Friday, September 24, 2010

Fractional Reserve Banking, revisted - Part Three

Part Three – The other arguments and last words

Since I am an opponent of the practice, I will begin by dealing with the other arguments in favour of the practice. After that I will deal with other major arguments against the practice and show why they are also wrong.

The Idle Cash Argument
I’ll deal with a quick one, first, and which has already been implicitly despatched in the course of prior discussion. Here the argument is that the practice puts money that would otherwise be sitting idle in bank vaults and tills to good use. This argument would be raised most particularly (though not exclusively) in regards to those large sums occasionally parked in transaction accounts while their owners make savings and investment plans.

The basis for the reason why this argument is nonsense has already been shown: people use daily transaction accounts holding demand deposits because they don’t want that specie on their person or in their homes or offices, or anywhere else that is unwieldy or comparatively unsafe. They want to use the more convenient money-substitutes in their place, ie to use bank notes or issue cheques instead of hauling around heavy specie, to do internet shopping and pay bills online, and so on. That means every time the bank makes loans and the funds are withdrawn in specie to be spent, in short order that specie comes back in to banks again as the recipient people deposit unwanted specie into their transaction accounts so they can likewise use money substitutes. This will keep on happening, over and over again, until exactly the same quantity of specie is back in bank vaults and tills for the sake of reserves as was deposited in the first place. In fact, most often the specie never even leaves the bank premises in the first place, because the loan funds are received as credits to the borrowers’ own transaction accounts and the spending is mostly done by money-substitutes.

Therefore, the idle-cash argument is a fallacy. That specie WILL sit physically idle no matter what lending and relending is done, because that is the whole point of having daily transaction accounts and using the money substitutes associated with those accounts. The only difference with fractional reserve banking is that the total value of deposits outstanding for these accounts will be greater than this amount of specie, and the merits of that have been shown to be highly questionable.

Economies of scale
Okay, cherry-picking aside, it is time to deal with the main remaining argument for the practice. Besides the increase in credit through use of otherwise idle cash, another reason for the pro-FRB position is the claim that the practice is needed because without it there wouldn’t be anywhere near as good economies of scale. Banks are in the business of lending, and so without the use of funds in daily transaction accounts where else would borrowers get their loans from?

The argument is overlooking quite a range of issues. The first is the already-identified failure to distinguish between demand for money and actual saving. Banks can easily attract a large amount of money for proper on-lending through their normal savings-accounts operations. Once the financial sector gets large and sophisticated enough the efficiencies can run full swing by virtue of there being enough business for dedicated professionals in each part if the industry and its component processes. In fact, it doesn’t take much, being something of the order of a few million people. For instance, in Australia – a country whose population is 21 million as of 2010 – fractional deposits in banks are markedly outweighed by non-fractional deposits, and yet the finance sector of this nation is among the most sophisticated and respected in the world.

Another issue that the argument is overlooking is the non-account sources of funding that banks can lend out of. These are the issue of commercial notes, bonds, debentures, and of course equity. Without recourse to fractional reserve banking the banks would simply increase their activities here, which are also already quite substantial to begin with. Again, the section of the banking industry geared towards this is already in full swing and as efficient as it is going to be in any modernised country with more than about a million people in it. If there were no fractional reserve banking then this sub-sector of the banking industry could pick up what slack there was in a snap. Looking at some actual numbers in Australia, using Reserve Bank of Australia statistics, it turns out that lending from of fractional reserves is only a small proportion of total bank-issued credit issued in the Australian economy of June 2010. Total current deposits are $206b. Those deposits turn out to be only a ninth of total bank credit issuance of $1,864b. The rest of bank lending comes from time deposits, other non-fractional borrowing, and bank equity.

In both of these cases the banks of a sophisticated modern nation are already in full possession of all the economies of scale they need even without recourse to lending out of transaction accounts. Just on that point alone the argument has been fatally undercut, but we can go further still, remembering how the advocates forgot about non-bank capital-providers. Outside the banking sector altogether there are financial institutions that have vast sums at their disposal, the use of which has nothing to do with the practice of fractional-reserve banking. These are the insurers, superannuation funds, and other fund managing entities, plus also the funds directly owned by individuals in the form of personally-held stocks and bonds. These sources can and do compete directly with banks for lending, and so whatever custom the banks could not get these other competitors could easily move in for, providing businesses with all the credit they can ever profitably use.

