“Fractional Reserve” Banking

“Fractional Reserve” Banking

July 9, 2006

When certain nominally “Austrian” types want to get all medieval on you, they start to talk about “fractional reserve banking,” which is an antiquarian term for what we now call “banking.” Banks today (and for the last few centuries) are intermediaries: they borrow from depositors and make loans to borrowers, and pocket the “spread” between the two interest rates. Thus, banks are exposed to business risk: if their borrowers can’t pay their loans back, then the bank can’t pay the depositors back, and the bank goes bankrupt. This is quite a traumatic event — or it used to be, back before deposit insurance was introduced in the 1930s. However, for the last seventy years or so, depositors have faced basically no risk whatsoever, although they have gotten paid for their non-risk by making interest income from their deposits. This, one would think, is a cushy situation. Of course, taxpayers must foot the bill for the occasional depositor bailout, the most recent of which, in the United States, happened in the early 1990s as busted S&Ls were liquidated.

Getting paid for taking no risk (besides currency risk) is attractive enough that, although there are indeed banks which take deposits and do not make loans, but merely “warehouse” the deposited money, their services are rather unpopular. Some Swiss banks are known to do this for their most risk-averse clients, and of course they must charge a small fee to do this since the business would not otherwise produce any revenue.

We can imagine that, back in the 19th or even 18th or 17th centuries, the unlettered peasant may have believed that their deposits in a bank were kept in the walk-in safe typically on prominent display behind the teller’s window. What a surprise to find that the bank had gone bust, its doors locked and the deposits unrecoverable! No wonder that, for many years, people warned of the dangers of keeping your money in a “fractional reserve bank.”

Add to this the fact that, prior to the introduction of standardized Federal Reserve Notes during World War I, banks were not only in the deposits-and-lending business, but also in the printing-money business. Many today are surprised to learn that, in the 19th century, there were no “national currencies,” but in fact anyone could print currency! Of course, the fact that you could print currency (and thousands of different banknotes circulated) did not mean that anyone would take your silly paper. The currency had to be reliably convertible into gold bullion. A banknote issued by the Bank of North Westchester could be taken (in theory) to the bank teller window, and the BoNW would fork over gold coins on demand. As long as the BoNW was considered to be reliable, people wouldn’t convert their banknotes to gold, because banknotes are actually more convenient than gold. Gold coins gradually wear down, or they are sometimes clipped and shaven on purpose, so each “one ounce” coin contains a little less than an ounce. This can make business quite troublesome, as each coin would have to be weighed separately for its bullion content.

Private banks engaged in money-printing in much the same way as they engaged in borrowing and lending: with a “fractional reserve.” The Bank of North Westchester may have issued $1m of banknotes, but it held only $100,000 of gold coins in reserve. If, perchance, the BoNW had redemptions of banknotes in excess of its $100,000 of gold, the bank could have done a number of things such as buy more gold on the open market to meet redemptions.

For a bank to hold 100% gold reserves for each banknote it issued would not have been much of a business. The gold would have had to be protected and insured, and there would be no way to recoup these costs. (Today they are about 0.50% per year.) The bank made money on the business by keeping only $100,000 of gold in reserve. The $900,000 of banknotes issued in excess of the gold reserve could be considered a “profit” from money creation. On a broader scale, it was beneficial not to have a 100% gold reserve, since the demand for money (due to the growing economy) steadily grew, which would have required more and more gold. Ultimately this would have reached physical limits: there isn’t that much gold in the world, then or now. Thus “economizing on gold” by using paper redeemable in gold was quite sensible.

While the bank had made $900,000 of cumulative “profit” in this example, these were not profits that could be distributed as dividends. There was always the chance that the banknotes would come back to the issuer, and the bank would be obliged to pony up the full $1 million in gold. Thus, the $900,000 was, in essence, lent out, and the bank’s “profit” became the interest on the $900,000 loan. (Central banks today buy government bonds instead of making loans, but the idea is the same.) If the day came when the bank would have to use the $900,000 to buy bullion to cover banknote redemptions, it would simply call in the loan, or more likely borrow against it.

In practice, these processes were often combined into one, and the bank would both issue banknotes and make loans in one step. It would print money and then loan it out. This worked as long as there was some demand for the money — otherwise it would come back to the bank to be redeemed for bullion. It all worked out in the wash, as long as the bank adhered to its legal commitment to deliver gold on demand for its banknotes.

Today, of course, banks do not print money. Central banks “print” the money, but do not make loans, while banks make loans, but do not print money. However, given this historical precedent, it is not too hard to see how a careless sort of analyst could accuse banks of “inflating the money supply” by “making loans,” all of this because the bank was a “fractional reserve bank.”

Now we leave the land of the balance-sheet realities of financial institutions and fly off into the vapors of economic metaphor. For some reason, people who regularly read and understand the balance sheets of banks do not concern themselves with broader macroeconomic realities; those who are “macro heads” are often incapable of reading the balance sheets of a shoe company, much less a complex financial intermediary. The metaphoric and rhetorical language, which reflected the realities of the 19th century, were pressed into service mostly during the 1930s for a different purpose. The shock of the Great Depression caused a blossoming of all sorts of inventive economic theories; or maybe we can use the fruiting of mushrooms as a better metaphor, as much of it continued to happen in the dark. To generalize, two vague camps seem to have developed: those who blame the Fed for being too tight in the early 1930s (why didn’t the Fed save us???), and those who blame the Fed for being too easy in the 1920s (why did the Fed blow a “bubble” whose collapse caused such economic hardship????). We remember, from our earlier discussions, that the latter group focused on “M2,” which is not the base money printed by the Fed (much of it was still being printed by private banks in those days), but deposits held by banks. A “money multiplier” based on “fractional reserve banking” was imagined to be operative, thus it was “fractional reserve banking” that caused the bubble that blew up the economy. We hear much the same sort of thing today about the “flood of liquidity” that is causing a “bubble” in asset prices. First of all: dollar base money growth has been quite low. Second: while it is true that M2, M3 and other measures reflecting “fractional reserve banking” have been rising at brisk though not unusual rates, there is nothing about this that is inherently inflationary. Third: inflation is due to a decline in currency value, not increases in M2 and the like, and the eventual result of inflation will be to crumple lending everywhere.

To summarize: if you blame banks for “an inflationary bubble” of the most destructive proportions during the 1920s/1930s, while the gold standard was in full operation, then you must conclude that a proper gold standard cannot function with “fractional reserve banks.” Thus, to create a future gold standard, you must conclude that “fractional reserve banking” must be outlawed. This is what the Rothbardians did, for about seventy years. I suspect they won’t be doing that anymore.

Oddly enough, the latest round of housing-related lending in the US has been done in large part the way the Rothbardians would like it done. The banks haven’t kept them on the books, but have packaged them into Mortgage-Backed Securities, which are bought and held much like regular government bonds.

Let’s clear away all the “fractional reserve banking” cobwebs, which have at their root an odd historical combination of 19th century experience with flawed Great Depression theories. Banks are merely banks; they aren’t that mysterious, from a broad macro standpoint. Just another business, like making cars. Banking can function perfectly well under a gold standard, and a gold standard (gold-pegged currency) can function perfectly well with banks. They did so for several centuries. The gold standard system of the future will have banks, just as did the gold standard systems of the past.