The Ills of Fractional Reserve Banking

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Two academics over at the International Monetary Fund (IMF) have come up with an interesting idea. Oddly enough, it requires you to assume something that is far more important and revolutionary than the idea itself. But the assumption barely gets a mention.

This is going to require your thinking cap, by the way. But it’s probably our favourite and most important point we make in the Daily Reckoning every now and again.

At hand are two different issues. The IMF authors have shmooshed the two ideas into one proposal and confused everyone in the process. Split the two issues apart, take out the bad bits, and you are left with a game changing idea for the future of the financial system.

The first issue is fractional reserve banking (FRB). If you put your gold coins into storage at the bank, the bank can’t just go and lend out those gold coins to someone else with interest, hoping you won’t come and claim them before the borrower returns them. If the bank did do that, it would be fraud.

But in a fractional reserve lending system the bank does just that with your deposited money. It lends out what you’ve handed over for safekeeping, and only holds onto a small part in reserves. It is illegal to engage in fractional reserve lending if you don’t have a banking license, and even then, you can only do it with bank deposits.

This is an absurd exception from the law given to bankers. And it’s the source of their remarkable profits, because they lend out money that was never theirs in the first place. The depositor deposits the money. It’s not lent or given away to the bank.

Because of FRB, bank runs can happen. People want their deposits, but the bank has lent them out to borrowers. Bank runs cause a type of financial crisis, which have been a big part of the economic instability we’ve faced ever since banks have existed. That’s more than a few thousand years, in one form or another.

Remember, taking deposits and then lending them out without a banking license is illegal. Somehow bankers get an exemption from this basic legal principle. It’s quite amazing to see an IMF paper admit this. They call the permit ‘an extraordinary privilege that is not enjoyed by any other type of business.’ People have called us all sorts of names for pointing out the same thing.

The second issue in the IMF paper is about who creates, or issues, money. It might seem odd, but through much of history money was created by banks, not governments. A historical remnant of this is that there are still around 10 note issuing banks in the UK. They all issue British Pound Sterling now, but they used to issue their very own currency. Even today, the bank notes they issue look different.

This practice of privately issued money, especially once combined with FRB, made banks immensely powerful. They could issue money and create vast amounts of it for lending out, because they only needed a small amount in reserves for the loans they made. As long as depositors didn’t figure out their deposits weren’t safely in the bank, but had been lent out, the bankers make a huge amount of money in interest.

But there was one limit. Under the private sector version of issuing money, banks needed to give the impression that their paper money had value. Nobody was willing to accept that a piece of paper had value.

So the banks made every bank note redeemable, usually in gold. But the banks quickly figured out that people never redeemed the gold. Instead, they just handed over the bank notes when they wanted to buy something.

So the banks realised they could issue far more bank notes than they had gold, and nobody would notice. They got free spending power each time they created a bank note without any gold to back it up. Just another fraud bankers pulled off as a core part of their everyday business.

The government saw the immense benefit of getting free spending power by issuing secretly unbacked money, known as seigniorage, and decided it wanted a share of it. By taking control over the issuance of money, the government was able to grab part of the financial sector’s immense power.

But the financial sector held onto its FRB rights. So it gave up seigniorage, but continued to lend out what was meant for safekeeping.

The banks also figured out they could create a new type of money – credit money. Essentially, credit money is just an IOU to pay real money. The easiest way to understand the difference between real money and credit money is to think about the difference between a debit and credit card. The first uses existing money and the second is an IOU created by the bank in the moment of the transaction.

The key question is, can you tell the difference between the two if you’re the one being paid? You can’t – you don’t know if you’ve been paid credit money or real money. They look the same because they are a number in your bank account. And you don’t really care that credit money is just an IOU, because the bank backs up credit money with its ability to pay real money.

The problem with this is that the amount of credit money depends on whether the banks are willing to create IOUs. A huge amount of credit can be created and then disappear quickly depending on lending and borrowing preferences. What seems like real money can suddenly dry up. That’s what happened in 2008.

Although the IMF paper goes into credit money, let’s leave that aside. The same goes for precious metal backed money. What’s important here is fractional reserve banking and who creates the ‘real money’.

Two Issues, Four Solutions

So if there are two issues at hand, there are four ways you can combine them. You can allow FRB or ban it, and you can have the government or the private sector issue the money.

Our trusty adaptation of game theory will explain it:

If you’ve never seen this way of showing a problem before, take a look at the box in the bottom right hand corner of the matrix – ‘the right system’. This is a system without fractional reserve banking and with privately issued money.

