Fractional-reserve banking

Fractional-reserve banking is the banking practice in which banks keep only a fraction of the value of their bank notes and demand deposits in reserve and invest the balance in interest earning assets while maintaining the obligation to redeem all bank notes and demand deposits upon demand. This practice is universal in modern banking. ["The Bank Credit Analysis Handbook: A Guide for Analysts, Bankers and Investors" by Jonathan Golin. Publisher: John Wiley & Sons (August 10, 2001). ISBN-10: 0471842176 ISBN-13: 978-0471842170] [ [http://www.bankintroductions.com/definition.html Bankintroductions.com - Economic Definitions] ]

History

At one time,When|date=October 2008 people deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.cite book
last=United States. Congress. House. Banking and Currency Committee.
title=Money facts; 169 questions and answers on money- a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964.
location=Washington D.C.
date=1964
url=http://books.google.com/books?id=9DlDs-o0arUC&q=goldsmiths&pgis=1#search]

As the notes were used directly in trade, the goldsmiths noted that people would not usually redeem all their notes at the same time, and saw the opportunity to invest coin reserves in interest-bearing loans and bills. This left the goldsmiths with more notes on issue than reserves to pay them with. This generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to redeem (pay) their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a "bank run" and caused the demise of many early banks.

Purpose and function

The United States' Federal Reserve gives a summary of why fractional reserve banking is used and what its effects are::The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to "create" money.Page 57 of 'The FED today', a publication released by the united states federal reserve education website designed to educate people on the history and purpose of the united states federal reserve system. http://www.federalreserveeducation.org/fed101/fedtoday/FedTodayAll.pdf]

How it works

A demand deposit at a bank (e.g. checking account) or banknote issued by a bank (bank-issued paper money) is essentially a loan to the bank, repayable on demand, which the bank uses to finance its investments in loans and interest bearing securities. The nature of fractional-reserve banking is that there is only a fraction of cash reserves available at the bank needed to repay all of the demand deposits and banknotes issued. The reason people deposit funds at a bank or hold banknotes issued by a bank is to store savings in the form of a demand claim on the bank. One important aspect of fractional-reserve banking is that the note holders and depositors still have a claim to repayment of their funds on demand even though the funds are already largely invested by the bank in interest bearing loans and securities. [Committee on Finance and Industry 1931(Macmillan Report)on bankers desire to complicate banking issues."The economic experts have evolved a highly technical vocabulary of their own and in their zeal for precision are distrustful, if not derisive of any attempts to popularise their science."]

For instance, you could ask to withdraw all the money in your checking account at any time. If all the depositors of a bank did that at the same time (a bank run), the bank could be in trouble. This used to be a rare event, but is recently more commonplace. The Northern Rock crisis of 2007 in the United Kingdom is an example of such an event, as was the collapse of Indymac bank in the United States. The collapse of Wachovia bank in September of 2008 was an example of a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer. Federal regulators seized Washington Mutual bank September 25, 2008 after a run. It was the largest bank failure in history. Bank failures are not limited to US banks. On October 7, 2008, Iceland nationalized its 2nd largest bank, Landsbanki, following a run by UK depositors.

Fractional-reserve banking works because::# Over any typical period of time, redemption demands are largely or wholly offset by new deposits or issues of notes. The bank thus needs only to satisfy the excess amount of redemptions.:# Only a minority of people will actually choose to withdraw their demand deposits or present their notes for payment at any given time. :# People usually keep their funds in the bank for a prolonged period of time.:# There are usually enough cash reserves in the bank to handle net redemptions.

If the net redemption demands are unusually large, the bank will run low on reserves and will be forced to raise new funds from additional borrowings (e.g. by borrowing from the money market or using lines of credit held with other banks), and/or sell assets, to avoid running out of reserves and defaulting on its obligations. If creditors are afraid that the bank is running out of cash, they have an incentive to redeem their deposits as soon as possible, triggering a bank run.

Money creation

The process of fractional-reserve banking has a cumulative effect of money creation by banks. In short, there are two types of money in a fractional-reserve banking system:Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdfA quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document::"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."] European Central Bank - Domestic payments in Euroland: commercial and central bank money:http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money::"At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"] [Macmillan report 1931 account of how fractional banking works http://books.google.ca/books?hl=en&id=EkUTaZofJYEC&dq=British+Parliamentary+reports+on+international+finance&printsec=frontcover&source=web&ots=kHxssmPNow&sig=UyopnsiJSHwk152davCIyQAMVdw&sa=X&oi=book_result&resnum=1&ct=result#PPA34,M1]
#central bank money (physical currency such as coins and paper money, as well as money deposited in current accounts with the central banks)
#commercial bank money (money created through loans) - sometimes referred to as checkbook money [Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm:the reference is found in the "Money Manager" section:::"the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."]

When a loan is funded with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

The table below displays how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money. An initial deposit of $100 of central bank money is lent out 10 times with a fractional-reserve rate of 20%. This means that of the initial $100, 20 percent of it, or $20, is set aside as reserves while the remaining 80 percent, or $80, is loaned out. The recipient of the $80 then spends that money. The receiver of that $80 then deposits it into a bank. The bank then sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so it then has more money to lend out.