Looking at some real-world numbers again, the various parts of the Australian managed funds industry can easily reallocate some of the $1211b its members have in their care to filling any gap left by the banking sector. Notice that NBFI’s, for whom there is no issue of fractionality, have almost as much capital to invest with as the banking sector does. Putting all this together we find that the total capital market in Australia held via financial institutions is fifteen times the size of outstanding fractional demand deposits, and we haven’t even included direct investment by individuals in debts and equities. This is the actual state of affairs in a modern industrial economy with fractional reserve banking in full swing and average reserve ratios of around 5% (banks hold around $10b in cash to cover withdrawals on $206b in current deposits). The economy has no need of fractional-reserve lending out of transaction accounts.

About the only time when the economies of scale argument might be valid is in relation to small and isolated places with a genuine dearth of specie. This is not simply that there is a low amount of cash and that this is reflected in prices, but that there literally is insufficient cash for the physical needs of transacting. In such a scenario, such as one might find in outback Australia or central-eastern Russia for instance, there could conceivably be a net benefit in the monetisation of credit by someone acting as the local banker. That banker would efficiently organise the whole community’s trade through an economic system of issuing more notes or whatnot than he has specie in his little safe. Yet, precisely because that scenario is for small and remote communities with a low level of commerce with the outside world, the argument is inapplicable on the scale of cities and nations, for whom there is no genuine dearth of specie.

The economies-of-scale argument has been disposed of. All the economies of scale required that would counter the hindrance against capital formation are already present without the practice, except in highly-isolated small communities. That means the practice of fractional reserve banking has been shown to have nothing to offer anyone but the tiniest tiny fraction of the population, and in many countries not even that. Under laissez-faire, then, we can predict that, as more people come to realise this fact, the market for fractional-reserve transaction accounts will contract, and eventually collapse entirely except for a smattering of remote parts of the world that few outsiders venture to.

The theft-by-embezzlement argument
Some opponents claim that bankers are guilty of a form of embezzlement when they practice fractional reserve banking. In this view, what’s happening is that the banker is taking money that doesn’t belong to him, investing it and getting a return, and then putting the money back while hoping he doesn’t lose it and that the depositor stays none the wiser.

In the early days of the practice this argument was entirely right. Depositors did expect the money to be sitting their safe and did not authorise the holders to lend from it. The reason the holders got away with it was that a major borrower was the various Governments and Crowns of those countries, who legalised the practice to get loans they otherwise wouldn’t get at low interest rates or at all. Of course, sometimes the holders were forced to make loans at the point of a sword, but that does not explain all of what went on in those days and there were many guilty bankers and goldsmiths who had no excuse.

The problem with this argument is that the past is just that. In the early days, the depositors were indeed being made subject to naked force, but by the middle of the 19th century there were few people making bank deposits who did not know what banks did with the funds. This was so obviously true by then that when the issue of bailment-versus-credit was finally brought to an English civil court the judge was able to rely on widespread public knowledge of bank practice as grounds for making a formal case-law precedent out of it.

Today, the plain facts are readily available from simple brochures one can pick up from the website of or the information racks in almost any branch of a bank, which brochures were put there precisely to let you know what’s happening. One can even ask a teller flat out what’s happening with your money, whereupon you’ll be told the plain truth without hesitation, and this teller will be genuinely baffled as to why someone might object. Four hundred years ago depositors expected to be under contracts of bailment, but today depositors know (or have more than enough notice to be expected to know) that they have contracts of credit.

One can argue that it is a travesty that what was formerly an injustice had been normalised by centuries of government connivance and public acceptance, but the fact remains that it had been normalised nevertheless. The theft-by-embezzlement argument doesn’t work any more. If you don’t want your bank lending out of your transaction deposits, then get an account set up that way. If there isn’t enough market for such accounts then while that’s upsetting it is not an indicator of moral wrongdoing. The only remaining valid option is to educate those who care to learn.

The theft-by-inflation argument
The second theft argument relates to what happens to the money supply. The allegation here is that the creation of extra money “out of thin air” and using it to buy things with it is another form of theft. The creator gets to buy goods and assets at a price that doesn’t take into consideration the dilution of money caused by creating more credit-money, where if the full effects of the creation and dilution were widely known then the prices to be paid would be much higher. The difference is what is stolen, according to this argument. There are a couple of problems with this argument.