In this scenario, the government is out of the money creation business and in the law enforcement business (it stops banks from engaging in dodgy FRB). This is the right system according to your editor’s views.

Our current system has government created money, with FRB. That means bank runs can happen, but the government, or its central bank, come to the rescue with freshly printed cash. That’s what you’ve seen happen over the past few years.

A system of privately issued money and FRB, the bottom left hand box, is a little odd. But it existed for much of western history. Many people blame the problems of this system on the fact that the money was privately issued by banks.

But the problem was really FRB, which makes the banking system unstable and liable to bank runs. If normal laws had been enforced on bankers, FRB wouldn’t have existed, because you can’t lend out money that someone has given you for safekeeping.

The IMF Plan to Deal With Fractional Reserve Banking

Last but not least is the system the IMF paper suggests we should give a go. It’s based on a theory worked on during the Great Depression. And it supposedly fixes a large amount of the problems we’ve got today. It suggests that government should continue issuing money, but it should ban credit created money and FRB.

In other words, when you deposit a dollar in your bank account, the bank can’t go and lend it out. It must have that dollar, and all other deposited dollars, ready and waiting for you at all times. That stops a bank run from happening. As for credit money, that would simply be banned.

So how would the bank get the money it needs to lend if it can’t create credit or lend out some proportion of deposits? This is where scepticism of the plan kicks in. Banks must borrow from the government treasury to lend. The treasury gets to create the money… as much as it wants to.

What’s interesting about this system is that money for lending comes into creation by being borrowed from the government. Under our current system, it’s sort of the opposite. Money the government currently creates is a liability, not an asset, for the government.

According to the IMF authors and the economists who came up with the idea in the 1930s, this change allows government debt to be reduced dramatically. The politicians can simply create money and pay back their debts.

A Forest Without Trees

The annoying thing about this IMF proposal is that it acknowledges that fractional reserve banking is a major problem, but deals with it as a secondary issue. In our opinion FRB is the biggest fraud ever contrived. But that’s another story.

If fractional reserve banking is a problem, as the paper acknowledges, why don’t we solve that problem before rejigging the entire financial system in all sorts of other ways? Why don’t we make banks operate under the same laws the rest of us do? We’re not allowed to lend out what isn’t ours. You don’t see Kennard’s Storage lending out their customer’s garden furniture.

Anyway, it’s quite amazing that this idea has traction at the IMF. Ending FRB, even if you mess about with other parts of the financial system at the same time, would destroy a huge part of the power of the banks. Unfortunately, the IMF plan hands power to the government at the same time.

If the plan moves forward, it’s a win and a loss at the same time. It gives government too much power, and takes unfair power away from the banks.

It’s not likely this idea will ever make it to the financial system though. But it is remarkable that a criticism of FRB is published by a mainstream institution. We’ve been ridiculed for making this argument for years. Now we’ll have to find something more ridiculous…

Regards,

Nick Hubble
for The Daily Reckoning Australia

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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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15 Comments on "The Ills of Fractional Reserve Banking"

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Felix
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Banning FRB seems a bit extreme given it is a perfectly good way of making money and lubricating the economy by lending out excess capital. However, I agree with the sentiment that it is fraudulent to take ‘safe deposits’ and lend it out. Given technology these days, why not move to a system of optional FRB or even scaled FRB. So if I want to make 5% interest on my cash, I’ll lend it to the bank in an 80% fractional reserve account. If you want to lend to the bank you lend at 0% interest on a 100% fractional… Read more »
pravin
Guest

how different is FRB from the ’24×7′ electricity availability advertised by power companies? everyone understands that if all of us plugged in together,the grid would collapse.
money like electricity is a commodity which can be subject to a simple queuing system.optimal usage of scarce commodity is a free market phenomenon.if banks “know” that everyone doesnt need their money at the same time,it is justifiable to indulge in FRB.

ofcourse,the govt shouldnt have a role in it.that would be central planning.FRB may or may not exist based on simply ‘demand and supply’ in the free market like any other commodity that is scarce.

Strongbad
Guest

If you ban fractional reserve banking a bank could still run into trouble because the duration of its loans and deposits might be mismatched. And if you required them to match the duration of its loans and deposits it could still be in trouble if the loans isn’t repaid. You could ban lending altogether, but it would be a pretty dismal economy.

shortchanged
Guest

Several banks in Hong Kong issue money, and as far as I am aware, always have.
The laws of fractional reserve banking will not change, because practically every Country in the world owes money to the banks. Unless of course some country pulls a stunt, like a king of France did to the Knights Templars in the days of the crusades. (The KT’s by the way are said to be the first international banksters.) So!! I’m afraid it will be business as usual.

