Friday, January 27, 2017

More on Fractional Reserve Banking

Frank Shostak has written a piece on this topic.  Some of his comments I disagree with, some I question, the largest portion I say are spot on – which raises, once again, my view on “focus” when it comes to this topic.  With this. Let’s begin:

The so-called multiplier arises as a result of the fact that banks are legally permitted to use money that is placed in demand deposits.

The banks are not only legally permitted to do this, there are several provisions in the contract between bank and customer that implicitly allow the banks to do this.  Importantly, they are not contractually prohibited from doing this.

As to the multiplier effect: consider a hypothetical.  Consider the “multiplier” that is possible if all bank transactions were to clear through a single bank – a monopoly on money and credit.  The bank would never have to fear a run because all withdrawals were immediately offset with the corresponding deposit (less currency withdrawals which are certainly immaterial relative to total balances). 

My point?  It isn’t a hypothetical.  There is a multiplier effect because the entire banking system can be considered as one single bank with a central bank to ensure every transaction can clear. 

A monopoly.

Banks treat this type of money as if it was loaned to them…

Depositors also treat this type of money as if they are loaning it to the bank – otherwise, why would they expect (and in most cases and in normal interest rate environments receive) interest income?

For example, if John places $100 in demand deposit at Bank One he doesn’t relinquish his claim over the deposited $100. He has an unlimited claim against his $100.

This isn’t really correct.  The regulation underlying the contract makes clear that his claim is conditioned on the bank’s ability to make good; the regulation makes clear that there are certain conditions under which John might have to wait some time before receiving his $100.  His claim is limited.

A case could be made that people who place their money in demand deposits do not mind banks using their money. But, if an individual grants a bank permission to lend out his money, he cannot at the same time also expect to be able to use that money.

Of course he can expect to “use that money.”  I will suggest that, since 1934, people have been able to “use that money” 99.99999999999% of the time “on demand.”  I suggest that this level of performance is higher than that to be found in any other industry; therefore, why wouldn’t he expect to be able to use that money? 

I can expect to use the money when I want to with a higher degree of certainty than I can expect my car to start in the morning or my Windows operating system to function properly.

…from an economic point of view, [this banking practice] produces a similar outcome that any counterfeit activities do. It results in money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of real wealth.

I will suggest that it is the consolidation of the banking industry into and under a monopoly central bank that allows for the creation of this money out of thin air.  An individual bank, with no backstop other than its own capital, would loan out only an amount of these types of deposits (given the contract) that it felt were secure; a prudent reserve ratio would be used. 

A bank that was imprudent to the point of insolvency would, of course, cost the depositors their deposits.  But absent the consolidation of the industry into a single bank, this would be nothing more than a blip to the larger economy.  And, with the insolvency, voilà!  A reduction in the multiplier.  Left to the market, it is all so self-regulating; markets will discipline banks as to the proper duration matching necessary.

Consider: if the individual bank with no outside backstop successfully predicts it can safely loan 80% of its demand deposits, what does this mean?  It means depositors never touch, in aggregate, 80% of the money deposited.  I don’t mean multiplier in digits – in passbooks or account statements; I mean multiplier in terms of circulating currency (or digits).  However one describes it, 80% is functioning as permanent capital for the bank.  So, where is the multiplier? 

This I pose as a question; I would welcome reasoned feedback.

The rest of Shostak’s post focusses on the primary issue – and in my mind, the only issue:

In a truly free market economy, the likelihood that banks will practice fractional-reserve banking will tend to be very low.

I don’t know how “very low” it would tend to be; but the solution is “a truly free market economy.”  A “truly free market economy” would not include a central bank or government deposit guarantees and the like.  I do know that in a truly free market economy banks and their customers will be required to exercise proper fiduciary caution.  This is what will discipline the practice of fractional reserve banking and this should be the issue of focus.

The issue is the monopoly.  Remove the government backing; the market via contractual relationships between bank and customer will manage the practice. 


  1. This is why fractional reserve banking as a concept doesn't bother me. It seems similar to insurance. In a free market, the retail banks would probably have someone similar to an actuary working for them to do risk assessments to arrive at suitable reserve ratios. Reserve ratios may vary by region and even community area. I would think that banks could afford to have lower reserve ratios in high income areas. They would maintain higher reserve ratios in low income areas as these people are more likely to need emergency access to their funds.

    My knee jerk response is that there would be no multiplier. If the bank is doing its job, the reserve ratio should never be breached for a prolonged period of time. It may happen at specific points if there is a mismatch between loan timeframes and depositor withdrawal rates but this should only be temporary. Even then, this just means the bank's aggregate deposits are being drawn down faster than expected. No new money is being created on the back of anything. Let's say the creditor used the loan to start a bakery. Receipts from the bakery would then be used to pay the bank who would then hold onto these funds to improve their reserve ratio correcting the issue. If the creditors default, and the bank does not have enough cash to keep depositors whole, it goes out of business. However, the money supply has not increased. The money just transferred hands to people outside the bank. The depositors are just the last to get updated on the fact that their account has zero dollars. The only way this would lead to a multiplier is if the bank kept paying depositors without any funds and that is impossible without a central bank creating money out of thin air.

    Another scenario is if the bank lends money out in risky way. Say 2.5 times their deposit balances. This would be impossible to sustain without a central bank as the bank would have no money to pay depositors.

    I am anxious to hear other people's thoughts as the whole fraction reserve banking concept seems to confuse even some economists and scholars.

  2. My guess is that in a free market banks would have many different types of products, including fractional-reserve accounts (for savings, typically) and warehouse receipt-type accounts (for checking, typically).