When stock market investments and property shrink in value, it is tempting to convert them into safer vehicles, such as bank deposits. Is the banking system still safe, or is it a house of cards that will collapse under pressure?

Fractional banking

Our monetary system is no longer backed by actual gold in Fort Knox, and we operate under a “fractional reserve banking” system. This means the banks are only required to keep a small fraction of depositors’ money available, while they use the rest to make loans. The difference between the lending rate and the interest on deposits is the bank’s profit. Supposedly, the bank evaluates its borrowers well enough to ensure that the money is repaid, but you don’t have a document guaranteeing that any of the borrowers owe you directly.

If you were thinking bad mortgage loans should be allowed to go into default, think again. Some states have passed laws precluding banks from seizing homes when mortgages go into default. Not only is the loan not being repaid, but the asset can’t be converted, which makes you the final backer of bad mortgage loans with no hope of acquiring anything in return.

The sub-prime lending debacle has increased awareness of the risks related to the lending process. As bank failures rise, authors such as Murray Rothbard, in his recent book, “America’s Great Depression,” warn against the “inherent bankruptcy” of the system and the vulnerability of most banks to even a small run on deposits, should customers decide to withdraw their funds en masse.

Since there is more than $8 trillion in deposits and about the same in loans throughout the system, our potential liability as taxpayers hovers around $25,000 for every person in the country. As weaker banks fail, customers will move their deposits into the stronger banks, creating a polarity where the weak fail faster and the strong get stronger. The trick is finding out which banks are the strong ones.

Insurance

Wait a minute. The Federal Deposit Insurance Corp. (FDIC) protects your deposits, and the maximum insured limit has been raised from $100,000 to $250,000. So most of your money should be safe. Right? Perhaps, but FDIC guarantees don’t really protect the system. They simply transfer the risk from weaker to stronger banks by charging higher premiums to the surviving banks after depositors of the failed banks are paid off.

No problem, though, because the federal government ultimately backs the system, and so far, it has never gone bankrupt. We have just seen an obvious example of this in the big bailout of 2008. However, if the economy worsens, tax receipts will keep decreasing, so where is the money going to come from to save the banks? At some point, just like Social Security, too few pay in and too much goes out.

Liquidity and interbank lending

Can’t your bank borrow money in the interim? That’s where the federal funds rate applies. At the end of each day, the bank either sells excess funds or borrows funds, depending on its loan-to-deposit ratio. These interbank transactions are done through the Federal Reserve Bank system, at the fed funds rate determined by the Federal Reserve Board. So, everyday deposits and withdrawals affect the bank’s ratio, and when the Federal Reserve Board alters the fed funds rate, it is changing the interest rate on interbank lending. That is why your bank wants to buy out your 3 percent mortgage balance when interest rates are rising; it also will be raising the interest rate it pays depositors to use their money.

As a depositor, you probably have no idea how liquid your bank is, or how often it sells or buys fed funds. Liquidity has shrunk to a level that even a small number of depositors attempting to collectively withdraw their funds can be dangerous. Your bank also may be speculating in more risky investments, such as leveraged derivatives. Not only are loan portfolios shaky, but so are the bank’s own investments.

One final caution: The items in your safe deposit box are not protected, since the bank has no idea what you have placed there. Therefore, if someone drills into the vault and takes your bearer bonds and jewelry, you have little or no ability to recover your losses.

Vault or shoe box?

So, your bank is probably less liquid, holding mortgages on devalued real estate, and overestimating the collateral backing its loans as well as the security of its own investments. You might be tempted to withdraw your money and keep it in a shoebox in the back of your closet. Don’t, or you may be contributing to a system collapse. For ratings on individual banks, go to www.veribanc.com or www.thestreet.com. Try not to worry, but if that fails, make sure to be first in line to get your money.

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].