One problem is that the thin-air allegation is nonsense. They are claiming that the new money is backed by nothing whatever and that its creation is pure gravy to the creator, which gravy is claimed to be stolen from people who sell to that creator. In fact, the creator also simultaneously creates a matching debt for it. It is this debt that is being added to the money supply, and the creator can only do so by the hard work of earning a good credit reputation. The loans are real assets having real economic effects and possessing real values that can be calculated. A bank profits not by getting gravy but by being good at judging creditworthiness and pricing loans appropriately. That’s part of what banks are supposed to do. There is no gravy, and no part of the money supply is truly created out of nothing.

Another problem is that it presumes that people have a right to know price structures and all the relevant information that goes into them. In fact, there is no such right, and the assertion that one does exist is essentially an egalitarian sentiment. Different people have different amounts of information about all sorts of topics, both economic and non-economic, and are fully entitled to exploit such differences to their advantage.

Another again is that there is no difference in principle from a fall in the value of a unit of money arising from new credit money versus new gold dug up. If the money supply is increased by yay much then the effect on prices will be the same irrespective of what form the new money takes. So long as no force is involved, the purchase of assets at prices that don’t take the expansion effect of the monetisation of credit into account is fully moral equal to when the same happens because of a gold find that people haven’t made accommodation for in their price calculations. The situation of a banker believing himself better than his peers at judging credit and his customers’ withdrawal patterns and thus creating more credit-backed money is identical to the gold miner’s find, switching only the asset behind the money from gold to credit.

In sum, the second theft argument falls down, too. There is no theft arising from changes in the money supply itself.

The Two-Places-At-Once Argument
Another argument is the idea that trying to spend the same money twice is attempting to contradict reality and hence cannot work. The claim is based on the fact that under the practice the people in an economy can in net simultaneously spend the money in bank accounts directly by cheque or other transfer while also spending money gained by borrowing the physical cash from the accounts. This argument differs from the theft-by-inflation argument in that instead of making a moral claim it is making a metaphysical claim and trying to say that it’s an attempt to cheat physical reality itself instead of cheating people in particular.

This claim is mistaken in that customers are not spending the same money twice at the same time. They are only spending one unit of money once at a time. This argument is overlooking the fact that when fractional reserve banking is being practiced the money supply is no longer just specie alone but a mix of specie and credit. The specie is and always is in just the one place, and likewise the credit is and always is in just one other place. There’s no issue of two places at once, no voodoo, and no contradiction of reality.

Conclusion and last words
That about wraps up the main arguments for and against the practice. If you have others you’d like to raise, feel free to comment and I will give more of my two cents’ worth.

I also have thoughts about the question "now what?" That is actually two questions in one. The first is about how to deal with a transition to a laissez-faire economy in general and how changes in finance law ought be made as part of that transition. Whatever is identified for the latter must be fully integrated with the whole context of the former. That is a complex topic I leave for another time.

The other question is, if we had laissez-faire and people began shifting their beliefs about fractional reserve banking, then what? The basic answer is that banks and other financial institutions would find a growing market for transaction accounts that are legally organised around bailment contracts rather than credit contracts. I think the main drivers of this would not be retail-level individuals with a few thousand dollars tops in their transaction accounts but corporations with transaction accounts that have millions of dollars flowing in and out every day. I can see two ways in which this would happen.

Internally, one of the roles of the Treasury function in corporations is to shift cash reserves around various bank accounts just to get a few extra basis points of interest (1bp = 0.01%) because the difference works out to a few thousand dollars per day, which is more than enough to pay for a few dedicated staffmembers to work this out. Under laissez-faire, since reserve ratios would be much higher and total rates of return lower, the interest rates and hence dollar returns would be much lower. That in itself sets the managers in a mood to cut costs by eliminating staff and unprofitable practices, but on top of that a pro-active driver of such a mood would be also that mangers would identify that the value of such accounts is net negative (because the value of the risk is higher than the value of the interest return net of fees), and so would just recommend total abandonment of fractional accounts in favour of non-fractional accounts and be done with it.