Ross
Guest

@shortchanged. Expect the stunt, and the ensuing pogrom. Go back a step though, the times suit me says the reincarnation of Lucas Cornelius Sulla. Ugly business is afoot.

shortchanged
Guest

Lucas Cornelius Sulla; must admit I had to google him Ross, your classical education has paid off. Seems to have been a bit of a lad, one way or another. So, who do you think will be the Dictator Prima, to follow in the footsteps of Sulla?. Is your comment rhetorical or do you have someone in mind? Whatever or whomever, we will live in interesting times.

Lachlan
Guest

SC Its hard to keep track with Ross and his historical inquiries but I like to follow up some of his ideas too.
RE The Emperors of Rome….Marcus Aurelius later. The stoics are right up my ally tending naturally that way anyhow. Maybe there is hope for a good king but such people don’t seek power or hope to change what they see as the inevitability of our human plight. A vein of rambling I have jotted into DRs comments the last 4 years or so.
Happy reading SC

Lachlan
Guest
Would like to know what you are saying in regard to a contemporary Sulla too Ross and just who get be pogrommed (a word I just made up). The financial class with their Jewish ancestry? That argument never stops. I don’t really care. Humans are humans. But yes we humans like to exorcise the evil occasionally it seems. Reminds me of those natives excommunicating coke bottles. It often never occurs we are not the innocent victims. We are the evil and the good. We choose. And thats why I like the stoics. They realise the ongoing inevitability…. human denial of… Read more »
shortchanged
Guest

Ah yes, Pandora’s Box, once opened never to be closed, until all the evil in the world is released. It’s only Greek mythology but poignant, much like the Banksters of our world, the self styled ‘masters of the universe’,maybe they are too stoical and have become ‘blase’ (used as an adjective) and emotionally detached from the problems of the world of their doing.

It seems we have strayed a bit from the original text, but reminds me to bone up on Greek and Roman history and philosophy.
More happy reading, Lachlan

Ross
Guest
Lachlan/SC, I don’t have a particular person or event in mind, just the shape of the personality and a purge. Among Sephardi Jewry there are many bent toward stoicism and mysticism. I am almost as big a fan of Maimonides as I am of Thomas Aquinas. Both are Aristotelian. Sulla cleaned out the tribunes. There would be many to be held to be in that category. I am not saying that ensuing events will be a good thing, let alone a noble enterprise. There are many that would claim Sulla’s mantle when the extend and pretend period is done. Just… Read more »
Lachlan
Guest

Many people seem to think Israel is about to go for broke and attempt to take on Gaza Lebanon Iran. The people wanted a king to protect them.. going back a few thousand years. But kings are just people like us. They fear they cannot have what they want without resorting to force. Doubtful little men. Around and around the mulberry bush we go.

shortchanged
Guest
Meanwhile we go along with the accepted mores and buckle under. I wish I had the courage and energy to fight the good fight, but I confess I just do as others do and surrender. For most of my adult life, some 50 years, I have wanted to believe in someone who would do the right thing, someone whom I could say ‘Yes you deserve those accolades, that knighthood’ but to often we are all let down. Political cowards who steal from the people, lie and cheat their way into office. Business men whose only thought is themselves, and a… Read more »
monk
Guest

What is taking place isn’t based on neo-classical theories but something that goes beyond fractional reserve banking. Read Steve Keen’s article for details:

http://www.businessspectator.com.au/bs.nsf/Article/money-supply-economics-economy-bank-reserves-infla-pd20121022-ZAS44

Michael
Guest

What everyone is missing here is bank interest.
Every dollar created needs to be payed back with interest.
If all the money ever borrowed was payed back there would still be the interest owing of which no money would be left to repay.
Under FRB we will always be in debt as the only option to pay back this interest is with more debt.
Money = Debt, no two ways about it.

Sly Gryphon
Guest
“You don’t see Kennard’s Storage lending out their customer’s garden furniture.” But would you really want to *ban* it if they were up front and made this arrangement with customers? If Kennard’s came to me and said “Hey, your not using your furniture, we will give you free storage and even pay you, if you let us hire it out” (and agree to compensate), how is this a problem? Provided it was all clearly communicated and agreed, there is no fraud involved. Now, garden furniture is not a good example as it’s not very fungible. (When I come back I… Read more »
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