Fractional-reserve banking
Fractional-reserve banking refers to the common banking practice of issuing
more money than the bank holds as reserves. Banks in modern economies
typically loan their customers many times the sum of the cash reserves that
they hold.
Contents
* 1 Example
* 2 Convertibility
* 2.1 Increased money supply and inflation
* 3 Financial ratios
* 4 Possible confusion
* 5 History
* 6 Government regulation
* 7 Influence of central banks
* 8 Criticisms
* 8.1 Risk
* 8.2 Incompatible with a gold standard
* 8.3 Inadequate government regulation
* 9 See also
* 10 References
* 11 External links
* 11.1 Libertarian viewpoint
[edit] Example
In line (a) of the example shown in Table 1, a bank receives a deposit of
100 paper dollars and credits the depositor's interest-bearing account with
100 dollars. At this point the bank is maintaining 100% reserves of paper
dollars against the interest bearing account dollars it has issued. If the
bank was required to keep 30% of its deposits in reserve it would then be
able loan $70. The person who borrows this money would likely spend it and
the money will likely end up as someone else's bank deposit. Line (c) shows
the banks balance sheet after the $70 was redeposited. Note that the bank
can now loan another $49 because its total deposits have increased. Line (e)
shows the banks balance sheet after that additional $49 is redeposited into
the bank. At this point the system has $219 dollars which is more than twice
the original $100 deposit. This process of loaning and depositing money can
repeat many times until reaching a theoretical maximum of $333 (1 divided by
the reserve ratio of 30% times the original cash deposit). Even though banks
seem to make money by re-loaning the same money many times they also must
pay interest on a deposit before they can loan it. Thus, banks can only make
money on the difference between the interest rate they charge on the loan
and the interest rate they pay to depositors.
Table 1: Private bank T-account
Assets Liabilites Reserves
(a) None $100 in interest bearing deposits 100 paper dollars
(b) Borrower's IOU worth $70 $100 in interest bearing deposits 30
paper dollars
(c) Borrower's IOU worth $70 $170 in interest bearing deposits 100
paper dollars
(d) Borrower's IOU worth $119 $170 in interest bearing deposits 51
paper dollars
(e) Borrower's IOU worth $119 $219 in interest bearing deposits 100
paper dollars
An alternative way of describing fractional reserves is to imagine that the
bank receives a deposit of 400 paper dollars, against which it issues 400
checking account dollars. The bank then lends 300 of its paper dollars to a
borrower, receiving the borrower's $300 IOU in exchange. Under either
alternative, the result is the same: The bank has issued 400 checking
account dollars against a total of $400 of assets--$100 in paper bills and
$300 in IOUs.
The issue of paper money by a central bank is illustrated in Table 2. In
line (a), the public deposits 100 ounces of silver into the central bank,
and the bank issues 100 paper receipts ("dollars") in exchange. At this
point the central bank is maintaining 100% reserves of silver against the
paper dollars it has issued. In line (b), the central bank prints 400 new
paper dollars and uses them to buy a government bond worth 400 ounces. At
this point the central bank is operating on fractional reserves, with a
reserve ratio of 20%. Thus the central bank has multiplied the original 100
ounce deposit by a factor of 5 (=1/.20).
Table 2: Central bank T-account
Assets Liabilites
(a) 100 oz. silver deposited 100 paper dollars
(b) Government bond worth 400 ounces 400 paper dollars
[edit] Convertibility
Typically, privately-issued checking account dollars are convertible into
paper dollars on demand. But paper dollars issued by the central bank are
normally not convertible into silver (or gold, as the case may be). The
paper dollar is thus physically inconvertible, although it remains
financially convertible, in the sense that the central bank stands ready to
use its bonds to buy back the paper dollars it has issued. For example,
during the Christmas shopping season, when the demand for cash is high, the
Federal Reserve will normally issue about 10 billion paper dollars in
exchange for $10 billion in bonds. After the shopping season ends, the
Federal Reserve will sell the $10 billion in bonds in exchange for 10
billion paper dollars, thus soaking up the now superfluous paper dollars.
