Information about Fractional Reserve Banking

Fractional-reserve banking refers to the common banking practice of issuing more credit than the bank holds as reserves. Banks in modern economies typically loan their customers many times the sum of the credit reserves than they hold.

Example

In line 1 of the example shown in Table 1, a bank receives a deposit of 100 credit dollars (Not Real Money) and credits the depositor's interest-bearing account with 100 credit dollars. At this point the bank is maintaining 100% reserves of credit dollars against the interest-bearing account dollars it has issued. If the bank was required to keep 30% of its deposits in reserve it would then be able lend $70. The person who borrows this money would likely spend it and the money will likely end up as someone else's bank deposit. Line 3 shows the bank's balance sheet after the $70 is redeposited. Note that the bank can now lend another $49, because its total deposits have increased. Line 5 shows the bank's balance sheet after that additional $49 is redeposited into the bank. At this point the system has $219, which is more than twice the original $100 deposit. This process of lending and depositing money can repeat many times until reaching a theoretical maximum of $333 (100 divided by the reserve ratio of 30% times the original cash deposit). Even though banks seem to make money by re-lending the same money many times, they also must pay interest on a deposit before they can lend it. Thus, banks can only make money on the difference between the interest rate they charge on the loan and the interest rate they pay to depositors.

Table 1: Private bank T-account
	Action	Assets	Liabilities	Reserves
1	Customer A deposits 100 paper dollars	None	$100 in interest-bearing deposits	100 paper dollars
2	Bank loans $70 to Customer B	IOUs worth $70	$100 in interest bearing deposits	30 paper dollars
3	Customer B deposits 70 paper dollars	IOUs worth $70	$170 in interest-bearing deposits	100 paper dollars
4	Bank loans $49 to Customer C	IOUs worth $119	$170 in interest-bearing deposits	51 paper dollars
5	Customer C deposits 49 paper dollars	IOUs worth $119	$219 in interest-bearing deposits	100 paper dollars

An alternative way of describing fractional reserves is to imagine that the entire banking system receives total deposits of $500 credit dollars, which are booked as $500 checking account dollars, of which $400 of said total deposits were lent to borrowers, receiving the borrowers' $400 IOU (promise to pay back) in swap. $100 credit dollars were the seed to $500 paper dollars, $400 of which were "issued" through the process of being lent into existence.

How a bank can lend more than it has

Reserves (silver, gold, and U.S. Bonds in past banking eras and U.S Bonds or Credit in the present banking era) are a special form of money which can be held by the commercial banks either in their vaults or on deposit at the central bank. They are generally described as a "high-powered" form of money and are needed to perform fractional reserve banking. When a bank is in possession of bank reserves this means that it is able to lend more currency to others than it has on deposit.

If we imagine a bank which has $100 in reserves, with a 20% reserve ratio the bank would be able to lend up to $400 without breaching the ratio. Hence, through each round of lending a portion is held in reserve until that portion approaches a limit of Zero and the issued credit lent into existence approaches of a limit of $400. Thus begetting a sum total of credit dollars approaching $500 total dollars (The initial seed currency "high-powered money" plus newly issued bank created credit dollars).

The balance sheet of the bank in this position will show:

Assets	Liabilities
Cash reserves $100	Deposit receipt $100

The bank is at the limit of the stipulated reserve ratio and we can see this by the following fraction:

For the bank to lend more money (while still staying within the reserve limits) it will need to wait until some of the loans have been paid back by the customers.

Murray Rothbard in The Mystery of Banking (page 64):

The Rothbard Bank has issued $80,000 of fake warehouse receipts which it lends to Smith, thus increasing the total money supply from $50,000 to $130,000. The money supply has increased by the precise amount of the credit-$80,000-expanded by the fractional reserve bank. One hundred percent reserve banking has been replaced by fractional reserves, the fraction being $50,000 / $130,000 or 5/13.

The form of the money supply in circulation has again shifted, as in the case of 100% reserve banking: A greater proportion of warehouse receipts to gold is now in circulation. But something new has now been added: The total amount of money in circulation has now been increased by the new warehouse receipts issued. Gold coin in the amount of $50,000 formerly in circulation has now been replaced by $130,000 of warehouse receipts.

