Fractional Reserve Banking, revisted - Part One

Since this topic has been done to death, and since under laissez-faire the practical problem is more or less negligible, unless you’re particularly interested in my thoughts feel free to roll your eyes and skip right over this one. I’m only bringing it up because of Dr Binswanger’s semi-regular reiteration of his belief of there being nothing wrong with it either morally or economically. I agree with the former, but not the latter. The wrongness with it today is a technical matter, no more than that. The historical origin of the practice does show grievous immoralities, but that is only particular implementations and doesn’t address the actual principles.

This Part One deals with what the practice is and what its major consequences in the first instance are. Part Two goes into the details to show why the practice has no merit. And then, Part Three responds to various arguments used by others on both the pro and anti sides.

Update: I've since done a post on how much one can draw from historical empirical data.

Part One – The practice of fractional reserve banking

Two kinds and the common principle

There are two kinds of fractional reserve banking. The original practice was when banks issued their own notes and had less specie on hand than was outstanding as total amount of notes in circulation. For example, a bank may have printed $1000m in notes that it lent or spent and only have $125m in specie to cover the payments that have to be made when someone brings in a note to be cashed. This is the version you’ll find discussed in Adam Smith’s “Wealth of Nations”, where he talks about adverse clearing as a limiting factor on note issuance. Nowadays however, this variant of the practice is dormant because banks are no longer allowed to issue their own notes – the central banks of the world have taken on that role as national monopolies. Since what I say below applies to all variants, I needn’t discuss this variant in particular any further and will just deal with the broader principles.

The second type of fractional reserve banking relates to demand deposits. A demand deposit is one that the customer is entitled to withdraw from at any time (ie on demand). Here, the banks still have that $125m in reserve but instead of having $1000m in notes outstanding the banks have $1000m in demand deposits that the customers can use in transactions directly without touching physical cash, through the use of cheques, wire transfers, direct deposits, EFTPOS cards (NOT credit cards – that’s a different phenomenon), and so on. This is the norm today.

What is common to both practices is the use of money-substitutes. Those money substitutes – which are the bank-issued notes in the first kind and the various payment methods using demand deposits in the second kind – are not themselves money but are used in the place of money: the actual money is the real value being counted on. The practice of fractional reserve banking in both cases is that the issuing banks have more of these money-substitutes outstanding than they have specie stored in their tills and vaults. What backs the difference is the credit that the extra substitutes are used to invest in by the issuing bank. This means that people are now using credit alongside specie as the actual assets used as the media of exchange, made interchangeable via the use of fungible money-substitutes. In other words, the practice of fractional reserve banking is nothing more than the monetisation of credit, with some additional practices associated with its implementation.

The practice also depends on the switching of the legal relationship between banker and depositor away from bailment contracts to credit contracts. That is, depositors are no longer owners of specie stored in the bank, which is held under law of bailment as applicable to fungible commodities, but are now creditors to the bank who do not own anything physical and instead have legal claims on the bank under the law of credit. We’ll get to the importance of this shift later.

The monetisation of credit

This ‘monetisation of credit’ sounds complicated, but it isn’t: the principles are easy to understand. It is nothing more than using the debts one is owed (which is the credit) as themselves tradable assets that one can use to buy stuff with (which is the monetisation of that credit). For example, if Joe creates some credit by lending Pete $100, and then Pete gives Joe a paper or electronic note saying “I, Pete, will pay the bearer $100”, Joe can use that note to buy something from Sally by handing it to her in a transaction that is independent of the physical $100 that Pete borrowed from Joe. Then Sally can either demand payment on the note from Pete or on-trade the note to Bobby for something she buys from him. If she on-trades it then Bobby likewise has that choice, and so on ad infinitum until someone actually does demand the actual cash from Pete. The credit owed by Pete has now been used as a medium of exchange by way of the physical exchange of the note and moral exchange of the claim against Pete, independently of and now alongside the original $100 in cash. When this practice is widely accepted in a community the credit to Pete is now part of the money supply. That is, the credit to Pete has been monetised by means of the transferability of the note and of the rights of its possessor.