[edit] Increased money supply and inflation
Main articles: Money supply and Inflation
The relation of fractional reserve banking to inflation has been the subject
of debates that have spanned centuries, and can still not be said to have
ended. According to the quantity theory of money, the expansion of the money
supply leads to "more money chasing the same amount of goods" and thus to
inflation. According to the backing theory (see real bills doctrine), as
long as every new issue of money is matched by an equal increase in bank
assets, the value of money is unaffected by a change in its quantity.
Some monetarists 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
reducing the exchange rate and causing inflation. In fact quantity theorists
often call the issue of bank-money 'inflation' and consider a falling
exchange rate merely a symptom of inflation. However, this view is only held
by those who use a broad measure of money supply in the quantity theory of
money. Those who hold that that the price level is only affected by base
currency (minted coin), or base currency and government-issued paper
currency, do not see fractional-reserve banking as having an inflationary
effect.
Others, however, hold that the exchange rate of money is governed by factors
other than the quantity of money. An alternative to the quantity theory
considers the notes and demand deposits to be holding and representing the
value of the non-reserve assets as well as the reserve assets. For example,
if a bank issues notes and holds 10% of the funds as reserves and 90% as
commercial loans (disregarding bank assets supported by owner equity and
term debt), then the value of the currency is unaffected, since when
counting all the assets it supports, there is no deficiency. Another
complementary theory is that the monetary standard of legal tender creates
an anchor on the value of money, independently from the quantity of money.
For example under a gold coin standard, since all notes and demand deposits
may be redeemed in gold coin, and gold coin has its own price relative to
other goods and services, notes and demand deposits payable in gold coin
cannot affect the exchange rate of gold coin, and therefore of notes and
deposits payable in gold coin.
Quantity theorists, understandably are typically either hostile to
fractional reserve banking, or supportive of minimum reserve ratios, and
other government controls on the quantity of money created by commercial
banks. The process with which commercial banks practise fractional-reserve
banking is explained at deposit creation multiplier.
[edit] Financial ratios
The key financial ratio used to analyse fractional-reserve banks is the cash
reserve ratio, which is the ratio of reserves to demand deposits and notes.
For example this could be 10%, which would mean the bank has 10% reserves
for all funds deposited at the bank, with the remaining 90% used for loans.
Term deposits such as certificate of deposit are ignored when calculating
this ratio because the bank only needs reserves to pay the term deposit at
its maturity, and not during its term. Many Countries have even gone to a
zero-reserve banking system, as Canada did in 1991
http://laws.justice.gc.ca/en/B-1.01/. The opposite of zero-reserve banking
would be full-reserve banking.
The 'reserves' part of the reserve ratio, can be most narrowly defined as
legal tender, i.e. assets that can be directly paid out as withdrawals, and
do not have to be exchanged or sold. However, banks and financial analysts
use other liquidity ratios and methods to measure and monitor liquidity in
order to capture other cash outflows and sources of liquidity (such as early
redemptions of term deposits, and lines of credit with other banks,
respectively).
[edit] Possible confusion
The reserve ratio should not be confused with the capital ratio, which is
the ratio of the bank's capital to its assets. The capital of a bank
includes the net worth of the bank (assets less liabilities), and
subordinated debt, which ranks behind the claims of general depositors and
other unsecured creditors, and thereby provides similar protection from
loss. The capital ratio is adjusted by risk-weighting the assets of the
bank, and the result is called the risk-adjusted capital ratio.
[edit] History
<http://upload.wikimedia.org/wikipedia/commons/thumb/e/ee/Circle-contradict.
svg/33px-Circle-contradict.svg.png> This article appears to contradict
another article (History of banking). Please see discussion on the talk
page.
At one time[citation needed], people deposited gold coins and silver coins
at goldsmiths for safe keeping, 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 gold certificates and silver certificates.
As the notes were used directly in trade, the goldsmiths noted that people
would never redeem all their notes at the same time, and saw the opportunity
to issue new bank notes in the form of interest paying loans. These
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. When creditors (the owners of
the notes) lost faith in the ability of the bank to exchange their notes
back into coins, many would try to redeem their notes at the same time. This
was called a bank run and many early banks either went into insolvency or
refused to pay up.
[edit] Government regulation
Banking has been subject to generally a greater extent of government
regulation and controls than other forms of business, and banking law has in
many countries been the subject of extensive political debate.
