly do.
Imagine a new form of Musical Chairs. The players circle around the chairs as the music plays. But there are always new players, and there are never enough chairs, or anywhere near enough chairs. Unlike regular Musical Chairs, the chair shortage isn't merely one chair at a time, with one player losing each time the music stops. Instead, imagine a game of musical chairs with a thousand players, and 10 chairs. And the music doesn't stop, signaling the players when to grab a place to sit. The music keeps playing. Eventually, some small number of players decide they'd rather have a chair to sit on than continue the march around the chairs. As soon as just a few players make that decision, there is a panicked rush for chairs, and most of the players end up with no chair.
That's how banking used to work. Then after the start of the Great Depression, the U.S. Federal Government instituted deposit insurance. Depositors are guaranteed the return of their deposits, up to the limits set by the government. And if the failed bank is big enough, and important enough, the FDIC will arrange a merger with another bank, and all deposits will be safe. IndyMac bank isn't big enough. Some depositors will lose significant sums.
This situation presents the typical American with few problems, since the typical American doesn't have deposits in banks above the insured limits. But if you do, you'd do well to split them up between two or more banks. There is a further problem. Often, the sums involved in normal business operations are far greater than the insurance limits. There is no practical way to protect the business's deposits. And modern business practices virtually force businesses to use banks to manage their money transactions. There is no way around that.
So what can a business money manager do? Well, he'd better be watching the business news very carefully, every day. If there is any "chatter" about the potentional difficulties his chosen bank, or one of his chosen banks, may be facing, he'd do well to move his accounts to other banks. Waiting for the rumors to be confirmed or disproven could be fatal. This would not be the time for "bravery" or calm. Even if a negative rumor turns out to be false, the rumor itself can destroy the bank, due to the fractional reserve nature of all the banks.
Clearly, this is an unacceptable situation. What can be done? If we wake up to the dangers inherent in fractional reserve banking, and require that banks abandon the obviously flawed practice, the resultant depression would be far greater than the Great Depression. The other alternative is to remove the limits on deposit insurance. This would require the banks to pay higher rates on their deposit insurance, but given the alternative of abandoning fractional reserve banking entirely, they should be glad to pay.
Or we could go on, stumbling from one banking crisis to the next, all the while blaming those few among us who see the problem and warn us of it. Yes, you can bet that's what we'll do.