The demand deposits people have at banks under fractional reserve banking are exactly the same thing in principle: you don’t “have money in the bank” - what you have is credit that the bank owes you, which the bank is legally obliged to settle whenever you front up with a withdrawal demand. What you can still do is transfer that owing amount directly to someone else as payment for what you bought from that someone. When you are doing this you are telling the bank that it no longer owes you $100 and instead now owes it to someone else. Thus banks are just the Petes of the world borrowing from lots of Joes, keeping some of the money aside to pay the occasional Joe or Sally or Bobby back on the spot as needed, and lending the rest to Tom, Dick and Harry. People issuing cheques or doing internet direct-debits etc are then the Joes of the world buying things from the Sallys of the world by using the debts that the Petes of the world owe them as money independently of the original cash.

So, it is not the case that financial institutions are creating money out of thin air. Instead the banks are counting on their credit ratings and reputations in the eye of their customers, which they have to work hard to generate and maintain through prudence and profitability, and using that credit rating to give the money-substitutes they issue real value. People wouldn’t be able to pass Pete’s notes around with ease unless there was widespread confidence in Pete’s ability to pay his debts, which can only arise if Pete has earned a reputation for solvency and profitability. That is a real value of Pete’s and banks’ own creation, and it is not at all fraud for Pete or banks to trade on it and with it.

What the departure from laissez-faire in banking does is reduce the strength of credit rating required to do this, making it easier for banks to mix in heavier proportions of credit to specie to form the total money supply before depositors get anxious. Indeed, this laxity engendered by government intervention can grow so much that some of the regulations in the finance sector are aimed at not letting this get too far before depositor indifference lets fierce competition among banks put the economy on a knife’s edge. This is a classic example of controls breeding controls.

The extra risks created

If there were no fractional reserve banking then the money supply would only be specie and the quantity of money would be reliable. Money doesn’t have to have a stable value to do its job, just be capable of being valued objectively. When money is only specie this is a straight forward matter: specie is only lost in very small quantities, and is added to by at reasonably predictable rates that are only a few percent per year of total stock. In combination with the generally slow-changing nature of total transactional velocity (a complex topic – take this for granted for the purposes of these post), total spending in the economy would then also be reliable. The main risks in the economy overall are then just the integration of all the individual risks of each debtor, and resulting in a moderate overall market risk for participants practicing good diversification (itself another topic, which is a bit more complex than it seems at first glance).

However, when banks keep only fractional reserves, the practice of monetising credit creates risks over and above the mere credit risks of each individual debtor. The risk arises because the ephemeral nature of credit makes for an ephemeral element to a total money supply that includes it as a component. This risk has two sources: the credit and reserve policies of each bank individually, and how the solvency of each bank is connected with other banks’ solvencies through potential for “contagion.” Without fractional reserve banking these risks have little effect on aggregate spending, but with fractional reserve banking aggregate spending can vary markedly, independently of and in turn adding to the credit risks of each debtor.

The first is bank policies and practice. Credit has a definite lifespan, with maturities now ranging from a microsecond to a century. When it does mature the funds repaid back have to be lent again for the total outstanding credit amount to remain constant. This means that the credit component of the money supply has to be actively regenerated at an immensely greater pace than specie, which is regenerated much more slowly over time in response to physical wear and tear (especially when disposable substitutes are in use). This also means that the money supply is based on lending policies and capacities that can equally be changed in very short order. If in good economic times a bank lowers its reserve policy and grants more credit from deposits then it will make the money supply shoot upwards, while if in bad economic times a bank chooses to curtail its lending and increase its reserves against deposits then it will make the money supply fall. These have the effect of turning good and bad times into full-blown booms and busts because the expansion of the money supply gives the impression to each debtor that their proportion of total real demand has increased while the contraction in the money supply gives the impression that their proportion of total real demand has decreased.

