Fractional Reserve Banking: Much Ado About the Wrong Thing

As if to demonstrate that not all Austrians march lock-step in line behind one leader, prophet, saint, or [insert your preferred title of authority here], fractional-reserve banking has come along as a needed controversial issue – one that divides Austrians in the same way that abortion divides libertarians or that war divides the left from the right (wait…check that last one).

This subject has floated to the surface recently, as it occasionally does, perhaps due to hearings recently held by Ron Paul on this subject.  As it seems prompted by Ron Paul’s hearings, I will start with Dr. Paul:

Fractional reserve banking is the practice by which banks accept deposits but only keep a fraction of those deposits on hand at any time. In practice, nearly 100% of deposits are loaned out, yet depositors believe that they can withdraw the full amount of their deposit at any time.

Banks take deposits.  For certain of these deposits, they purportedly claim to maintain a position of being able to return the deposited funds immediately upon request of the depositor.  Consider this the historical warehouse-receipt function: deposit a bar of gold, receive a receipt for the gold deposited; upon demand retrieve the deposited gold (more likely, its equivalent) whenever desired.  Somewhere in there, pay a fee for storage, accounting, and safekeeping.

Ron Paul uses what I believe to be a very appropriate word in the above statement; as I believe he is quite well versed in economics, banking, and finance, I don’t believe the word was chosen casually – believe it or not.  Have you guessed the word yet?  I don’t believe you have.  Here goes: “…yet depositors BELIEVE that they can withdraw the full amount of their deposit at any time.”

Now, people are want to believe many things: the sun will come up tomorrow, my country right or wrong, the Navy is a force for good, Japan attacked Pearl Harbor completely by surprise, dropping the bomb saved a million American lives, money printing by a central bank creates wealth, borrowing is the key to prosperity, man is having a significant impact on the global climate, and Muslims are going to take over the world.  That these are believed by many does not make them right, nor does it mean that the belief is even grounded in fact.

That the depositor believes he can withdraw the money at any time does not make it so.  It is certainly true that what is called a demand deposit evolved from the warehouse function described above.  But just like “liberal” no longer means “liberal”, and “anarchy” no longer means “anarchy”, and “fiscally conservative” no longer means “fiscally conservative,” it seems that “demand deposit” no longer means “demand deposit,” although the term is still used.  The meaning of the term has certainly evolved; it strikes me that there is no such thing as a demand deposit anymore in modern banking.  While the name is familiar, the meaning is gone.  It is gone by contract – contract based on regulation.

Modern banking has stripped the availability of a demand deposit as the term is historically defined.  Availability of funds is highly regulated, and specifically addressed by Regulation CC.  I am willing to bet a dollar that this regulation is cited somewhere in the dozens of paragraphs of every bank-account opening document in the U.S.  This regulation provides when deposited funds must be made available, and under what conditions exceptions are allowed.  Many of the exceptions seem reasonable – checks deposited from sources deemed unreliable, accounts that have been regularly overdrawn, etc.  I will focus on Subparagraph (f), addressing exceptions under “emergency conditions”:

(f) Emergency conditions. Sections 229.10(c) and 229.12 do not apply to funds deposited by check in a depositary bank in the case of—

(1) An interruption of communications or computer or other equipment facilities;

(2) A suspension of payments by another bank;

(3) A war; or

(4) An emergency condition beyond the control of the depositary bank,

if the depositary bank exercises such diligence as the circumstances require.

How is it possible that a bank doesn’t have the funds for a demand deposit?  Of the exceptions listed above, it is item (2) that I would focus on (although as the U.S.is perpetually at war, item (3) offers the possibility of perpetual exception – an exception at any time as the war is continuous).  This exception (item (2)) is not dealing with an overdrawn check, where the check being deposited is drawn on an account with insufficient funds; that issue is dealt with specifically elsewhere in the list of exceptions.  This is dealing with bank to bank funding – for example, when a weak bank is deemed to be a credit risk and therefore loses access to daily money market and other short term markets for financing, an event that occurred numerous times, especially four years ago in instances known and unknown.

But why does any bank, weak or otherwise, need to rely on daily or short-term borrowing or otherwise receiving money from another bank in order to meet the funding for withdrawals for funds the bank supposedly is holding – available “on demand”?  If the weak bank is honestly holding a combination of cash in the vault and digits in its computer, from where does the shortage arrive? 

It cannot arrive, not if a classical definition of the term “demand deposit” is used.  By the fact that Regulation CC identifies such an exception, it is clear that demand deposits as the term is commonly understood do not exist.  However, as Ron Paul so properly suggests, the belief is there despite the contradictory contractual fact.

