What can we say about fractional serve banking? It has its pros and cons. Perhaps, though, it also has its con jobs. It certainly has its defenders and detractors. What is the average layperson to make of all this?
Familiarity with the basic practices of the system is assumed in what follows. Unfamiliarity with those practices would recommend first reading this introductory article before launching into this one full throttle.
The defenders argue for the virtues of increased liquidity in the financial system: greasing the gears of our complex economy. Fractional reserve banking puts currency into the system, ensuring sufficient funds for entrepreneurs who want to launch new businesses and consumers who want to purchase high-end goods like houses and cars. The loans available through fractional reserve banking makes all this possible, thus contributes to increased demand and production, employment and so on.
Some of the fundamentals of those claims are certainly challenged. However even if, only for the sake of argument, one accepts such proposed benefits, it would be poor economic analysis to ignore the costs. What are the costs of fractional reserve banking?
Three potential costs in particular are considered in this article. First, what is the threat to the individual bank; second, the threat to the larger financial system; and third, what are the costs to the monetary system? This third, indirect, cost is still vitally important as it increases the first and second threats to the financial system.
1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.
Events will sometimes transpire to alert depositors to the systemic fragility of the fractional reserve system. Under such conditions, many depositors start demanding their money in cash. This is a bank run. And recent events have demonstrated that bank runs can even occur in the digital banking world. (See the recent Mt. Gox run.) Runs can bankrupt a bank. At the least, they result in fiscal burden for taxpayers, forced to bail them out of their liquidity shortage.
2) In our densely interwoven banking world, though, what's bad for one bank can be bad for all. (And, of course, for all of us, who have money in banks, anywhere.) In our globalized financial world, banks borrow from and deposit with each other: they are the creditors of other banks, either long or short term. As you'd expect, bankers are more sophisticated about the reserve system than the average depositor. They appreciate the danger of a bank run's cascading consequences.
That though is no guarantee against a run. Should a heavily indebted bank, say, that has supplied a series of poor loans, resulting in high levels of default, come to be regarded as unsalvageable, the other bankers will let it fall. Lender and depositor banks conclude that continuing credit is throwing good money after bad, and so cut their losses. In such a situation, effectively, the banks instigate a bank run against another bank. The consequences for the individual bank are still insolvency.
There is though an additional problem to consider. The extremely high level of inter-bank borrowing in the current global banking system means that an explosive chain reaction can be set off by such events. Just such a dynamic was a major contributor to the 2008 financial crash. The entire global financial system becomes vulnerable.
3) Finally, fractional reserve banking worsens the destructive tendency to inflation already characteristic of a fiat currency. The worst culprits in such a scenario are of course the central banks and the governments - who employ their police powers to enforce the use of such play-money. Fractional reserve banking though plays its role in the sad tale.
A description of the precise mechanics of this inflationary process would exceed the space limits, here. It should be enough to grasp the obvious fact that, as long as we're taking the laws of physics seriously, the same money cannot be both in a depositor's bank account and a borrower's loan portfolio. Somehow this bit of financial black magic is precisely what we're supposed to take seriously.
This bit of fractional reserve voodoo leads directly to distortion in the information feedback system about accurate depiction of saving levels in the economy. The result of this distortion is erroneously suppressed interest rates on borrowing. Unsurprisingly, then, demand for borrowing increases as does incentives for banks to further game the reserves system. All this predictably results in the economically debilitating valleys of the business cycle: recession or depression. Needless to say, such economic downturns lead to more borrowers defaulting on loan repayments. And all this merely heightens the dangers of points 1 and 2, discussed above.
These numerous and dangerous consequences arising from fractional reserve banking have given rise among some critics for demands to ban the practices. Some claim it is nothing more than criminal fraud. I don't think the matter is quite that simple, though. As usual, I prefer free market solutions over government coercion.
I'll have more to say on this in a soon to be published article on free market fractional reserve spending. Stay tuned!