Issuing more warehouse receipts than there is gold has an inflationary impact on the money supply.

A bank can lend the money immediately

From The Federal Reserve Bank of New York (Reserve Requirements and Money Creation):

If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100 + $90 + 81 + $72.90 + ... = $1,000).

Again this process shows that the reserve portions approaches a limit of Zero while the issued bank created credit dollars approaches a limit of $900 dollars. Thus begetting a sum total of credit dollars approaching $1,000 dollars.

The overarching principal of fractional reserve banking rests on the collective agreement within the banking community that it is impossible to distinguish between currency issued by different banks under the umbrella of Federal Reserve Note System. Therefore all Credit-Money issued in this way is generally fungible which means that the any bank is unable to determine if new money taken in on deposit has come from any other bank including its own bank branches or even the same branch. It is for this reason that there is nothing to prevent the customer from depositing the $90 immediately back into the same bank or any bank and the next borrow to borrow $81 and so on until we approach the $900 dollar limit.

In reality it is not necessary for the group of customers to go through all of these steps and they can borrow the full amount (up to $900) immediately. In this instance the $100 of seed currency whether it be a silver certificate as in past banking eras or $100 of bank created credit in the present banking era, does immediately become $100 dollars of reserve currency and must be held in Vault ATM or Till Cash at the bank (or) Vault Cash/Electronic Book Entry/and or in U.S. Treasuries all held on account with that banks local Federal Reserve Bank.

Convertibility

Typically, privately-issued checking account dollars are convertible into paper dollars on demand. But paper dollars issued by the central bank are no longer convertible into silver (or gold, as the case may be). The Federal Reserve Note is thus physically inconvertible, although it remains financially convertible, in the sense that the central bank stands ready to use its bonds to buy paper dollars issued by the commercial banking system. For example, during the Christmas shopping season, when the demand for cash is high, the Federal Reserve will normally swap about 10 billion paper dollars for $10 billion in bonds from the commercial banking system. After the shopping season ends, the Federal Reserve will swap $10 billion in bonds in 10 billion paper dollars from the commercial banking system, thus soaking up the now superfluous paper dollars.

Increased money supply and inflation

Main articles: Money supply and Inflation

The relation of fractional reserve banking to inflation has been the subject of debates that have spanned centuries, and can still not be said to have ended. According to the quantity theory of money, the expansion of the money supply leads to "more money chasing the same amount of goods" and thus to inflation. Some monetarists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as reducing the exchange rate and causing inflation. In fact quantity theorists often call the issue of bank-money 'inflation' and consider a falling exchange rate merely a symptom of inflation. However, this view is only held by those who use a broad measure of money supply in the quantity theory of money. Those who hold that that the price level is only affected by so-called "high powered money", that is base currency (minted coin), or base currency plus bank issued credit swapped for paper currency at the Federal Reserve, do not see fractional-reserve banking as having an inflationary effect. However, it should be noted that minted coin currency by the Treasury and actually "printed" Federal Reserve Notes (Electronic Credits converted to paper form) make up a very small fraction of the total banker fiat credit money supply and thus vastly under service total purchasing demand for a 12 Trillion dollar GDP economy.

Quantity theorists, understandably are typically either hostile to fractional reserve banking, or supportive of minimum reserve ratios, and other government controls on the quantity of money created by commercial banks. The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.

Others, however, hold that the exchange rate of money is governed by factors other than the quantity of money. An alternative to the quantity theory considers the notes and demand deposits to be holding and representing the value of the non-reserve assets as well as the reserve assets. For example, if a bank issues notes and holds 10% of the funds as reserves and 90% as commercial loans then the value of the currency is unaffected, if all the assets that supports the loans are considered. An illustration of this theory is: when a mortgage is backed by the land and or building used to collateralize the newly issued credit. The market price of the "actuated asset" supports the credit used to actuate it. In other words, purchase demand (resale price) supports newly created credit. Therefore if demand falls, outstanding credit and thus the new deposits created by it, rather the entire money supply is stressed and inflation may ensue. Thus the scenario rationalizes itself to once again the quantity theory of money. It is an irrational assumption to assume or assign direction or permanence to a theory of "value" or "wealth".

