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.
Some of the fundamentals of those claims are certainly challenged. However even if, only for the sake of argument, one accepts such proposed benefits, it would be poor economic analysis to ignore the costs. What are the costs of fractional reserve banking?
Here we'll examine three potential costs: the threat 1) to the individual bank; 2) to the larger financial system; and 3) the costs to the monetary system, which increases the dangers of the threats to the larger financial system.
1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.
It is only on the exceptional occasion that some event alerts depositors to the actual fragility of the bank's accounts. On such occasions, many of them simultaneously demand redemption of their deposits. The result is a bank run. And we've learned recently that even the digital banking world is not immune to such runs. (See the recent Mt. Gox run.) Bank runs can put the bank out of business. Minimally, it can be costly for taxpayers forced to bail the bank out of its liquidity crunch.
2) Problems for individual banks can turn into problems for the entire banking systems, due to the heavily interrelatedness of global banking. Banks these days, as a matter of course, borrow from and deposit with each other. Banks are creditors of other banks, either as long or short term positions. Naturally, the bankers tend to be more sophisticated about the nuances of the reserve system than the average depositor. They better appreciate the cascading consequences of a bank run.
However, if a heavily indebted bank has engaged in a series of poor loans, with high danger of systemic default, lender and depositor banks may come to the conclusion that further credit is throwing good money after bad. In effect, banks can lead a bank run against another bank, no less surely putting it out of business.
There is though an additional problem to consider. The extremely high level of inter-bank borrowing in the current global banking system means that an explosive chain reaction can be set off by such events. Just such a dynamic was a major contributor to the 2008 financial crash. The entire global financial system becomes vulnerable.
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.
Space limitations won't allow a thorough explanation of how all this works. For purposes, here, though, it should be enough to observe what should be self evident to any child. The same dollar cannot be simultaneously in one depositor's bank account and one borrower's loan portfolio. Somehow, though, it is precisely this bit of magical thinking that is taken at face value in the accounting practices of fractional reserve banking.
This voodoo of fractional reserve banking distorts accurate information about the level of savings. This misimpression that there are more savings in the economy than there actually are erroneously contributes to lower interest rates for borrowing. The lower interest rates increase the demand for borrowing, which incentivizes banks to play even more fast and loose with their reserves. The result of all this is the crushing valleys of the business cycle: recession or depression. Such economic downturns of course make it decreasingly likely that borrowers will repay their loans. The positions of all banks are rendered more precarious, increasing the dangers of the first and second points discussed above.
These numerous and dangerous consequences arising from fractional reserve banking have given rise among some critics for demands to ban the practices. Some claim it is nothing more than criminal fraud. I don't think the matter is quite that simple, though. As usual, I prefer free market solutions over government coercion.
I'll have more to say on this in a soon to be published article on free market fractional reserve spending. 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.
Some of the fundamentals of those claims are certainly challenged. However even if, only for the sake of argument, one accepts such proposed benefits, it would be poor economic analysis to ignore the costs. What are the costs of fractional reserve banking?
Here we'll examine three potential costs: the threat 1) to the individual bank; 2) to the larger financial system; and 3) the costs to the monetary system, which increases the dangers of the threats to the larger financial system.
1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.
It is only on the exceptional occasion that some event alerts depositors to the actual fragility of the bank's accounts. On such occasions, many of them simultaneously demand redemption of their deposits. The result is a bank run. And we've learned recently that even the digital banking world is not immune to such runs. (See the recent Mt. Gox run.) Bank runs can put the bank out of business. Minimally, it can be costly for taxpayers forced to bail the bank out of its liquidity crunch.
2) Problems for individual banks can turn into problems for the entire banking systems, due to the heavily interrelatedness of global banking. Banks these days, as a matter of course, borrow from and deposit with each other. Banks are creditors of other banks, either as long or short term positions. Naturally, the bankers tend to be more sophisticated about the nuances of the reserve system than the average depositor. They better appreciate the cascading consequences of a bank run.
However, if a heavily indebted bank has engaged in a series of poor loans, with high danger of systemic default, lender and depositor banks may come to the conclusion that further credit is throwing good money after bad. In effect, banks can lead a bank run against another bank, no less surely putting it out of business.
There is though an additional problem to consider. The extremely high level of inter-bank borrowing in the current global banking system means that an explosive chain reaction can be set off by such events. Just such a dynamic was a major contributor to the 2008 financial crash. The entire global financial system becomes vulnerable.
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.
Space limitations won't allow a thorough explanation of how all this works. For purposes, here, though, it should be enough to observe what should be self evident to any child. The same dollar cannot be simultaneously in one depositor's bank account and one borrower's loan portfolio. Somehow, though, it is precisely this bit of magical thinking that is taken at face value in the accounting practices of fractional reserve banking.
This voodoo of fractional reserve banking distorts accurate information about the level of savings. This misimpression that there are more savings in the economy than there actually are erroneously contributes to lower interest rates for borrowing. The lower interest rates increase the demand for borrowing, which incentivizes banks to play even more fast and loose with their reserves. The result of all this is the crushing valleys of the business cycle: recession or depression. Such economic downturns of course make it decreasingly likely that borrowers will repay their loans. The positions of all banks are rendered more precarious, increasing the dangers of the first and second points discussed above.
These numerous and dangerous consequences arising from fractional reserve banking have given rise among some critics for demands to ban the practices. Some claim it is nothing more than criminal fraud. I don't think the matter is quite that simple, though. As usual, I prefer free market solutions over government coercion.
I'll have more to say on this in a soon to be published article on free market fractional reserve spending. Stay tuned!
About the Author:
If you want to keep tabs on how the global banking system wreaks havoc with your savings, be sure to follow the Fractional Reserve Banking Review. Wallace Eddington has emerged as an important commentator on finance and investing. His no-holds-barred promotion of a Free Market Economy in Money is required reading for anyone who wants to understand our current financial situation.