Government controls and bank regulations related to fractional-reserve
banking have generally been to impose restrictive requirements on note issue
and deposit taking on the one hand, and to provide relief from bankruptcy
and creditor claims, and/or protect creditors with government funds, when
banks defaulted on the other hand. Such measures have included:
1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Peels
Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many
months or even years, and
6. Central bank support for distressed banks, and government guarantee
funds for notes and deposits, both to counter-act bank runs and to protect
bank creditors.
[edit] Influence of central banks
Central banks are government owned and/or sponsored banks that issue notes
and typically receive special privileges in the form of exemption from
restrictions or taxes on note issue, or whose notes are made legal tender by
government fiat (hence the term fiat currency -- the notes are current
(legal tender) by government fiat (law).
Central banks also operate as fractional-reserve banks, and the reserve
ratio policies of the central bank influence specie flows and credit
conditions, making the control of fractional-reserve banking a political
issue, with financial and economic impacts. Also involved with reserve
ratios is the interest rate, because the primary method of attracting
reserves of specie from within a country and from abroad into the central
bank treasury, or stemming their outflow, is to offer higher interest rates
on deposits (central banks take deposits as well as issue notes).
Some political libertarians and some supporters of a gold standard use the
term fractional-reserve banking in reference to fractional-reserve banking
by central banks in particular, where the nation's central bank holds
fractional reserves of gold bullion or specie (gold coin). This occurred
before the adoption of irredeemable fiat money in most developed countries
in 1971 with the collapse of the Bretton Woods system, when the US
government ended the convertibility of the US dollar into gold. This usage
is superficially similar to the standard usage in economics, in that the
ability of a country to redeem only part of its currency in gold can be seen
as analogous to the ability of a bank to redeem only part of its deposits in
cash, but referring to partly-reserved currencies as a form of
fractional-reserve banking may create more confusion than it alleviates.
Mainstream economists do not generally make this analogy.
[edit] Criticisms
Although fractional-reserve banking is near universal, it is not without
criticism. The primary criticisms relate to the financial risk note holders
and depositors bear, and the impact bank notes and demand deposits have on
the stock of money, and allegedly thereby, its exchange rate. Fractional
reserve banking started with reserve of gold and silver, but still continues
in current fiat-money based banking, where money is no longer backed by
precious metals and therefore has no inherent value.
[edit] Risk
Main article: Full-reserve banking
Fractional-reserve banking allows for the possibility of a bank run in which
the demand depositors and note holders collectively attempt to withdraw more
money than the bank has in reserves, causing the bank to default. The bank
then would be liquidated and the creditors of the bank would suffer a loss
if the proceeds from the bank's assets were insufficient.
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.
Responses to the problem of financial risk described above include:
1. Opponents of fractional reserve banking who insist that notes and
demand deposits are 100% reserved, and
2. 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) and
3. Proponents of free banking, who believe that banking should be open
to free entry and competition, and that the self-interest of debtors and
creditors would result in effective risk management.
4. Terms and Conditions of some bank accounts place a limit on daily
cash withdrawals and may require a notice period for very large withdrawals.
[edit] Incompatible with a gold standard
Main articles: Gold standard, Seigniorage, and Austrian
School
Many critics of irredeemable fiat currency see fractional-reserve banking as
incompatible with a return of the gold standard, through fractional-reserve
banking leading to exhaustion of reserves, prompting governments to make the
notes of government-favoured banks legal tender, even though the issuer is
in default. If such defaulted bank notes are made legal tender by government
fiat, as they trade at a discount to their face value in terms of gold coin,
will be a cheaper way to discharge debts, driving out gold coin.
However, other critics of irredeemable fiat currency, from the free banking
school, support fractional-reserve banking, and view the threat to the gold
standard as originating from central banking and government controls on the
formation and winding-up of banks and the business of banking.
[edit] Inadequate government regulation
Critics of current bank regulations argue that:
1. Minimum reserve ratios put reserves beyond reach in a time of need
2. Minimum capital ratios are poor regulators of financial risk, as
they ignore other portfolio risk drivers such as scale and diversification
and come at a heavy compliance cost
3. Government bond deposit schemes distort government bond prices, bank
portfolios and finance methods, and create inflexibility
4. 100% marginal reserve requirements can be met even if the bank has
no reserves
5. Protecting insolvent banks from their creditors creates moral
hazard, and increases the losses bad banks make, and is inequitable, and
6. Central bank support and government protection of creditors creates
moral hazard and socializes credit risk.