Externally, the biggest corporations would be acutely aware of how sensitive their own performance is to the general state of the economies and the money supply. Now knowing the deleterious role played by fractional reserve banking, and combining their internal procedure shifts as above, they also have strong incentive to put into the contracts they sign the requirement that their suppliers and partners only take payments by deposit in non-fractional accounts. This, I think, would be a major accelerator of a shift to non-fractional banking, partly because of the direct influence itself but also that others seeing sophisticated behemoths withdrawing sanction for fractional accounts would give many others cause to reconsider the issue in greater depth, who would in time identify the facts for themselves. Soon the issues would then become part of the standard contents of classes for both students of both Economics (banking practice in general, interest rates, money supply, etc) and Business (particularly concern for treasury-function operations) in university. Once that happened it would be all over for fractional reserve banking, because there'd be so little a market left for them that the vast majority of financial institutions would no longer bother offering such accounts.

Another change would be that the distinction between savings accounts and transaction accounts would be made much sharper. More specifically, savings accounts would be just mechanisms for making time deposits on a wide variety of maturities to choose from, say from a day to a year. Unlike today, where you can still withdraw almost at will from savings accounts, without fractional reserve banking any money you lend to the bank would be out of your reach for the time you select because the bank is on-lending it - this is non-fractional because you can't then buy anything using the contents of those accounts. On maturity the money would then be automatically deposited back into your nominated transaction accounts for you to spend as you please as normal. People on long-cycle pay periods (eg those living on dividend and coupon payments) could use systems like these to speed up income payment cycles by locking funds in for the various multiples of weeks up to the next payment from dividends or bond coupons, and so on. (As a technical note, today the distinction is blurry in part due to taxes such as stamp duty and other regulations).



  1. Thank you very much for posting this series of very interesting and well-written articles. They made me rethink an issue which I thought was open-and-shut.

    I'd be curious to hear your thoughts on one point, though. I've long regarded fractional reserve banking (FRB) as just an extreme case of maturity transformation, where the bank effectively borrows at a tenor of zero and lends at longer tenors. I've also regarded maturity transformation as one of the key beneficial roles played by banks and other financial intermediaries, by allowing savers and borrowers to save and lend at tenors which suit them even if there is no "double coincidence of wants" in these tenors (i.e. every time deposit of one year is lent to a borrower for exactly one year, etc).

    Am I correct in regarding FRB as an extreme form of maturity transformation? If not, what is the relationship between FRB and maturity transformation? Do you view maturity transformation in the same way as FRB, i.e. economically destructive although not violating individual rights, and unlikely to occur under laissez-faire?

    Thank you very much!

  2. As an issue of esotetic banking theory, I see FRB as a peculiar instance of duration mismatch, though one with ramifications beyond just the issue of bank prudence. So, I partly answer yes, though the more accurate way of putting it is duration transformation rather than maturity transformation.

    It's only part because duration mismatch is *not* inherently economically destructive. It is always unwise for banks themselves to have a notably non-zero net duration (imprudence on one side, inefficiency on the other), but DM alone is not the cause of economic destructiveness. Destructiveness only comes from the facts that, (a) the money supply is involved and is being made less dependable, and (b) the increase in nominal funding by use of FRB is not based in an increase in actual savings by the ultimate owners of investible resources, with (a) and (b) together leading to a net negative influence on total real capital in an economy. A bank that avoids practicing FRB but nevertheless practices DM can thus operate and collapse without that operation or collapse being economically destructive (no more so than any business in general going bust, that is), while a bank that does practice FRB (and necessarily also DM) is flirting with destruction for others as well as itself.

    As to the moral questions, yes: unless there are express contractual bars against it DM is not a violation of anyone's rights. As to the issue of likelihood, that is an issue of the education of both finance graduates and those who invest in banks, though I do think that under laissez-faire the trend will definitely be towards the elimination of DM as investors grow more savvy and bank officers stop bothering making excuses for it. For both, you're right again, in that this is just the same as for FRB. DM and FRB could exist indefinitely under laissez-faire, or be wiped out PDQ, it's up to investors and depositors to choose.

    That was a good question, though I did deliberately avoid mentioning DM in the main posts because it is a technicality very few would understand and not essential to a discussion of fundamentals. Still, DM *is* something I would put in a large article or book, though, as a further concretisation of increased and unjustifiable risks.


  3. Gah. Esoteric, dammit, and no apostrophe on it's.

  4. So you view FRB and DM as similar, and both likely to be eliminated or reduced dramatically under laissez-faire, but the former as much more destructive economically due to its effects on the money supply.

    Very interesting - thanks very much!