Familiarity with the basic practices of the system is assumed in what follows. Unfamiliarity with those practices would recommend first reading this introductory article before launching into this one full throttle.
The defenders argue for the virtues of increased liquidity in the financial system: greasing the gears of our complex economy. Fractional reserve banking puts currency into the system, ensuring sufficient funds for entrepreneurs who want to launch new businesses and consumers who want to purchase high-end goods like houses and cars. The loans available through fractional reserve banking makes all this possible, thus contributes to increased demand and production, employment and so on.
Some of the fundamentals of those claims are certainly challenged. However even if, only for the sake of argument, one accepts such proposed benefits, it would be poor economic analysis to ignore the costs. What are the costs of fractional reserve banking?
Three potential costs in particular are considered in this article. First, what is the threat to the individual bank; second, the threat to the larger financial system; and third, what are the costs to the monetary system? This third, indirect, cost is still vitally important as it increases the first and second threats to the financial system.
1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.
Events will sometimes transpire to alert depositors to the systemic fragility of the fractional reserve system. Under such conditions, many depositors start demanding their money in cash. This is a bank run. And recent events have demonstrated that bank runs can even occur in the digital banking world. (See the recent Mt. Gox run.) Runs can bankrupt a bank. At the least, they result in fiscal burden for taxpayers, forced to bail them out of their liquidity shortage.
2) In our densely interwoven banking world, though, what's bad for one bank can be bad for all. (And, of course, for all of us, who have money in banks, anywhere.) In our globalized financial world, banks borrow from and deposit with each other: they are the creditors of other banks, either long or short term. As you'd expect, bankers are more sophisticated about the reserve system than the average depositor. They appreciate the danger of a bank run's cascading consequences.
That though is no guarantee against a run. Should a heavily indebted bank, say, that has supplied a series of poor loans, resulting in high levels of default, come to be regarded as unsalvageable, the other bankers will let it fall. Lender and depositor banks conclude that continuing credit is throwing good money after bad, and so cut their losses. In such a situation, effectively, the banks instigate a bank run against another bank. The consequences for the individual bank are still insolvency.
There is though an additional problem to consider. The extremely high level of inter-bank borrowing in the current global banking system means that an explosive chain reaction can be set off by such events. Just such a dynamic was a major contributor to the 2008 financial crash. The entire global financial system becomes vulnerable.
3) Finally, fractional reserve banking worsens the destructive tendency to inflation already characteristic of a fiat currency. The worst culprits in such a scenario are of course the central banks and the governments - who employ their police powers to enforce the use of such play-money. Fractional reserve banking though plays its role in the sad tale.
A description of the precise mechanics of this inflationary process would exceed the space limits, here. It should be enough to grasp the obvious fact that, as long as we're taking the laws of physics seriously, the same money cannot be both in a depositor's bank account and a borrower's loan portfolio. Somehow this bit of financial black magic is precisely what we're supposed to take seriously.
This bit of fractional reserve voodoo leads directly to distortion in the information feedback system about accurate depiction of saving levels in the economy. The result of this distortion is erroneously suppressed interest rates on borrowing. Unsurprisingly, then, demand for borrowing increases as does incentives for banks to further game the reserves system. All this predictably results in the economically debilitating valleys of the business cycle: recession or depression. Needless to say, such economic downturns lead to more borrowers defaulting on loan repayments. And all this merely heightens the dangers of points 1 and 2, discussed above.
These numerous and dangerous consequences arising from fractional reserve banking have given rise among some critics for demands to ban the practices. Some claim it is nothing more than criminal fraud. I don't think the matter is quite that simple, though. As usual, I prefer free market solutions over government coercion.
I'll have more to say on this in a soon to be published article on free market fractional reserve spending. Stay tuned!
About the Author:
When you need to understand how the international banking regime plays havoc with your savings, be sure to follow the Fractional Reserve Banking Review. Wallace Eddington has emerged as a major commentator on finance and investing. His no-holds-barred promotion of a Free Market Economy in Money is required reading for anyone who wants to understand our current financial situation.
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