15. Effects the Business Cycle Exerts on the Banking Sector

At this point in our analysis it should be easy to identify the effects and relationships which link the business cycle and the banking sector. To begin with, we must recognize that the business cycle stems from credit expansion the banking sector brings about as a result of its legal privilege of implementing monetary demand-deposit contracts with a fractional reserve ratio. Moreover in chapter 4 we saw that this privilege explains the trend toward mergers in the banking industry, since the larger a bank's relative size is in the market, the greater are its possibilities for credit expansion unlimited by the corresponding bank clearing house. Furthermore bank consolidation makes it possible to better “manage” fractional cash reserves, allowing banks to satisfy normal withdrawals with lower central cash balances.

Nevertheless in chapter 5 we saw how the credit expansion process inevitably provokes a crisis and readjustment period, during which much of the book value of banks’ assets evaporates, and in addition a widespread increase occurs in the demand for money and in the withdrawal of deposits (at least in the marginally less solvent banks). Therefore this accounts for the fact that bankers have forced the creation of a public institution, called the “central bank,” designed to act basically as lender of last resort in the stages of economic recession which are so dangerous for banks. Also the difficulties and overwhelming worries which beset bankers as a consequence of default and the withdrawal of deposits during the stage of readjustment and economic recession reinforce even further the trend toward bank mergers. In fact in this way banks are able to treat defaulters more uniformly, achieve significant economies of scale in the management of payment arrears and avoid the marginally more insolvent situation in which they would find themselves if a higher percentage of their loans were non-performing or if the public had less confidence in them.

Hence we can conclude that an inherent trend in the privileged exercise of fractional-reserve banking leads to bank consolidation and encourages bankers to develop and maintain close relations with the central bank as the only institution capable of guaranteeing banks’ survival in moments of crisis, situations banks themselves create regularly. Furthermore the central bank directs, orchestrates, and organizes credit expansion, making sure that banks expand more or less in unison and that none stray far from the established pace.