Another complementary theory is that the monetary standard of intrinsic value creates an anchor on the value of money, independently from the quantity of money. For example under a gold coin standard all notes and demand deposits used to be redeemed in gold coin, and gold coin has its own price relative to other goods and services, notes and demand deposits payable in gold coin cannot affect the exchange rate of gold coin, and therefore of notes and deposits payable in gold coin. However this presumes a fixed exchange rate declared by legal doctrine of a certain amount of gold in ounces for a certain number of credit created dollars and also presumes that redemption will not exceed actual gold supplies. If redemption tends to exceed gold supplies then the integrity of this value system for currency fails and once again the scenario rationalizes itself to the quantity theory of money.

According to the backing theory (see real bills doctrine), as long as every new issue of money is matched by an equal increase in bank assets (mortgages, asset loans etc.), the purchase power of the currency supply is unaffected by a change in its quantity. The question then resolves to a value of money concept where the "value of money" is only affected by the "cost of money", the interest, or better described as the "transfer potential". To illustrate this point, when interest is added to the loan, the Debit to society becomes greater than the Credited money supply to society and thus reduces the purchasing power of society and transfers it to the lender via the interest rate. Holding all things equal "the Goldie Locks Economy" the value of money is thus represented mathematically as the transfer potential of purchasing power through the interest rate mechanism, which synthesizes yet further to a gross transfer of wealth. Only taxation reverses the flow of wealth back to society thus generating a net wealth transfer to the banking system.

The chief weakness and criticism with this theory is that any counterfeiter could purchase or actuate assets directly and hold a balance sheet resembling a bank's, yet under the real bills doctrine theory, the counterfeiter would create no inflation which would leave the counterfeiters increase in wealth unknowable as a data point with regards to the establishment of an interest rate regime for the purposes of establishing a theory of the value of money based on the cost of money or simply the interest rate. Real increase in wealth should be represented by an increase in Debt not Money.

For example, if the Federal Government simply spent "counterfeited" money into existence rather than banks lending it into existence, the value of money could not be dictated by the fictionalized scarcity (there is no real limit to banker created currency supply) as mathematically represented by banker interest rates as the society entire would understand the source of money is the government and is unlimited in supply. Society might prefer government programs over bank loans as a source of funds. In this respect the once fictionalized banker interest rate (A pivot rate as mandated by the Federal Reserve Bank helps to assist the fiction)would be now actually be set by depositor demand for interest income and net wealth would transfer to society's savers not bankers. Bankers would earn only on the much thinner spreads of interest rates for time deposits and loans made by the banks. The reason is that banks would have to be extremely competitive and bid up the interest they would be willing to pay to attract deposits from those who have the ability to save.

So in final analysis, the cost of money theory is undermined when money is created outside the interest rate regime mechanism and once again the question of value of purchasing power is resolved down to the quantity theory of money. In the example above, if the government were to spend "counterfeit" to much currency into society beyond its purchasing demand as measure by income, savings and investment gains then the value of the currency would fall and prices would rise, i.e. inflation. Interest rates would be little significance in the greater view of the value of money.

Financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of reserves to demand deposits and notes. For example this could be 10%, which would mean the bank has 10% reserves for all funds deposited at the bank, with the remaining 90% used for loans. Term deposits such as certificate of deposit are ignored when calculating this ratio because the bank only needs reserves to pay the term deposit at its maturity, and not during its term. Many Countries have even gone to a zero-reserve banking system, as Canada did in 1991 [1]. The opposite of zero-reserve banking would be full-reserve banking.

The 'reserves' part of the reserve ratio can be most narrowly defined as legal tender, i.e. assets that can be directly paid out as withdrawals and do not have to be exchanged or sold. However, banks and financial analysts use other liquidity ratios and methods to measure and monitor liquidity in order to capture other cash outflows and sources of liquidity (such as early redemptions of term deposits, and lines of credit with other banks, respectively).

Possible confusion

The reserve ratio should not be confused with the capital ratio, which is the ratio of the bank's capital to its assets. The capital of a bank includes the net worth of the bank (assets less liabilities), and subordinated debt, which ranks behind the claims of general depositors and other unsecured creditors, and thereby provides similar protection from loss. The capital ratio is adjusted by risk-weighting the assets of the bank, and the result is called the risk-adjusted capital ratio.

