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?
A basic familiarity with the practices of fractional reserve banking is assumed in this article. If you don't feel that you understand these basics, it might be a good idea to begin with this introductory article instead.
The defenders of fractional serve banking point to the liquidity benefits of greasing the gears of our large, complex economy. By means of such liquidity, obtained through lending, sufficient funds are made available for entrepreneurs to start new enterprises and consumers to purchase big ticket items like houses and cars. All this is said to stimulate demand, production, and employment.
Even if we concede all such claims (a concession that by no means do all critics make), it is a failure of economic thinking to ignore the trade-offs. What, then, we have to ask, 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) To be precisely technical all fractional reserve banks are at every moment bankrupt. That is to say they are incapable of fulfilling all their financial obligations. Since, fortunately, most depositors are not cognizant of this fact, 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) Problems for individual banks can turn into problems for the entire banking systems, due to the heavily interrelatedness of global banking. Banks these days, as a matter of course, borrow from and deposit with each other. Banks are creditors of other banks, either as long or short term positions. Naturally, the bankers tend to be more sophisticated about the nuances of the reserve system than the average depositor. They better appreciate the cascading consequences of a bank run.
However, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.
The situation is considerably complicated by wide prevalence of inter-bank borrowing. Under these conditions a bankers' bank run can ignite chain reactions of default. This was a major contributing factor to the 2008 financial crash. So, we see that the entire global financial system can be endangered.
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.
The precise mechanics of how this happens are too involved for discussion here. Suffice it to say that the same money cannot be both in one person's bank account and another person's loan portfolio. Yet, this is precisely what the formal position of accounting presumes.
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.
Some of the most vocal critics of fractional reserve banking have concluded, on the basis of such analyses, that the practice is merely criminal fraud and should be banned. I'm not so convinced of this claim. There are other factors to consider. As usual, I'd prefer the market to solve the problem, rather than turn to coercive government intervention.
For insight into how such a solution could work, watch for my upcoming article on Free Market Fractional Reserve Banking, coming soon. Stay tuned!
A basic familiarity with the practices of fractional reserve banking is assumed in this article. If you don't feel that you understand these basics, it might be a good idea to begin with this introductory article instead.
The defenders of fractional serve banking point to the liquidity benefits of greasing the gears of our large, complex economy. By means of such liquidity, obtained through lending, sufficient funds are made available for entrepreneurs to start new enterprises and consumers to purchase big ticket items like houses and cars. All this is said to stimulate demand, production, and employment.
Even if we concede all such claims (a concession that by no means do all critics make), it is a failure of economic thinking to ignore the trade-offs. What, then, we have to ask, 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) To be precisely technical all fractional reserve banks are at every moment bankrupt. That is to say they are incapable of fulfilling all their financial obligations. Since, fortunately, most depositors are not cognizant of this fact, 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) Problems for individual banks can turn into problems for the entire banking systems, due to the heavily interrelatedness of global banking. Banks these days, as a matter of course, borrow from and deposit with each other. Banks are creditors of other banks, either as long or short term positions. Naturally, the bankers tend to be more sophisticated about the nuances of the reserve system than the average depositor. They better appreciate the cascading consequences of a bank run.
However, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.
The situation is considerably complicated by wide prevalence of inter-bank borrowing. Under these conditions a bankers' bank run can ignite chain reactions of default. This was a major contributing factor to the 2008 financial crash. So, we see that the entire global financial system can be endangered.
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.
The precise mechanics of how this happens are too involved for discussion here. Suffice it to say that the same money cannot be both in one person's bank account and another person's loan portfolio. Yet, this is precisely what the formal position of accounting presumes.
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.
Some of the most vocal critics of fractional reserve banking have concluded, on the basis of such analyses, that the practice is merely criminal fraud and should be banned. I'm not so convinced of this claim. There are other factors to consider. As usual, I'd prefer the market to solve the problem, rather than turn to coercive government intervention.
For insight into how such a solution could work, watch for my upcoming article on Free Market Fractional Reserve Banking, coming soon. Stay tuned!
About the Author:
If you want to keep tabs on how the international banking system wreaks havoc with your savings, stay tuned to the Fractional Reserve Banking Review. Wallace Eddington has emerged as an important analyst of finance and investing. His no-holds-barred proposal of a Free Market Economy in Money is required reading for anyone who wants to understand our current financial situation.
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