“Sept. 14 (Bloomberg) — A group of banks including Bank of America, CitiGroup and JPMorgan Chase & Co. are putting up $70 billion for a borrowing fund aimed at providing liquidity… Each participating financial firm will provide $7 billion to establish the fund and have the ability to borrow up to a third of the total. Other banks include Barclays Plc, Credit Suisse Group AG, Deutsche Bank AG, Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co. and UBS AG. The pool could expand as other companies join.

Now, let’s get this straight. Ten banks put up $7 billion for a total of $70 billion. Because any bank can withdraw up to $23.3 billion, if three banks take $23.3 billion each, there will be nothing left for the others. Am I missing something?

There is nothing wrong with the plan, per se. The flaw lies in the flawed character of the participants. These are investment banks and if investment banks can exploit a situation, they will do so. That’s what investment banks do for a living, they exploit situations for their own advantage in order to maximize profits.

Last year when two Bear Stearns highly leveraged funds were in danger of failing, Bear Stearns came to the “rescue” of one of its funds and lent it more capital, albeit with the caveat that Bear now had first claim on the fund’s assets. Then, when the fund collapsed shortly thereafter Bear Stearns exercised its now first-in-line rights to all the assets.

Since self-serving behavior is common among investment bankers, it will be interesting to see how the bankers’ $70 billion fund will fare. After the first withdrawal, there may be a “bank run” on the remaining assets by the remaining banks—a real life version of what will be “the Banker’s Dilemma”.

A FRACTIONAL RESERVE SAFETY NET

The investment banks’ $70 billion liquidity fund is predicated on much the same premise that fractional reserve banking is based. While it is understood there may not be enough in the fund to cover all needs, it is assumed that not everyone one will need their funds at the same time.

This thinking/sic assumption is the basis of today’s fractional reserve banking system; because, as in the banker’s “liquidity plan”, there is not enough money in US banks in the event of significant withdrawals by savers.

There is $6.84 trillion on deposit in US banks; but US banks have only $273.7 billion cash on hand. The banks cannot possibly pay back depositors all their money as only 4 % of depositors’ funds are actually available. The rest has been loaned out, i.e. to real estate developers, etc.

The safety net of both bankers and depositors may prove inadequate in the days ahead. Be forewarned….”

More by Darryl Schoon.