History

At one time, people deposited gold coins and silver coins at goldsmiths for safe keeping, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.

As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.

Government regulation

Banking has been subject to generally a greater extent of government regulation and controls than other forms of business, and banking law has in many countries been the subject of extensive political debate.

Government controls and bank regulations related to fractional-reserve banking have generally been to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counter-act bank runs and to protect bank creditors.

Influence of central banks

Central banks are privately owned and/or sponsored banks that issue notes and typically receive special privileges in the form of exemption from restrictions or taxes on note issue, or whose notes are made legal tender by government fiat (hence the term fiat currency -- the notes are current (legal tender) by government fiat (law).

Central banks also operate as fractional-reserve banks, and the reserve ratio policies of the central bank influence specie flows and credit conditions, making the control of fractional-reserve banking a political issue, with financial and economic impacts. Also involved with reserve ratios is the interest rate, because the primary method of attracting reserves of specie from within a country and from abroad into the central bank treasury, or stemming their outflow, is to offer higher interest rates on deposits (central banks take deposits as well as issue notes).

Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking in reference to fractional-reserve banking by central banks in particular, where the nation's central bank holds fractional reserves of gold bullion or specie (gold coin). This occurred before the adoption of irredeemable fiat money in most developed countries in 1971 with the collapse of the Bretton Woods system, when the US government ended the convertibility of the US dollar into gold. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partly-reserved currencies as a form of fractional-reserve banking may create more confusion than it alleviates. Mainstream economists do not generally make this analogy.

Criticisms

Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the financial risk note holders and depositors bear, and the impact bank notes and demand deposits have on the stock of money, and allegedly thereby, its exchange rate. Fractional reserve banking started with reserve of gold and silver, but still continues in current fiat-money based banking, where money is no longer backed by precious metals and therefore has no inherent value. With that said, the value of any commodity, including paper bank notes and precious metals, simply depends on a person's perception of its worth.

Business Cycle

Main articles: Austrian School and Business_cycle#Austrian_School

Fractional Reserve Banking allows an increase in the supply of currency available to make loans to purchase investment capital, without increasing the quantity of investment capital or real savings. The quantity of loans will be higher than the actual supply of saved resources available for investment. Investors will assume that the quantity of loans available represents real savings. This misinformation leads investors to misallocate capital, borrowing and investing too much in long-term projects for which there is insufficient demand and real savings. As investors spend borrowed currency, segments of the economy will boom. Later investors will find the prices of their outputs falling and their costs rising, leading to the failure of new projects and a bust.

Risk

Main article: Full-reserve banking

Fractional-reserve banking allows for the possibility of a bank run in which the demand depositors and note holders collectively attempt to withdraw more money than the bank has in reserves, causing the bank to default. The bank then would be liquidated and the creditors of the bank would suffer a loss if the proceeds from the bank's assets were insufficient.

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run.

Responses to the problem of financial risk described above include:

1. Opponents of fractional reserve banking who insist that notes and demand deposits are 100% reserved, and
2. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below) and
3. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors and creditors would result in effective risk management.
4. Terms and Conditions of some bank accounts place a limit on daily cash withdrawals and may require a notice period for very large withdrawals.

Incompatible with a gold standard

Main articles: Gold standard, Seigniorage, and Austrian School

Many critics of irredeemable fiat currency see fractional-reserve banking as incompatible with a return of the gold standard, through fractional-reserve banking leading to exhaustion of reserves, prompting governments to make the notes of government-favored banks legal tender, even though the issuer is in default. If such defaulted bank notes are made legal tender by government fiat, as they trade at a discount to their face value in terms of gold coin, will be a cheaper way to discharge debts, driving out gold coin.

However, other critics of irredeemable fiat currency, from the free banking school, support fractional-reserve banking, and view the threat to the gold standard as originating from central banking and government controls on the formation and winding-up of banks and the business of banking.

