Fractional Reserve Systems

Fractional Reserve Banking – Two Approaches to Regulation

The meaning of a “fractional reserve” Banking system seems simply enough – the first way to understand it would be simply place it in opposition to a full reserve banking system. A full reserve bank is a bank where assets are placed in a vault, and held there (presumably against them). Owners of assets are given promisory notes which all them to return and withdraw their deposits when they please. For this protective service, the owners of they money held at the bank pay a fee. On the other hand, in a fractional reserve bank, we might assume that deposits are made by the owners of assets, the Bank holds a fraction of those assets are a reserve and loans the rest out at a rate of interest. They then pay some of this interest back in proportion to the deposits – and in a free system a tension between security (your assets will be there when you return for them.

On the surface, the fractional reserve system seems just as safe as the full reserve system because the possibility of a loan not being repaid (loosing a depositors money) is evened out by the interest paid on the loan (i.e. I pay interest to conver someone else’s actual default, which is in fact the possibility that I might default). However, this seems to hold true even when banks are making deposits in other banks. Imagine BankA makes a deposit of 100$ into BankB – the 100$ must have been taken out of moneys deposited into BankA, from the portion other than the reserve fraction, so in loaning the money from a bank to another bank, Bank A looses 100$ of money it could loan to someone else (it’s oppertunity cost), and Bank B gains 100$ more it can loan out, but must pay for it by an interest rate. This system has a high degree of protection from systemic risk – BankB might fail, but unless Bank A had made many loans to Bank B, Bank A will take a reasonable hit. The key here is that Bank A has not issued loans on the basis of money it has already loaned.

However, the fractional reserve system that we have is a bit different from this when it comes to deposits made by a central bank. Whereas when a depositer places money in the bank, the money, say 100$, is simply divided into the 20$ fractional share, and the 80$ loan share, when a central bank deposits 100$ into a bank there is a third thing created. In addition to the 80$ that can be loaned out and the 20$ that is kept as a reserve, there is another 80$ in the form of a promisary note, which is effectively the treatment of the loan as an asset. Since the bank has an extra 80$, it can loan this to another bank, who will take 16$ of that and place it in the reserves, and loan the 64$, and then loan the 64$ (again, this is not a 64$ bill from the reserve, but a promisory note for such a bill) again to another bank. This repetition means 100$ of money placed into a bank from the federal reserve creates 500$ (although not in a single bank, but spread across the banking system), whereas when 100$ is placed in a bank by an investor, only 100$ is created.

There is no way to tell between the “original” 80$ that is loaned out to the public, and the 80$ that is subsequently loaned to another bank – except when there is a run on the banks. When there is a run on the banks, people want federal reserve notes, not the promisary notes banks right to each other based on federal reserve notes – these are worth nothing to anyone except bankers – they do not represent actual M1 dollars, but rather are a mechanism to allow banks to lend more money out than there exists in M1.

The importance of this system in the U.S. has become great, although that is no argument that the system is neccesary. M1 in the U.S. is apparently 900 billion dollars – roughly half the size of the combined stiumulus packages to deal with the current crisis. However, the actual money supply is much greater than M1 – the amount it is greater depends on the reserve ratio (i.e. if it is 20%, the actual supply is something like 4.5 trillion).

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8 thoughts on “Fractional Reserve Systems

  1. This may interest you:
    The financial crisis
    Don’t forget the benefits

    Jan 15th 2009
    “Emerging economies, having experienced the crises of 1997-98, resolved to inoculate themselves by refusing to rely on foreign financing. They kept their exchange rates cheap so as to run current-account surpluses and build up foreign reserves. That way, if their banks got into trouble and foreign financiers took flight, they would have a war chest of dollars with which to repay the foreigners and avoid a collapse in their currencies.

    This determination to run surpluses has proved wise: Brazil, Russia and South Korea have all drawn heavily on reserves during the current crisis. But a precaution that makes sense from the perspective of one country can prove toxic for the global system as a whole. If everyone is trying to run a current account surplus, a corresponding deficit must show up somewhere. And so it did, in America. Capital from emerging markets poured into Wall Street, inflating the subprime bubble.

    The scary thing is that the process could repeat itself. Having experienced the current crisis, emerging nations may redouble their determination to export capital and another bubble could be inflated. This makes Mr Wolf’s first question urgent: how should countries make finance safer without resorting to the destabilising policy of capital dumping?”