Dr. Paul continues:

While mainstream economists extol this "money multiplier" as a nearly miraculous process that results in a robust economy, low reserve requirements actually enable banks to create trillions of dollars of credit out of thin air, a process that distorts the structure of production and gives rise to the business cycle.

On this he is for the most part correct again – my only quibble is that it isn’t the “low reserve requirements” enabling the “banks to create trillions of dollars of credit out of thin air”, but the monopoly use of government enabled central banking.  This monopoly protection by the state is the enabler of the low reserves.

Credit created from anything other than truly saved wealth is inflationary in the most classical sense.  Credit-financed demand for goods cannot be made without someone else deferring his demand for goods made possible by his savings.  Credit un-backed by savings allows two (or more) people to demand goods although only one person has “saved” any “goods” from a previous excess of production.

Distortions compound, as the first recipient of this artificially created credit can buy at prices available prior to the inflation being noticed through the market.  Goods are shifted to the beneficiary of the artificial credit and away from those who have saved.  From this boom comes the inevitable bust – as there is not enough savings to justify all of the shifted and increased demands placed when the credit was artificially expanded.

Am I suggesting that because, technically, due to Regulation CC, there is only one claimant to the asset, that there is no inflation of credit?  Yes.  And no. While there are two claimants to the asset, one is senior (the bank and in its failure the bank’s secured creditors) and the other junior (the depositor, an unsecured creditor).  In the bankruptcy of a bank, this is quite clear – senior creditors are covered by bank assets, depositors are covered by FDIC insurance to the extent remaining bank assets don’t suffice.  However, with the issue of government-backed monopoly protection (is there any other kind), the banking industry is able to practice banking in manners and leveraging deposits to a degree that could never survive in a free market.

Absent the Federal Reserve as lender of last resort, absent FDIC insurance, and absent the monopoly position of the US Dollar, banks and the current banking system could not engage in the practice of fractional reserve banking / lending to anywhere near the extent possible today (again, because banks almost always are able to make funds available on demand does not mean they are obligated to do so – Regulation CC).  Without the Fed as backstop would the banks be solvent?  Without FDIC insurance, would depositors blindly trust the banking system with their funds?  The answer is a clear no to both, and the market would stop these practices long before the leverage reached systematically dangerous levels (regulating far better than government regulators).  In other words, without the Fed backstop and monopoly protection, banks might moderately inflate credit, but the market would disallow the leverage seen today.  There might be inflation, but relatively minor – and regulated by market forces. 

Therefore, while I hold there is only one ultimate claimant to the deposit (the bank and in its failure, its senior creditors), the ability to create almost unlimited leverage due to various governmental supports introduces inflation and instability that would not be possible under a free-market, competitive environment.

The solution to the problem of financial instability is to establish a truly free-market banking system. Banks should no longer have a government backstop of any sort in the event of failure. Banks, like every other business, should have to face the spectre of market regulation. Those banks which engage in sound business practices, keep adequate reserves on hand, and gain the confidence of their customers will survive, while others fall by the wayside.

Again, Dr. Paul hits it out of the park here – but as a former top baseball prospect, would you expect anything less?  Here he calls for a “truly free-market banking system,” one without “a government backstop of any sort.” 

He believes that banks that “keep adequate reserves on hand” will gain.  It should be noted: he uses the word “adequate” and does not suggest that banks keep 100% reserves on hand.  This is a key omission and distinction, and one that I do not believe he made by mistake.  Ron Paul has often cited Sennholz as one who has influenced his views on money and banking.  In his book “Money and Freedom,” Sennholz identifies his criteria for a free-market banking system.  He does not list a requirement of 100% backing in his recommendations for free banking.

Mises also does not call for such regulation, in fact accepting that banks might stretch the reserves if left free.  He would leave it to markets to regulate this issue – suspect banks would be quickly subject to a run. 

Unlike Mises, Rothbard and others call for 100% reserves for demand deposits.  Some of these look at anything less as fraud – receipts printed for goods that don’t exist.  Perhaps this is so, if the contract calls for the goods to always exist for every receipt printed. 

Ron Paul cites Murray Rothbard, a man who has done invaluable service by doing more to make Austrian economics more clear and understandable than any man in the last 100 years…in other words, ever:

As Murray Rothbard put it, "Fractional reserve banks ... create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit."*

*Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 98.

But under Regulation CC, it seems this is not the contract.  If it is not the contract, how can it be fraud? It can certainly be inflationary, and horrendously so when protected by government-granted monopoly protection, but if two or more are voluntarily gathered in the name of “my deposits will usually be available but may not always be”, where is the fraud?  (And if they agree to this, it is then not fractional reserve banking, I suspect.)  Just because one of the parties is not clear on the terms to which he agreed doesn’t make the activity fraudulent.

