Fractional Reserve Banking: Separating the Truths from the Untruths

Within the subject of economics, there is likely no other topic so nebulous, confusing, and weird as fractional reserve banking.  The simple reason is that the millions of loans  issued by banks on a daily basis, all the way from large commercial loans down to credit card loans, involve so many transactions that it’s almost impossible to scrutinize them as a single entity that can be observed in a sort of flow diagram.  I think the best way to understand F.R.B. is to have an examination of some total economy metrics that are easily accessible, as well as examine some regulations that impact banking and some truths and untruths that surround F.R.B.  I should note that this is an educated opinion based on research.  It is simply the position I take at the moment, in which I’ve examined as much of the information I currently have at my disposal.

For the purpose of brevity, fractional reserve banking is the way banking is conducted in modern market economies.  As opposed to a full reserve banking system where banks must back up all demand deposits with a 100% reserve of monetary units, fractional reserve banking allows banks to vault only 10% of the demand deposit while making a loan with the other 90%.  The theory of why banks do this relates roughly to an analogy about bicycles.  Suppose a individual, X, owns 1,000 bicycles.  In all likelihood, the vast majority of those bicycles will not be sold all at once.  Instead of putting those bikes in a warehouse and selling them one by one over time to secure funds, X decides to loan many of them out, along varying time tables and according to how he sees fit so that bicycles are returned at various times.  This analogy shows the concept of why banks decide to loan your deposit out: on average you will simply not need the vast majority of your deposit at once.  Keep in mind this simplistic analogy is only appropriate in the sense that it teaches the concept of time-based necessity for funds.  The actual flow diagram as it relates to monetary units is obviously quite different.

Chicken vs. Egg: How Are Loans Created?

Now that we’ve addressed the concept of why banks loan out deposits, let’s examine the depth of a banking operation.  Most importantly: what is the origin of a loan?  The classic money multiplier model taught in economics textbooks presents the notion that loans are created AFTER a deposit is received.  This suggests that banks are ready to fire off a loan the moment they receive a deposit, which would result in a money multiplier effect.  Once the loan is issued, the borrower takes most of the loan to the same bank or another bank where the deposit is once again turned into a loan.  This process continues down the line until the marginal loan created equals/is close to $0.  The multiplier is the inverse of the reserve requirement.  Thus if a bank set a reserve requirement at 10%, the monetary amplification/inflation would be equal to 10x in the case of extreme abuse of the system.  At a reserve requirement of 20%, it would be 5x, etc.

This is false.

Of course the consequences of this would be catastrophic.  A major buildup of artificial wealth would be created, leading to exponential inflation and loan interest payments would completely cease all economic activity until a serious debt deflation or write-off took place.  In reality, loans are created prior to the receipt of a deposit, which completely flips the idea of the money multiplier on it’s head.  However, the research that disproved the money multiplier model was not always known.  As Frank Shostak of the Mises Institute so eloquently writes:

“Indeed, economists from the post-Keynesian school of economics (PK) have expressed doubt about the validity of the popular framework.

It is argued that the key source of money expansion is the demand for loans together with the willingness of banks to lend.

The supply of loans, in this way of thinking, is never independent of demand — banks supply loans only because someone is willing to borrow bank money by issuing an IOU to a bank.

Accordingly, the driving force of bank credit expansion and thus money supply expansion is the increase in the demand for loans and neither the money multiplier nor the central bank. Bank lending is not constrained here by reserves that are injected by the central bank, but by the demand for loans.”

In short, we can rest assured that the money multiplier is a myth in that banks respond to the aggregate demand for loans and must have a willingness to lend based on their view of the creditworthiness of the borrower.

This does not mean that fractional reserve banking does not create problems.

Where Banking Can Suffer

The easiest way to observe the illness that results from fractional reserve banking is to keep an eye out for private debt levels at all times.  When private debt levels are too high, it signifies the overextending of credit to the point of exhaustion to the economy.  Currently the US consumer and corporations are overloaded with debt.  Low interest rates and Q.E. primarily created a moral hazard whereby credit was too cheap at a time when prices needed a serious deleveraging following the housing bubble that grew until 2008.  Deleveraging would have allowed prices to drop and created a more advantageous environment for the American consumer to build savings once again.  While a serious pullback in loan creation would throw the economy into a deflationary illness, debt needs to be deleveraged in order to drive production and economic value creation.

How Fractional Reserve Can Lead to Inflation

With our revised knowledge surrounding the fractional reserve system, we now know that loans are created based on the aggregate demand for loans in the economy and that the money multiplier effect is a myth.  However, fractional reserve banking still has the capacity, without question, to inflate the money supply.  The creation of a loan of say $50 for X at a rate of interest to purchase bulldozers with the assumption that his housing business will expand now results in X spending against a demand deposit from the loan.  Let’s say Adam then deposits $100 in his checking account from working with a company that has produced a widget that consumers have purchased due to the fact that it’s cost is cheaper than previous widgets in the market by 40%.  The bank considers this a deposit that will balance it’s loan portfolio.  The $100 produced through economic value added is now being spent by Adam while X is spending monetary units against the $50 created through a bank loan out of thin air.  Here is the part that ties it all together: the mere fact that two sources are spending while only one has created the economic value added means that this is inflationary by nature, unless risk is allowed to take its course and liquidate bad loans while rewarding loans that result in E.V.A.  In a full reserve banking system, Adam could have risked $50 of his own $100 to loan to X; however, with the explicit risk in mind that his $50 could be lost.  Adam also gives up $50 in present goods so that the loan can be made.  If the business proposition fails, he is only capable of spending the $50; however, the money supply remains steady in the process.

While the banking institution can engage in making loans with the express consent happily given by the depositor, the creation of loans prior to balancing with deposits makes this a bad business model.  That being said, nothing a bank does that we’ve just discussed is truly illegal.  Banks do offer safety deposit boxes, which should be in far greater demand than savings accounts.  One revision that should be made: the depositor should be advised of the interest rate risk of each loan the bank is attempting to make.  Considering this stipulation, depositors would surely demand a far higher rate of interest than is currently set by the Federal Reserve system.  The “prime lending rate” is around 3-4%, but how do we know that is an appropriate rate of interest?  After all, the FDIC moral hazard and notorious failures of the centralized interest rate Politburo known as “the Federal Reserve Bank” almost guarantee that whatever rate has been set for prime lending… it is probably the wrong one.  If depositors knew infinite information, they might, in reality, demand 15-20% from those so-called prime borrowers.  Surely depositors would require 30-40% for the most risky loans.  This alone would drastically decrease the economy’s reliance on loans and only the most prime projects would be funded through loan issuance.

Considering the fact that depositors do not possess infinite information at their disposal, it seems logical that banks should primarily be in the business of safeguarding money.  A select percentage of depositors can feel free to take risk; however, the vast majority simply want a safe-guarded storage of present monetary units.  This would also open up the possibility for depositors to make their own investments and loans as they see fit coming from real savings.  Thus the depositor can feel free to charge his own rate of interest: 20, 30, 40, 50%… whatever he sees fit for a risky project that might result in a loss of money.