  2. “If everyone is trying to run a current account surplus, a corresponding deficit must show up somewhere.”

    Milan, this is exactly my point. It’s only because we allow banks, countries, individuals maybe, to lend out deposits – i.e. keep a fractional reserve, that a reserve somewhere “has” to be a deficit somewhere else.

    If we did not allow fractional reserve lending, if we did not allow the multiplier effect to occur, the only ‘reserves’ people could hold would be M-zero reserves, which means it’s not someone else’s debt, it’s just money. The simple solution is just coin or print M zero to the same size of existing M1 and then make the fractional reserve ratio 100% instead of 10%.

  3. I don’t think a full reserve system would change this. Countries that had crises before wanted to build up dollar reserves. In doing so, they lent money to Americans, reducing the cost of capital there. I think such imbalances could occur even with a gold standard.

  4. I don’t think your comment makes sense. How can you build up dollar reserves by lending money to the Americans, at least in the sense of money as commodity.

    You’ve just pointed out the greatest problem of the American currency being the world reserve currency (Capital is too cheap in the US, the US only consumes, does not produce, trade imbalances, impending collapse of the world reserve currency), and said “I think such imbalances could occur with a commodity money”. But how? If we had a commodity standard there would be no reason to lend money to the US to build up your reserves – if you want to increase the exchange value of your currency you increase your gold reserves so you can increase the number of grains per ounce it can be exchanged for. You do this by investing in commodity production, and most of the Gold production is in Australia and Chile, I believe.

    So, I don’t see how your worry makes sense. There might be problems that would come out of investing too much money in gold production, but reducing the cost of capital elswhere, I don’t think this would be one.

  5. There is a simple test for this. Bretton Woods One. People like to say currency exchange rates were “fixed”, but this is just bullshit. They were fixed according to a Gold standard, which meant they could change at the rate that the gold reserves moved from State to State. Ever wonder why Nixon pulled out? Because if France had been able to renumerate all its greenbacks in Gold, the US currency would have been horribly devalued. Nixon’s pulling out of Bretton Woods 1 was a brutal attack on the free-market basis for currency.

  6. I don’t think your post specifically targets the fractional reserve system as the problem. What you are really rallying against is leverage, and perhaps more specifically asset back loans (where the value of the assets are inflated by availability of cheap money) and possibly mark-to-market accounting practices that allow businesses to hide the questionable loans off the balance sheet. The main problem you have, boiled down to the essentials, is the practice of creating something from nothing – you related this to the fractional reserve because in your post the specific example is the creation of a phantom $20 – but the main issue is leverage. We know it is possible to get more capital than secured by assets through credit; (1) it happened, (2) the mechanism is thoroughly understood. However, the problem has more to do with the nature of leverage, specifically it’s ability to cause losses many times larger than the principle, than only needing to keep a fraction of a loan on reserve. I understand the practice of holding the complete loan in a vault solves the problem, but the FIRE sector (Finance, Insurance and Real Estate) depends on using the same money multiple times. The problem stems from how many times we let them make leveraged investments on credit, and the poor pricing of the assets that served as security, and the poor pricing and estimation of risk, rather than the fact that the money a bank loans to an individual to buy a house is liable to be (re)deposited by the seller and loaned out by the bank again.

  7. Banks create money by lending the principal of loans, but those loans must be repaid with interest. On long term loans, like 30 year house mortgages, the interest is often larger than the principal. Since both the Federal Reserve and commercial banks create 99.9% of the money as the principal of loans, the impact of interest is devastating to economy.

    An executable contract is base on some form of equality and can be expressed as a mathematically as an equation. If gasoline cost $2.50 a gallon and you wish to buy 10 gallons, you pay the attendant $25.00 and he pumps 10 gallons: 10 gallons of gasoline = $25.00.

    In the case of fractional reserve lending there is a fundamental mathematical inequality revealing an inherent flaw in the system: an impossible contract. Since all of the Nation’s money, with the exception of coins comprising just 0.08% of the money supply, is created as the principal of loans that must be repaid with interest, and repaying the principal would require the entire amount of money created, leaving no money to pay the required interest, the contract is impossible to fulfill when seen as a whole.

    The appearance of fiscal stability is created by lending institutions continually creating new and large loans, using the newly created money to service old loans while expanding the debt base and increasing bank profits. This is a pattern often seen in investment schemes, and has been given the name of a notorious practitioner: it is a Ponzi scheme.

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