Mish Shedlock is one who sees the fraud, and he sees it loud and clear.  Even if two or more are voluntarily gathered at the table, he finds the harm caused to others (unwilling participants) enough to condemn the practice – in a manner even Mises, the small government (as opposed to anarchist) Austrian never did.  Mish uses the term “fractional reserve lending” as it is in the lending supported fractionally with reserves where the leverage comes into play. 

On to Mish:

Before we can state the problems and concerns with fractional reserve lending we need to define the term. Here is the meaning I use for my analysis:

Fractional reserve lending is the act of lending out more money than banks have ownership of.

But if, by regulation incorporated into contract, banks are allowed to delay making funds available for reasons such as “a suspension of payments by another bank” (or war, perpetually), is ownership so cut and dry?  One might wish that the depositor has first and senior claim to his deposit, but wishing doesn’t make it so.

In addition to the conclusions that can rightly be drawn from the banking regulation, consider the payment of fees and receipt of interest: in most types of accounts today, including so-called “demand deposits,” there are no “fees” charged for storage, and interest is paid to the depositor.  It is certainly true for accounts with larger-than-average balances.

If the bank was truly storing my deposit in order that it is available to me upon demand, would not a charge be made for such a service?  Would not the charge be more the larger my balance (as opposed to larger balances often resulting in lower fees, or no fees)?  Was this not the usual practice in the case of warehouse services for gold?  After all, the bank requires a location to keep the funds (physical or virtual), insurance and administration, and other such costs in order to carry out this duty.  Yet the depositor is often charged nothing for these services.  Is it feasible for the depositor to believe that the bank performs such services out of the goodwill of the heart of management or the shareholder?

More confounding: the bank is paying interest to me for the privilege of storing my funds at no cost.  How is the bank earning money in order to pay me interest on top of charging me no fee if my funds are at the same time always and completely available?

Back to Ron Paul’s use of the word “believe.”  That some people “believe” the bank is doing all of this out of goodwill and altruism does not make it so.  The only way such arrangements can make sense for the bank is if it is lending out the money that was deposited at interest.  The depositor can believe whatever he wants, but I am aware of only one recorded event where manna fell from heaven, and Jamie Dimon wasn’t the benefactor.

Now, if the bank contractually was obligated to a) hold the funds, b) not charge a fee, and c) pay interest (there is a business model destined for failure), and it failed to do so – there is certainly a breach, and perhaps fraud.  However, for anyone to believe such blessings are possible as a matter of normal course – well, if something sounds too good to be true, it isn’t.  And belief doesn’t make a contract.

Now back to Mish:

Here are few key points [regarding fractional reserve lending].

1.       Fraudulent lending (banks lending more than they have ownership of) pushes up assets prices and favors those with first access to cash (banks and the wealthy). The housing bubble was a result of such fraud.

Setting aside the characterization of the practice as “fraudulent,” this statement is true (and can only be true in a systematically dangerous way) in an environment of monopoly banking, protected by the state.  In other words, it is true for those who utilize and hold the inflated currency.  Where there is a monopoly, this is everyone as we cannot escape the monopoly of the system without removing ourselves from the benefits of a division-of-labor economy.  Why not go after the issue of monopoly, thus relieving the unwilling from the risk?

2.       The existing fractional reserve system allows lending of money that is supposed to be available on demand. Lending of money banks have no ownership of is outright fraudulent.

Instead of “believe,” Mish uses “supposed to be.”  But, who says?  Not the contract.  Not common sense – is it logical to believe storage can result in not only no fees charged but also interest paid to the depositor?

3.       Excessive credit backed only by artificially inflated asset prices is simply another form of fraud. Moreover, such lending also sends false signals to the market about the true state of the economy.

False signals?  True in an environment of monopoly banking, protected by the state.  If one is free to use alternatives as developed by the market, one need not fear artificially inflated asset prices or false signals.  One would make a choice in the form of money, credit and currency – just as one would make a choice in specification of steel for a bridge.  If someone else made a poor choice of steel for his bridge, it wouldn’t affect the structural integrity of my bridge.

4.       In the ensuing and inevitable busts, the central bank inevitably punishes savers by artificially holding rates too low.

So far, true just about every time.

Thus, money that is supposed to be available on demand isn't. People think that money in their checking accounts is sitting in banks. It most assuredly isn't. It has been "swept" away nightly into savings accounts that banks can lend out. Bookkeeping says the money is there. Physically it isn't.

What are these terms? “…supposed to be available;” “People think that money in their checking accounts is sitting in banks.”  According to whom?  Based on what agreement?  Certainly not based on the guiding regulation, the one that defines the relationship. On such foundations of sand, fraud is to be assumed?