Criticism

Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the potential fragility of bank liquidity in a fractional reserve banking environment, the financial risk of bank runs that depositors bear when depositing money with banks, and the impact that demand deposits have on the stock of money, and on inflation (that is, the implicit debasement of the currency and its associated impact on the exchange rate). An alternative to fractional reserve banking is making the practice illegal and classifying the practice as a form of embezzlement, only permitting full-reserve banking. [ [http://www.mises.org/Books/mysteryofbanking.pdf Murray Rothbard, "The Mystery of Banking"] ] With full-reserve banking, some monetary reformers as such as Stephen Zarlenga of the American Monetary Institute, support the concurrent issuance of debt-free fiat currency from the Treasury, while others such as Congressman Ron Paul and the Ludwig von Mises Institute call for a commodity currency such as was possible under the Gold Standard. [Stephen A. Zarlenga, "The Lost Science of Money" AMI (2002)] [ [http://www.house.gov/paul/congrec/congrec2003/cr090503.htm Paper Money and Tyranny, Ron Paul] ] [ [http://www.lewrockwell.com/paul/paul125.html Fiat Paper Money, Ron Paul] ]

Exacerbation of the business cycle

Austrian School economists claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a full-reserve banking system. They argue that this will affect the role of the interest rate as the price of investment capital, guiding investment decisions. In their view, the natural (free of government influence) interest rate reflects the actual time preference of lenders and borrowers. Government control of the money supply through central banks and regulations allowing fractional-reserve banking disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments are liquidated, freeing capital for new investment. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, was awarded the Nobel Prize in Economics, [ [http://nobelprize.org/nobel_prizes/economics/laureates/1974/press.html The Prize in Economics 1974 - Press Release ] ] but the theory is not generally accepted as an adequate refutation of Keynesian economic theory. [http://www.slate.com/id/9593 Paul Krugman, "The Hangover Theory", Slate.com, says the Austrian Theory of the business cycle is "about as worthy of serious study as the phlogiston theory of fire".] A few Austrian School economists, such as Pascal Salin, also suggest that a full-reserve banking system should not be enforced and rather advocate the abolition of central banking and having free banking replace the current system.

Risk

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on-demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractional-reserve system.

Responses to the problem of financial risk described above include:
#Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
#Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
#Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used;
#Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved.

Effects of an increased money supply

Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply on an exponential basis. According to the quantity theory of money, this increase in the money supply leads to more money "chasing" the same amount of goods, which leads to inflation. [Charles T. Hatch, "Inflationary Deception" [http://mises.org/journals/scholar/hatch.pdf] ] Some monetarists and Austrian economists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as the main cause of inflation. [Ludwig von Mises, "The Theory of Money and Credit", ISBN 0-913966-70-3 [http://mises.org/books/Theory_Money_Credit/Contents.aspx] See also: Jesus Huerta de Soto, "Money, Bank Credit, and Economic Cycles", ISBN 0-945466-39-4 [http://mises.org/books/desoto.pdf] ]

Most schools of economics recognize the link between money supply and inflation; many mainstream economists, however, consider the issue of money through the banking system as a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Quantity theorists may either be hostile to fractional reserve banking or supportive of minimum reserve ratios and other government controls on the quantity of money created by commercial banks. Some support a gold standard or silver standard to restrain "unfettered", "speculative" fractional-reserve banking activities. [Hans-Hermann Hoppe, "The Devolution of Money and Credit" [http://mises.org/journals/rae/pdf/RAE7_2_3.pdf] ] [Andrew Dickinson White, "Fiat Money in France" [http://mises.org/books/inflationinfrance.pdf] ] [ [http://news.goldseek.com/GoldSeek/1192819378.php Mike Hewitt, The Forgotten War] ]

The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.

ee also

* Bimetallism
* Bretton Woods system
* Credit money
* Digital gold currency
* Fiat currency
* Free banking
* Full-reserve banking
* Gold standard
* Islamic banking
* Money supply
* Money creation
* Monetary reform
* Seignorage
* Usury
* List of economics topics
* List of finance topics
* List of business ethics, political economy, and philosophy of business topics

Further reading

* Huerta de Soto, J. (2006), "Money, Bank Credit and Economic Cycles", Ludwig von Mises Institute
* Meigs, A.J. (1962), "Free reserves and the money supply", Chicago, University of Chicago, 1962.
* Crick, W.F. (1927), The genesis of bank deposits, "Economica", vol 7, 1927, pp 191-202.
* Philips, C.A. (1921), "Bank Credit", New York, Macmillan, chapters 1-4, 1921,
* Thomson, P. (1956), Variations on a theme by Philips, "American Economic Review" vol 46, December 1956, pp. 965-970.
* Parliament of Tasmania, Monetary System, Report of Select Committee, With Minutes of Proceedings, 1935.

References

External links

* [http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf Rothbard, M. N. (1983) The Mystery of Banking, Richardson & Snyder, 1983, pp 87-110]
* [http://ideas.repec.org/p/lev/wrkpap/77.html Narrow banking]
* [http://www.unimaas.nl/media/um-layout/fdewb/opmaak.htm?http://www.fdewb.unimaas.nl/algec/block/framespages/1203/Seignorage.htm Seignorage and inflation tax]
* [http://i29.tinypic.com/11tl9vs.pngSchematic diagram to explain the fractional-reserve process]
* [http://www.islamic-finance.com/item1_f.htm Fractional reserve banking and usury]
* [http://www.mises.org/journals/qjae/pdf/qjae1_3_7.pdf Free banking and fractional reserves: a comment (Pascal Salin)]