Fractional-Reserve Banking

From Goldsmiths To Hedge Funds To… Chaos

 

Submitted by Tyler Durden

From Chapter 15 of The Money Bubbleby James Turk and John Rubino:

Banking didn’t start out as a reckless, parasitical plaything of a moneyed and politically-connected aristocracy. In the beginning, in fact, bankers weren’t even bankers. They were jewelers and goldsmiths who had to maintain their inventory with vaults, guards etc., and offered storage services to others with valuables to protect. So the original banks were, in effect, very safe warehouses.

Eventually some goldsmiths noticed that the paper receipts they gave to their customers to evidence the valuables left in storage began to circulate as currency alongside their countries’ coins. A shopkeeper accepting these receipts in payment knew that he could go to the goldsmith to redeem them for gold and silver, and also recognized that a paper receipt was more convenient to use as currency than were pieces of metal. Gradually these receipts became a widely-accepted form of payment, circulating among buyers to sellers and saved like other forms of wealth.

The goldsmiths then noticed something else about their new paper-money invention: Only a tiny fraction of their clients asked for the return of their valuables in any given period, which led to a bright – but legally and morally-dubious – idea. Why not start issuing receipts in excess of the gold and silver on hand? The goldsmiths could spend this currency themselves or lend it to others – thus inventing the business/consumer loan. Henceforth the total gold and silver in the vault (the goldsmith’s reserves) would equal only a fraction of the receipts circulating as currency.

“Fractional reserve banking” was thus born of deception if not outright fraud, because for the receipts to retain their value the goldsmiths had to pretend that those paper claims to gold and silver were backed by an equal amount of metal and were therefore of equivalent value. They were not, of course, because a tangible asset is more valuable than a promise to pay a tangible asset, particularly when the latter outnumbers the former.

The goldsmiths, having evolved into more-or-less recognizable bankers, then realized that more deposits equaled more profits. So they began paying people for deposits of gold and silver rather than charging for their storage, thus inventing the interest-bearing account.

The resulting system had some inherent dangers, most obviously that it tempted bankers to lend out ever-greater multiples of deposits, increasing the odds that they would be unable to meet withdrawal requests and collapse. This happened frequently early-on, eventually leading governments to regulate the amount that a given bank could lend against its capital.

For a sense of how this works, imagine a bank with $100 in capital that is required to hold a reserve equal to 20 percent of its loans outstanding – which based on experience is usually more than enough to satisfy a typical day’s withdrawal requests. In our example, the bank can lend 4/5ths of its depositors’ money, or $80, while 1/5th, or $20, remains in reserve. Now here’s where it gets interesting: When our hypothetical bank makes a loan, the recipient deposits the proceeds in another bank, which can lend out 4/5ths of that deposit. The recipients of those loans make deposits in other banks, and so on, until a huge multiple of the original deposit base has been turned into circulating currency.

The result is an “elastic” money supply. When borrowers are optimistic and want to increase their borrowing, banks in a fractional reserve system can in the aggregate offer them immense amounts of new credit. So the money supply, instead of being determined by the amount of gold, silver or other bank capital in the system, can expand dramatically to accommodate an energetic society’s demands.

But it can also contract dramatically. If an economy that has greatly increased its money supply through bank lending suddenly takes a downturn or is unnerved by an unexpected crisis, borrowers will pay off their loans or default on them and banks won’t replace them, while depositors seek the return of their cash. These actions cause the money supply to collapse, potentially all the way back to the level of base money in the system. The result of this fluctuation in the supply of circulating currency is a recurring series of booms and busts that wipe out businesses, individuals, and banks and frequently send the general economy into recession or depression.

Fractional reserve banking was, in fact, a major cause of the Great Depression. To condense a long, complex story into a single paragraph, the extra currency that was printed by the belligerents during World War I (which ended in 1918) was recycled through the fractional reserve banking system and massively amplified via the process we’ve just described. This tsunami of new credit caused the Roaring Twenties boom in asset prices – especially global equities – that popped in 1929, destroying the pseudo-wealth created in the previous decade. The collateral supposedly guaranteeing bank loans evaporated and sentiment turned negative, sending the fractional reserve credit machinery into reverse and collapsing both the banking system and the real economy.

Today’s situation is much, much worse. To see how, click here.

 

Prominent Economists Call for End to Fractional Reserve Banking

Submitted by George Washington on 05/01/2014 

Excessive leverage by the banks was one of the main causes of the Great Depression and of the 2008 financial crisis.

As such, lower levels of “fractional reserve banking” – i.e. how many dollars a bank lends out compared to the amount of deposits it has on hand – the more stable the economy will be.

But economist Steve Keen notes (citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board):

The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.

So huge swaths of loans are not subject to any reserve requirements.

Indeed, Ben Bernanke proposed the elimination of all reserve requirements for banks:

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Economist Keen informs Washington’s Blog that about 6 OECD countries have already done away with reserve requirements altogether (Australia, Mexico,  Canada, New Zealand, Sweden and the UK).

But there is a growing recognition that this is going in the wrong direction, because fractional reserve banking can destabilize the economy (and credit can easily be created by the government itself.)

It was big news this week when one of the world’s most prominent economics writers – liberal economist Martin Wolf – advocated doing away with fractional reserve banking altogether… i.e. requiring that banks only loan out as much money as they actually have on hand in the form of customer deposits:

Printing counterfeit banknotes is illegal, but creating private money is not. The interdependence between the state and the businesses that can do this is the source of much of the instability of our economies. It could – and should – be terminated.

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What is to be done? A minimum response would leave this industry largely as it is but both tighten regulation and insist that a bigger proportion of the balance sheet be financed with equity or credibly loss-absorbing debt. I discussed this approach last week. Higher capital is the recommendation made by Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute in The Bankers’ New Clothes.

A maximum response would be to give the state a monopoly on money creation. One of the most important such proposals was in the Chicago Plan, advanced in the 1930s by, among others, a great economist, Irving Fisher. Its core was the requirement for100 per cent reserves against deposits. Fisher argued that this would greatly reduce business cycles, end bank runs and drastically reduce public debt. A 2012 study by International Monetary Fund staff suggests this plan could work well.

Similar ideas have come from Laurence Kotlikoff of Boston University in Jimmy Stewart is Dead, and Andrew Jackson and Ben Dyson in Modernising Money.

***

Opponents will argue that the economy would die for lack of credit. I was once sympathetic to that argument. But only about 10 per cent of UK bank lending has financed business investment in sectors other than commercial property. We could find other ways of funding this.

Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and was then forced to insure it when performing that function. This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.

(The IMF study is here.)

In fact, a lot of experts have backed this or similar proposals, including:

Interestingly, the Chicago Plan for full reserve banking came very close to passing in 1934. But the unfortunate death of one of its main Congressional sponsors – Senator Bronson M. Cutting  – in a plane crash reversed the momentum for the bill.

As Wikipedia notes:

Cutting played a key role in the political struggles over the reform of banking which Roosevelt undertook while dealing with the Great Depression, and which resulted in the Banking Reform Acts of 1933 and 1935. As a supporter of the Chicago Plan proposed by economist Irving Fisher and others at the University of Chicago, Cutting was among a handful of influential Senators who might have been able to remove from the private banks their ability to manipulate the money supply by enforcing a 100 percent reserve requirement for all credit creation, as stipulated in the Chicago Plan. His unfortunate death in an airliner crash cut short what may have been his most enduring legacy to the nation.