The second is bank solvency, and arises if the busts grow large enough to send banks under. Depositors, having forgone the right of beneficial ownership, are now legally in the position of unsecured creditors, meaning that their deposits are way down on the pecking order to be paid back in the event of liquidation. Therefore, if the bank goes under then most or all of those deposits will be wiped out. The destruction of those deposits – which is also the destruction of money substitutes – would then demonetise what’s left of the bank’s credit assets, so that means part of the money supply would also be wiped out by the same extent in a single instant. In turn, this hit on the money supply feeds back into the above effects on aggregate spending, and so endangers all the other banks because their debtors’ revenues are going down in general, which is happening because there’s less money to spend and it takes time for the economy to adjust to the reduced money supply even under laissez-faire. These banks are then likewise pushed closer to insolvency, which starts getting people anxious and seeking to withdraw money, which can turn into a run if the sentiment grows strong enough. In any event, this withdrawal from banks in general further reduces the total amount in demand deposits, and so by the operation of the money-multiplier in reverse further reduces the money supply and makes businesses and banks even more insolvent. One by one the most insolvent banks drop like flies, itself causing difficulties for all the other banks in the same economy. When strings of bank troubles and insolvencies like that begin actually taking place in cascade fashion before people have time to adjust, this cascade is what is known as “contagion:” the cross-linking of the ephemeral money supply among banks means that when one bank gets into serious trouble that in itself causes trouble for other banks.

Thus, either way, if credit is used alongside specie as money then the total money supply is made considerably more risky to calculate and plan with than were it composed exclusively of the specie. This is how the practice creates more risks for the economy than arise just from the credit risks of individual borrowers.

This general increase in risk for everyone in turn occasions all investors to increase their risk premiums when determining hurdle rates for their investments. This means that projects they might have funded before will now not be funded. Only the remaining and potentially more profitable projects get funded, and the difference in funding is used for present consumption instead of investment. No serious advocate of fractional reserve banking denies this effect. In fact, these results of pursuit of the practice too far as a consequence of government interference is part of the practical side of their argument against that government interference, whereof course the immorality of intervention takes front seat (among Objectivist advocates, anyway).

The mere increase in risks, and its consequent increasing of investors’ hurdle rates, is not enough to condemn fractional reserve banking, for a few reasons. The most fundamental is morality, of simple recognition that having even a strong interest in the vicissitudes of the money supply does not translate to a right to have that money supply regulated. In economic substance a contraction in credit as money is absolutely no different to what would happen if say a ship carrying a lot of gold coin en route from one major trading house to another were to be lost at sea, with contagion being wreckage in busy shipping lanes leading to cascade ship founderings until pilots learn to steer clear and the wreckage is cleaned up. The only difference is how easy it can be for virtual ships (carrying cargo of real value) to be sunk and how quickly virtual wreckage can pile up as a threat to other virtual ships. In a free market people have the right to be customers of fractional reserve banks or not as they choose, and if one of the consequences of other people’s choices to patronise fractional banks is increased risks for others then that’s the way it goes. In the meantime, one of the rational things to do is to prepare for bad times in some manner, such as money in actual deposit boxes that can’t legally be lent out of by the bank.

The other reason why the risks is not enough is because although it increases hurdle rates the practice also increases total amount of nominal lending. Thus while individual investors may reduce their own personal lending the practice puts more money into the pockets of more borrowers and investors in aggregate. Indeed, the practice does create more nominal credit.

Bookkeeping

Before we look at this more-credit issue, let us first look at how banks account books without the practice would look, ignoring things like buildings and equipment etc.

