Yesterday I noted how Canadian mortgage company Home Capital ran into serious problems because of one of the more notable aspects of our financial system.

Fractional reserves or capital reserves let you lend money on deposit, keeping only a small amount of readily availabe cash to cover withdrawals.

This enables the lender to earn money on the deposits, pay the depositor an income and keep a profit for themselves. It also helps the economy grow more quickly by expanding the money supply.

So basically a good idea, but not without risks.  As long as depositors do not withdraw more money than is in reserve (say 10 %) or withdraw at a rate faster than the reserve can be replenished, the system chugs along happily.

Also of course if the loan default rate is high (say more than 2 to 3%) the ability to replenish and maintain the reserves is impacted and the house of cards can come tumbling down.

In the case of Home Capital, deposit holders began to panic.  The panic led to depositers making withdrawals.  A combination of factors created the perfect storm that led to this “run” on the Bank.

Home Capital focuses on higher risk mortgage borrowers and their executive were recently charged with a security violation and their stock is heavily shorted.  Short sellers were encouaging panic and the combination of factors made them successful.

In this case, the worst is over for the moment and we all can breathe a sigh of relief this did not turn into a systemic problem leading to contagion (i.e., a run on multiple banks).

The question for tomorrow’s post, since we fully aware of the potentially fatal and disastrous impacts that can arise from our fractional reserve/ fractional capital system,  why don’t we do something about it?