What can we say about fractional serve banking? It has its pros and cons. Perhaps, though, it also has its con jobs. It certainly has its defenders and detractors. What is the average layperson to make of all this?
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.
Defenders of fractional serve banking claim it provides valuable liquidity to grease the wheels of a large, complex economy. It ensures there are adequate funds for entrepreneurs to start new businesses and consumers to purchase on loan high-end goods like houses and cars - stimulating demand and production, employment and so on.
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) 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.
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) In our densely interwoven banking world, though, what's bad for one bank can be bad for all. (And, of course, for all of us, who have money in banks, anywhere.) In our globalized financial world, banks borrow from and deposit with each other: they are the creditors of other banks, either long or short term. As you'd expect, bankers are more sophisticated about the reserve system than the average depositor. They appreciate the danger of a bank run's cascading consequences.
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.
The situation is considerably complicated by wide prevalence of inter-bank borrowing. Under these conditions a bankers' bank run can ignite chain reactions of default. This was a major contributing factor to the 2008 financial crash. So, we see that the entire global financial system can be endangered.
3) Finally, fractional reserve banking contributes to the extreme destructiveness of inflation. While the worst culprits are the central banks and the governments whose debt they feed, banks too play a major role.
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 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.
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.
Defenders of fractional serve banking claim it provides valuable liquidity to grease the wheels of a large, complex economy. It ensures there are adequate funds for entrepreneurs to start new businesses and consumers to purchase on loan high-end goods like houses and cars - stimulating demand and production, employment and so on.
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) 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.
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) In our densely interwoven banking world, though, what's bad for one bank can be bad for all. (And, of course, for all of us, who have money in banks, anywhere.) In our globalized financial world, banks borrow from and deposit with each other: they are the creditors of other banks, either long or short term. As you'd expect, bankers are more sophisticated about the reserve system than the average depositor. They appreciate the danger of a bank run's cascading consequences.
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.
The situation is considerably complicated by wide prevalence of inter-bank borrowing. Under these conditions a bankers' bank run can ignite chain reactions of default. This was a major contributing factor to the 2008 financial crash. So, we see that the entire global financial system can be endangered.
3) Finally, fractional reserve banking contributes to the extreme destructiveness of inflation. While the worst culprits are the central banks and the governments whose debt they feed, banks too play a major role.
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 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.
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:
When you need to understand 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 analyst of finance and investing. His no-holds-barred proposal of a Free Market Economy in Money is required reading for anyone who wants to understand our current financial situation.
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