Reserves? We Don't Need No Stinkin' Reserves

EconomicDisconnect pointed me toward a story last night from the Economic Collapse Blog regarding Ben Bernanke's comments on the need (or lack thereof) for reserves in the fractional reserve banking system.

Fractional reserve banking mean that when you deposit $100 in the bank, the bank can lend out, say, roughly 90% of that money - they may keep 10% as reserves.  MikeyMortgage takes a loan from the bank ($90 of your $100) and buys a house with it.  The home seller, HarryHomeseller, receives MikeyMortgage's $90, and deposits it in the bank, who then lends out roughly 90% of it again, this time to CarlCarbuyer, who borrows $81 of HarryHomeseller's $90, etc etc etc. 

Some people scream and yell about how fractional reserve banking is a scam because if everyone wants their money back at once, the bank doesn't have it.  That's not quite true, at least in theory - if you want your initial $100 back, the bank doesn't have it in the above example - they've lent it out, but they do theoretically have assets that they can sell that are WORTH $100.  Assuming the bank has made good loans, they can sell MikeyMortgage's mortgage note and get the money to pay you back.

This brings us to the next point - it makes perfect sense to have some reserves.  First, as we've proven over the past few years, the value of this collateral (the loans) can drop - we need some cushion.  Second, if you have reserves on hand, you have cash to pay back to depositors who want their money back without necessitating that you liquidate assets.   Which brings us to the Economic Collapse Blog:

"Up until now, the United States has operated under a "fractional reserve" banking system.  Banks have always been required to keep a small fraction of the money deposited with them for a reserve, but were allowed to loan out the rest.  But now it turns out that Federal Reserve Chairman Ben Bernanke wants to completely eliminate minimum reserve requirements, which he says "impose costs and distortions on the banking system". At least that is what a footnote to his testimony before the U.S. House of Representatives Committee on Financial Services on February 10th says. So is Bernanke actually proposing that banks should be allowed to have no reserves at all?

That simply does not make any sense. But it is right there in black and white on the Federal Reserve's own website....

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system."

Now, it's been brought to my attention that there are several countries who currently operate banking systems without reserve requirements.  The real question is, is Bernanke suggesting that we don't need reserve requirements because in a rational free markets world, banks would hold adequate reserves anyway, and thus don't need more expensive restrictions imposed on them?  I think that claim can be easily refuted by saying "See:  U.S. Banking System 2007-2009."   The alternative, then, is that Bernanke really believes that banks don't need to hold reserves at all.  

Ben Bernanke's expertise in banking is greater than mine.  That much is given - although I wasn't riding shotgun next to Alan Greenspan as the metaphorical car that is the U.S. Financial System was driven off a cliff.  However, I literally do not understand how zero-reserve fractional reserve banking can work.  If, in reality, banks lend out every dollar of deposits, with no allowance for depositor redemptions or decline in collateral (read: LOAN) value, isn't the system guaranteed to fail?

Anyone care to explain this?  Anyone?  I'm looking for someone who can explain to me the rationale, even in theory, for how banks could operate with no reserves.  My specific questions:  most importantly:  if you have no reserves, and the price of your assets (loans you have made) declines, aren't you instantly insolvent?  Also, if you have no reserves, how do you handle depositor requests for redemptions?  Is the answer simply that the Federal Reserve is there to backstop insolvencies arising from these two situations?  That's not really an answer.  Maybe the answer is that the Fed backstops "temporary" insolvencies until they can recover and right themselves - until the value of the assets "comes back."  Extend and pretend!  What if the value doesn't come back though? 

-KD