Are there deleterious effects of fractional reserve banking? While many insiders defend the practices, others point to a host of potential and certain damages that directly ensue.
This article assumes a basic familiarity with the practices. For those unfamiliar with them, it's suggested that you start 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.
Occasionally, though, something happens to alert depositors to the fragility of the bank's accounts and large numbers of them start demanding their money. This is called a bank run. And we've seen that it can even happen in the digital world. (See the recent Mt. Gox run.) Such events can put a bank out of business. At the very least it can prove extremely costly for the taxpayers to bail the bank out of its liquidity shortage.
2) In our heavily interrelated banking world, banks borrow from and deposit with each other. That is banks can be the creditors of other banks, either long or short term. Such banks are of course more sophisticated about the reserve system than are most depositors and appreciate the cascading effects 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 creates an illusion about the level of savings, which erroneously lowers the interest rate on borrowing, increasing demand for borrowing and incentives for banks to further stretch their reserves. The result is the crushing valleys of the business cycle: recession or depression. And of course such economic downturn reduces the prospects of borrowers being able to repay their loans, hence heightening the dangers of 1 and 2, above.
Given these numerous affects of fractional reserve banking, it is understandable that some have called for the outlawing of the practice. However, even if one believes that the costs considerably outweigh the benefits under current conditions, it's not at all clear that such a prohibition is sound either as government legislation or as social norm.
For insight into how such a solution could work, watch for my upcoming article on Free Market Fractional Reserve Banking, coming soon. Stay tuned!
This article assumes a basic familiarity with the practices. For those unfamiliar with them, it's suggested that you start 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.
Occasionally, though, something happens to alert depositors to the fragility of the bank's accounts and large numbers of them start demanding their money. This is called a bank run. And we've seen that it can even happen in the digital world. (See the recent Mt. Gox run.) Such events can put a bank out of business. At the very least it can prove extremely costly for the taxpayers to bail the bank out of its liquidity shortage.
2) In our heavily interrelated banking world, banks borrow from and deposit with each other. That is banks can be the creditors of other banks, either long or short term. Such banks are of course more sophisticated about the reserve system than are most depositors and appreciate the cascading effects 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 creates an illusion about the level of savings, which erroneously lowers the interest rate on borrowing, increasing demand for borrowing and incentives for banks to further stretch their reserves. The result is the crushing valleys of the business cycle: recession or depression. And of course such economic downturn reduces the prospects of borrowers being able to repay their loans, hence heightening the dangers of 1 and 2, above.
Given these numerous affects of fractional reserve banking, it is understandable that some have called for the outlawing of the practice. However, even if one believes that the costs considerably outweigh the benefits under current conditions, it's not at all clear that such a prohibition is sound either as government legislation or as social norm.
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:
When you need to understand how the international banking regime wreaks havoc with your savings, stay tuned to the Fractional Reserve Banking Review. Wallace Eddington has emerged as a major 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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