What are the consequences of fractional reserve banking? Certainly some insiders defend the practice. Critics though argue that there are many dangers that we neglect at our peril.
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 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.
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 are considered below: risks 1) to the individual bank; 2) to the overall banking system; and 3) to the monetary system - increasing the vulnerability of the economy and thereby increasing the dangers of the first two costs.
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, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.
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) It is also important to consider the contributions of fractional reserve banking to destructive inflation. The lead culprits in that story certainly are central banks and governments, who employ their police powers to enforce the fraudulent fiat currency. Fractional reserve banking though also contributes considerably to the mess.
A description of the precise mechanics of this inflationary process would exceed the space limits, here. It should be enough to grasp the obvious fact that, as long as we're taking the laws of physics seriously, the same money cannot be both in a depositor's bank account and a borrower's loan portfolio. Somehow this bit of financial black magic is precisely what we're supposed to take seriously.
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.
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.
For insight into how such a solution could work, watch for my upcoming article on Free Market Fractional Reserve Banking, coming soon. 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 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.
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 are considered below: risks 1) to the individual bank; 2) to the overall banking system; and 3) to the monetary system - increasing the vulnerability of the economy and thereby increasing the dangers of the first two costs.
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, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.
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) It is also important to consider the contributions of fractional reserve banking to destructive inflation. The lead culprits in that story certainly are central banks and governments, who employ their police powers to enforce the fraudulent fiat currency. Fractional reserve banking though also contributes considerably to the mess.
A description of the precise mechanics of this inflationary process would exceed the space limits, here. It should be enough to grasp the obvious fact that, as long as we're taking the laws of physics seriously, the same money cannot be both in a depositor's bank account and a borrower's loan portfolio. Somehow this bit of financial black magic is precisely what we're supposed to take seriously.
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.
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.
For insight into how such a solution could work, watch for my upcoming article on Free Market Fractional Reserve Banking, coming soon. Stay tuned!
About the Author:
If you want to keep tabs on how the international banking system plays havoc with your savings, stay tuned to the Fractional Reserve Banking Review. Wallace Eddington has emerged as an important analyst of finance and investing. His no-holds-barred proposal 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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