Fractional Reserve Disaster

There is no question that the financial markets are facing a liquidity crisis of unimaginable proportions. But the federal government seems to be sending a clear message: It will only save some of these institutions on the condition that stringent new regulatory oversight rules are passed.

Normally, laissez-faire business types decry such government intervention, claiming that it interferes with a free market. But sadly, none of them seems to have a problem accepting a handout from the government when they find they can’t back the risky plays they called.

Yet it seems almost hypocritical for the government to go around pointing fingers, when its own chartered institutions, Fannie Mae and Freddie Mac, also teeter on the verge of collapse as a result of risky lending practices. Astoundingly, although only a small percentage of Fannie- and Freddie-backed loans are in distress, the institutions are so over-leveraged that they can’t cover the bill.

Furthermore, the failures of large regional banks, including last week’s FDIC takeover of Indy Bank, point to a much deeper problem: the failure of fractional reserve banking as a whole. Despite a concerted last-ditch effort to save the bank, and despite having over $20 billion in deposits, less than $1 billion of which was uninsured by the FDIC, there was still a run on the bank that caused it to be closed Friday by the Office of Thrift Supervision. The question is whether there were really so many panicked depositors seeking to withdraw funds, or whether the cash reserve ratios of large banks are too low to justify the risks they are taking with their investments.

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