Inadequate government regulation

Critics of current bank regulations argue that:

1. Minimum reserve ratios put reserves beyond reach in a time of need
2. Minimum capital ratios are poor regulators of financial risk, as they ignore other portfolio risk drivers such as scale and diversification and come at a heavy compliance cost
3. Government bond deposit schemes distort government bond prices, bank portfolios and finance methods, and create inflexibility
4. 100% marginal reserve requirements can be met even if the bank has no reserves
5. Protecting insolvent banks from their creditors creates moral hazard, and increases the losses bad banks make, and is inequitable, and
6. Central bank support and government protection of creditors creates moral hazard and socializes credit risk.

Further to this critics also argue that the Federal Reserve System did in the past and still does currently operate above and beyond the scope of the federal government.

This can be explained in the abstract:

1. The ability in the past to issue money which was then used to bribe the congress and individual politicians to consolidate the power and position it currently holds.
2. The semi private nature in which the bank operates.
3. The longer terms of contract to the federal reserve board members.
4. The deceptive name Federal Reserve System, as it is semi federal and has little reserve (which has never been questioned by the congress).

And with the direct effect:

1. With the ability to expand or shrink the money supply and thus cause a deflationary or inflationary recession.
2. Which is achieved by selling bonds (deflationary)
3. Buying government bonds (inflationary)
4. Interest rate control.
5. Discount Rate control

Critics claim this method of creating a purposeful recession has been used in the past to "fear" the public and governments into a semi or totally private Fractional Federal Reserve System, which in turn compounds the problem (as they see it) by further consolidating the issuing power with the central fractional semi private Federal Reserve System.

Critics also claim the ownership and monopoly of the major print and visual media was a major factor in the consolidation of the federal reserve power; this has been achieved they say by the power to stay semi invisible, which is disproportionate to the immense power that federal reserve bank holds, and in contradiction to democratic human rights, which state that a representative of an economy must have a duty of care and engagement to the citizens who participate in that economy. Critics have noticed similar trends in Canada.

See also

• Bimetallism
• Bretton Woods system
• Credit money
• Debt-based monetary system
• Digital gold currency
• Fiat currency
• Full-reserve banking
• Gold standard
• Islamic banking
• Money supply
• Money creation
• Monetary reform
• Seignorage
• List of economics topics
• List of finance topics
• List of business ethics, political economy, and philosophy of business topics

References

• Huerta de Soto, J. (2006), Money, Bank Credit and Economic Cycles, Ludwig von Mises Institute
• Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
• Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191-202.
• Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
• Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965-970.
• Parliament of Tasmania, Monetary System, Report of Select Committee, With Minutes of Proceedings, 1935.
• John F. Kennedy vs The Federal Reserve
• More John F. Kennedy vs The Federal Reserve

External links

• Rothbard, M. N. (1983) The Mystery of Banking, Richardson & Snyder, 1983, pp 87-110
• Narrow banking
• Money upside down
• Seignorage and inflation tax
• Fractional reserve banking and usury

Libertarian viewpoint

These links discuss "fractional-reserve banking" using Libertarian terminology, from a Libertarian point of view. They are cited here because as of 2003 Libertarians are a group that has been vocal in attacking the practice.

• Fractional-reserve banking Murray N. Rothbard uses the term "fractional-reserve banking" in reference to both commercial and central bank practices. He characterizes the customary modern-day practices with terms such as counterfeit, swindle, and "creating money out of thin air," and asserts that "the general public, not inducted into the mysteries of banking, still persists in thinking that their money remains 'in the bank.'"
• Money, Banking, and The Federal Reserve, afs video stream from The Ludwig von Mises Institute. Good presentation of the Misesean case against the Federal Reserve System.
• The Libertarian Case Against Fractional-Reserve Banking is a critical analysis of Rothbard's views by Gene Callahan, who finds them unconvincing, and asserts that banking practices are compatible with Libertarianism, or could be made so with only minor alterations. He discusses at length (but inconclusively) the question of what depositors actually believe, which he sees as relevant to the charge that fractional-reserve banking is fraudulent or deceptive.
• The Wikipedia Entry Business Cycle: Austrian School give an overview of the Austrian School's views on the relationship between Fractional Reserve Banking, Fiat Money, Credit Policies and the Business Cycle.
• Fractional Reserve Banking as Economic Parasitism An extensively researched, free, 2002, 67-page scientific paper with a 69 item bibliography with notes/comments on most major references.
• Money as Debt , free video by Paul Grignon