Further to this critics also argue that the Federal Reserve System did in
the past and still does currently operate above and beyond the scope of the
federal government.
This can be explained in the abstract:
1. The ability in the past to issue money which was then used to bribe
the congress and individual politicians to consolidate the power and
position it currently holds.
2. The semi private nature in which the bank operates.
3. The longer terms of contract to the federal reserve board members.
4. The deceptive name Federal Reserve System, as it is semi federal and
has little reserve (which has never been questioned by the congress).
And with the direct effect:
1. With the ability to expand or shrink the money supply and thus cause
a deflationary or inflationary recession.
2. Which is achieved by selling bonds (deflationary)
3. Buying government bonds (inflationary)
4. Interest rate control.
5. Discount Rate control
Critics claim this method of creating a purposeful recession has been used
in the past to "fear" the public and governments into a semi or totally
private Fractional Federal Reserve System, which in turn compounds the
problem (as they see it) by further consolidating the issuing power with the
central fractional semi private Federal Reserve System.
Critics also claim the ownership and monopoly of the major print and visual
media was a major factor in the consolidation of the federal reserve power;
this has been achieved they say by the power to stay semi invisible, which
is disproportionate to the immense power that federal reserve bank holds,
and in contradiction to democratic human rights, which state that a
representative of an economy must have a duty of care and engagement to the
citizens who participate in that economy.
[edit] See also
* Bimetallism
* Bretton Woods system
* Credit money
* Debt-based monetary system
* Digital gold currency
* Fiat currency
* Full-reserve banking
* Gold standard
* Islamic banking
* Money supply
* Money creation
* Monetary reform
* Seignorage
* List of economics topics
* List of finance topics
* List of business ethics, political economy, and philosophy of
business topics
[edit] References
* 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.
* John F. Kennedy vs The Federal Reserve
<http://www.john-f-kennedy.net/thefederalreserve.htm>
* More John F. Kennedy vs The Federal Reserve
<http://mcadams.posc.mu.edu/weberman/jfk.htm>
[edit] External links
* Rothbard, M. N. (1983) The Mystery of Banking, Richardson & Snyder,
1983, pp 87-110 <http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf>
* Narrow banking <http://ideas.repec.org/p/lev/wrkpap/77.html>
* Money upside down
<http://elib.suub.uni-bremen.de/diss/docs/E-Diss1237_Dis_Money_upside_down.p
df>
* Seignorage and inflation tax
<http://www.unimaas.nl/media/um-layout/fdewb/opmaak.htm?http://www.fdewb.uni
maas.nl/algec/block/framespages/1203/Seignorage.htm>
[edit] Libertarian viewpoint
These links discuss "fractional-reserve banking" using Libertarian
terminology, from a Libertarian point of view. They are cited here because
as of 2003 Libertarians are a group that has been vocal in attacking the
practice.
* Fractional-reserve banking
<http://www.lewrockwell.com/rothbard/frb.html> Murray N. Rothbard uses the
term "fractional-reserve banking" in reference to both commercial and
central bank practices. He characterizes the customary modern-day practices
with terms such as counterfeit, swindle, and "creating money out of thin
air," and asserts that "the general public, not inducted into the mysteries
of banking, still persists in thinking that their money remains 'in the
bank.'"
* Money, Banking, and The Federal Reserve <http://mises.org:88/Fed> ,
afs video stream from The Ludwig von Mises Institute. Good presentation of
the Misesean case against the Federal Reserve System.
* The Libertarian Case Against Fractional-Reserve Banking
<http://www.anti-state.com/article.php?article_id=416> is a critical
analysis of Rothbard's views by Gene Callahan, who finds them unconvincing,
and asserts that banking practices are compatible with Libertarianism, or
could be made so with only minor alterations. He discusses at length (but
inconclusively) the question of what depositors actually believe, which he
sees as relevant to the charge that fractional-reserve banking is fraudulent
or deceptive.
