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.
A basic familiarity with the practices of fractional reserve banking is assumed in this article. If you don't feel that you understand these basics, it might be a good idea to begin with this introductory article instead.
The defenders argue for the virtues of increased liquidity in the financial system: greasing the gears of our complex economy. Fractional reserve banking puts currency into the system, ensuring sufficient funds for entrepreneurs who want to launch new businesses and consumers who want to purchase high-end goods like houses and cars. The loans available through fractional reserve banking makes all this possible, thus contributes to increased demand and production, employment and so on.
Even though if one grants all those claims (which not all critics do), it is the worst failure of economic thinking to ignore the trade-offs. What are the costs of fractional reserve banking?
Three potential costs in particular are considered in this article. First, what is the threat to the individual bank; second, the threat to the larger financial system; and third, what are the costs to the monetary system? This third, indirect, cost is still vitally important as it increases the first and second threats to the financial system.
1) Technically, fractional reserve banks are bankrupt. This is not a value judgment, but merely a factual statement: they are incapable of fulfilling all their financial obligations. The system only continues to function because the majority of depositors don't understand this fact.
Occasionally, though, something happens to alert depositors to the fragility of the bank's accounts and large numbers of them start demanding their money. This is called a bank run. And we've seen that it can even happen in the digital world. (See the recent Mt. Gox run.) Such events can put a bank out of business. At the very least it can prove extremely costly for the taxpayers to bail the bank out of its liquidity shortage.
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.
That though is no guarantee against a run. Should a heavily indebted bank, say, that has supplied a series of poor loans, resulting in high levels of default, come to be regarded as unsalvageable, the other bankers will let it fall. Lender and depositor banks conclude that continuing credit is throwing good money after bad, and so cut their losses. In such a situation, effectively, the banks instigate a bank run against another bank. The consequences for the individual bank are still insolvency.
The problem though is that there is so much inter-bank borrowing that a banker's bank run can set off a chain reaction of default. This was one of the circumstances leading to the 2008 financial crash. So the entire global financial system can be put in peril.
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 bit of fractional reserve voodoo creates an illusion about the level of savings, which erroneously lowers the interest rate on borrowing, increasing demand for borrowing and incentives for banks to further stretch their reserves. The result is the crushing valleys of the business cycle: recession or depression. And of course such economic downturn reduces the prospects of borrowers being able to repay their loans, hence heightening the dangers of 1 and 2, above.
Some of the most vocal critics of fractional reserve banking have concluded, on the basis of such analyses, that the practice is merely criminal fraud and should be banned. I'm not so convinced of this claim. There are other factors to consider. As usual, I'd prefer the market to solve the problem, rather than turn to coercive government intervention.
I'll have more to say on this in a soon to be published article on free market fractional reserve spending. Stay tuned!
A basic familiarity with the practices of fractional reserve banking is assumed in this article. If you don't feel that you understand these basics, it might be a good idea to begin with this introductory article instead.
The defenders argue for the virtues of increased liquidity in the financial system: greasing the gears of our complex economy. Fractional reserve banking puts currency into the system, ensuring sufficient funds for entrepreneurs who want to launch new businesses and consumers who want to purchase high-end goods like houses and cars. The loans available through fractional reserve banking makes all this possible, thus contributes to increased demand and production, employment and so on.
Even though if one grants all those claims (which not all critics do), it is the worst failure of economic thinking to ignore the trade-offs. What are the costs of fractional reserve banking?
Three potential costs in particular are considered in this article. First, what is the threat to the individual bank; second, the threat to the larger financial system; and third, what are the costs to the monetary system? This third, indirect, cost is still vitally important as it increases the first and second threats to the financial system.
1) Technically, fractional reserve banks are bankrupt. This is not a value judgment, but merely a factual statement: they are incapable of fulfilling all their financial obligations. The system only continues to function because the majority of depositors don't understand this fact.
Occasionally, though, something happens to alert depositors to the fragility of the bank's accounts and large numbers of them start demanding their money. This is called a bank run. And we've seen that it can even happen in the digital world. (See the recent Mt. Gox run.) Such events can put a bank out of business. At the very least it can prove extremely costly for the taxpayers to bail the bank out of its liquidity shortage.
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.
That though is no guarantee against a run. Should a heavily indebted bank, say, that has supplied a series of poor loans, resulting in high levels of default, come to be regarded as unsalvageable, the other bankers will let it fall. Lender and depositor banks conclude that continuing credit is throwing good money after bad, and so cut their losses. In such a situation, effectively, the banks instigate a bank run against another bank. The consequences for the individual bank are still insolvency.
The problem though is that there is so much inter-bank borrowing that a banker's bank run can set off a chain reaction of default. This was one of the circumstances leading to the 2008 financial crash. So the entire global financial system can be put in peril.
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 bit of fractional reserve voodoo creates an illusion about the level of savings, which erroneously lowers the interest rate on borrowing, increasing demand for borrowing and incentives for banks to further stretch their reserves. The result is the crushing valleys of the business cycle: recession or depression. And of course such economic downturn reduces the prospects of borrowers being able to repay their loans, hence heightening the dangers of 1 and 2, above.
Some of the most vocal critics of fractional reserve banking have concluded, on the basis of such analyses, that the practice is merely criminal fraud and should be banned. I'm not so convinced of this claim. There are other factors to consider. As usual, I'd prefer the market to solve the problem, rather than turn to coercive government intervention.
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 plays havoc with your savings, be sure to follow the Fractional Reserve Banking Review. Wallace Eddington has emerged as an important analyst of finance and investing. His no-holds-barred promotion of a Free Market Economy in Money is a must read for anyone who wants to understand our current financial situation.
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