Assets:

 - cash in vaults and tills: $U

 - loans receivable, not funded by fractional banking: $W

Liabilities:

 - time deposits, commercial notes and bonds etc payable: $V

Equity:

 - various kinds of stockholder funds: $T

As Assets = Liabilities + Equity (A=L+E), we know that U + W = V + T. The money held by the bank on behalf of demand depositors, call it $Y, doesn’t even enter the books as an asset. Likewise, neither do the demand deposits themselves, call them $Z, enter as liabilities. This is because that money is held under law of bailment and not law of credit (technically there are other contingent liabilities relating to theft or damage, but that’s a complexity we can totally ignore here). This means that the law regarding depositors’ claims to the money is the same as that for their claims to the contents of security boxes: the banks do not own the money, just as they do not own the contents of security boxes. The depositors are legally and fully the beneficial owners of the specie: the $Y and $Z are only in owner-registry books listing who owns what. Accordingly, in event of liquidation, the liquidators cannot do anything with the $Y except pay it back to the depositors in full, irrespective of however many cents on the dollar that the banks’ creditors get.

Now let us introduce the practice of keeping only fractional reserves and monetisation of credit. The legal situation of the depositors has changed from fungible bailment to credit. This change means that the money is now owned by the bank and can be lent by the bank. In the books, the $Y is then added to cash assets on hand and total outstanding deposits, $Z, is added to liabilities. Initially, therefore, Y=Z ... but it wont stay that way.

Then the bank begins extending credit from deposits, backing those $Z deposits with both specie and that credit, thereby monetising that credit because the $Z is also money substitutes. As might be imagined, the monetisation of credit and the use of this new money to extend further credit becomes telescopic. That is, credit becomes used as additional money, which funds more credit, which leads to creation of more money and so affords more credit, on and on. This happens through cycles of the banks first lending cash out of deposits, this cash being spent by borrowers, the receivers of this spending then depositing their revenues in their bank accounts, and then from which the banks lend out again. The process does come to a halt eventually because not all of the money deposited is lent out again. Some of the money, a fraction or ratio set by bank policies, is kept aside as reserves, hence “fractional reserve banking” and “reserve ratio.”

When the process is fully complete, there is a definite relationship between the total amounts of monetary and credit expansions on the one hand and the actual amount of money being kept in reserve on the other. In relation to monetary expansion, there exists what is called a money multiplier. Although the mathematics underlying the historical build-up can be complex, the end-result is easy to understand. Simply note that if banks have a policy of keeping cash reserves equal to X% of outstanding deposits, and customers want to keep $Y physical cash in banks while they physically use money-substitutes to trade with instead, then the process sees to it that $Z grows until it is that amount of which $Y is X%. Thus $Z = $Y / X%, and hence the multiplier, $Z/$Y, is 1/X%: the money multiplier is simply the inverse of the reserve ratio. For example, if the reserve fraction is 12.5% then the multiplier is 1/0.125 = 8. Here, $125 of initial deposits in cash would, in time, increase to $1000 in demand deposits (the liabilities), matched by $125 cash in the vault plus $875 in extra loans (which are both assets). The books now become:

Assets:

 - cash in vaults and tills: $U + $Y

 - loans receivable, not funded by fractional banking: $W

 - loans receivable, funded by fractional banking: $(Z-Y)

Liabilities:

 - demand deposits payable: $Z, where $Z = $Y/X%

 - time deposits, commercial notes and bonds etc payable: $V

Equity:

 - various kinds of stockholder funds: $T

Now, with the practice, A=L+E means U + Y + W + (Z-Y) = Z + V + T. The difference is the bank also having $Y in its vaults it now legally has as cash assets, $(Z-Y) in extra lending assets, and an extra $Z in its liabilities. That Z-Y is also the amount by which the total money supply has increased, because the use of the deposits by customers as money-substitutes (ie the whole of the $Z) allows the banks to monetise that credit.

Note also that although we know that there are differences in funding, in actuality all the loans-receivable of the same tenor are identical. It is not the case that loan A is funded by fractional reserves and loan B is funded by bonds or equity. There is only funding from a range of sources that is thrown into one common pot, out of which pot credit managers know that they can lend yay much. The practice of fractional reserve banking increases the quantities that go into and hence come out of that pot, to the tune of Z-Y in total. That is what the advocates of fractional reserve banking want. And so we come to the main contention: is that extra Z-Y worth of nominal credit beneficial? The advocates say “of course it is.”

I say “no, it’s not!” And I’m going to prove it.