Lending of money in "available on demand" checking accounts is purposeful fraud.  Greenspan authorized the practice, but that that simply makes it central-bank authorized fraud.

It isn’t fraud if the contract stipulates that this is possible (again, it isn’t that the regulation makes the impossible possible; it merely makes clear who has first claim on the deposit, and it isn’t the depositor).  Why the concern of the funds not being there (in Regulation CC) if, in fact, the funds are supposed to be there?  Mish can wish that the term “available on demand” account means what he believes them to mean, but that doesn’t make it so.

Some argue that as long as customers agree to these various banking schemes it is OK. That line of thinking says as long as it's in the agreement for banks to sweep money from checking accounts to savings accounts and lend it out, then it's OK for banks to do so.

I am one to argue this.  At least Mises and Sennholz also seem to believe so.  Remove the monopoly: in a free banking environment, by what justification should this practice be stopped?  If I am free to avoid using the currency and bank affected by this, what concern is it of mine?

However, it's not OK because such lending is nothing more than a gigantic kiting scheme. Moreover, it affects others by cheapening the value of money, pushing up asset prices for the benefit of those with first access to money, the banks and the wealthy.

There is such a leap of assumptions in these two sentences:

If my customer wants to pay me in toilet paper, and I willingly accept, under what justification should a third party intervene?  If my debtor wants to satisfy his debt to me by paying me in cheapened-value-money and I willingly accept, of what concern is this to anyone else?

As long as the monopoly over money, banking, credit, and currency is removed, no one is harmed beyond those who choose to make poor choices.  Just because I choose to use funny money, Mish is not forced to do so.  I may or may not be glad that he is concerned for my interest, but if I choose to go ahead anyway, it is no business of his.  Don’t fight this thing called fractional reserve banking; fight the monopoly.  That way you will not have to suffer for my poor choices – or worse, the poor edicts of a government-backed monopolized industry.

Finally, Mish has a right to his property, but he has no right to the value of his property.  The value of property changes regularly.  This is inherent in Austrian economics.  If I chose to keep property that subsequently is “cheapened” by market actors, I have no claim against anyone. 

The issue is not fractional reserve lending (which I believe technically does not exist today as both the contract and reason make clear the depositor only has an unsecured and secondary claim to the deposit); the issue is the monopoly of money.  Kill the monopoly, and this concern disappears completely.  Stop focusing on the wrong walnut shell – stop worrying about fractional reserves and start worrying about the lack of competition as enforced by the state.

Logically, two people cannot have the right to use the same money at the same time, whether they agree to such a scheme or not!

Of course not.  But, as I have outlined above, two people do not have equal claim to assets deposited with a bank under the current contract.  Further, one cannot logically expect to have his assets stored at no cost and to earn interest on the deposit to boot.

Steve Horwitz recently addressed precisely this issue:

This discussion [of fractional reserve banking] is prompted by Larry White’s testimony on the history and practice of fractional reserve banking before Rep. Ron Paul’s subcommittee on monetary policy in late June. White’s testimony is a concise yet thorough discussion of why fractional reserve banking came to be and why it is not at the root of monetary problems. As he points out, “[A] fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges.” U.S. history illustrates this point.

Monopoly–not fractional reserve–is the problem. As I’ve said before, there’s nothing wrong with fractional reserve banking that getting rid of central banking wouldn’t cure.

The issue is the monopoly. The issue is the protection and insurance afforded by the government.  Move to a free banking system, one where money, credit, banking and currency are all left to the market to decide, and reserve balances take care of themselves. 

(As an aside, in the same commentary, Horwitz also states that legal tender is another red herring.  On this, I will mildly disagree; not that I am an expert on what legal tender actually means in today’s environment, however any laws that favor one currency over another inherently benefits by dictate that currency.  It is no longer a fully free market.  For this reason, legal tender must also go.)

Many Austrians see 100% reserve banking based on gold to be best form of monetary and economic stability.  It cannot be so.  Any model planned outside of the markets (i.e. central planning) is certain to be unstable.  To say 100% reserve banking backed by gold is THE way is to say that central planning can succeed.  Leave it to the market.  The best way to achieve maximum stability is one where competition rules and where government policy does not set the standard.

A call to end fractional reserve banking (as improperly as that term is used) is the wrong call.  If two or more want to practice a certain banking relationship in an otherwise free-market environment, no one has a legitimate cause to intervene (again, by contract, fractional reserve banking is not possible). 

As long as the monopoly privilege is ended, the market will regulate itself.  Mises believed this would be enough.  Sennholz did not call for 100% reserves.  Ron Paul recognized the free market as the proper regulator in his above statement.

I tend to agree with all three.