Fractional Reserve Banking Explained – a Definitive Guide

Introduction to Fractional Reserve Banking Guide

Fractional Reserve Banking is the practice of holding bank deposits as cash and loaning out a greater amount against that cash, essentially creating the additional money. The practice has gained wide acceptance due to it’s power and flexibility, but has many detractors due to a number of shortcomings – discussed here.

Fiat Money System Origins

Is it a wonderful life?

In 1776, the Continental Congress declared anyone who would not accept the paper Continental an enemy of the state. That’s the essence of a fiat currency – the government mandates its acceptance.

Though less overt in the case of modern fiat currencies, the issue is forced nonetheless. And the currencies, of course, are not issued by the government, but banks. A private enterprise of the central bank is government enforced – it is the very anti-thesis of a free market.

There’s a lot of context in the gold wars. Some of the important things to understand are fractional reserve banking, shadow banking, and the central bank system. That’s because physical gold is extremely simple in its operation. It just sits there. It can be made into coins for exchange or bars for storing wealth or used to back money and so forth.

These functions are pretty straightforward. The banking, financial and investment systems, by contrast, are complex to the point of incomprehensibility. Individuals can only know sectors. 

Though gold-holding gave rise to modern banking, the two have radically diverged. Physical gold and modern banking are now mortal enemies, strange as that may sound. Gold has an inherent value due to its scarcity and cost of creation.

Banking instruments have no inherent value – they are created from nothing in unlimited supply. The bewildering array of modern instruments serve as a hidden form of money. They are the spawn of the fractional reserve system – at heart, a system of credit and debt.

The first known use of credit appeared among the Babylonians around 1300BCE with mortgage security and deposits. Babylon extended it with bills of exchange, enabling trade to faraway nations. Rome refined it much further to assist trade in the complex empire.

Credit survived the fall of Rome because traders preferred it to the dangers of porting solid coin around. The Middle Ages and finally the Renaissance saw a well-developed system arise.

During this later period, Great Britain emerged as a world financial power, using credit to devastating effect to create the first soft hegemonic empire. The great secret was the discovery, by the goldsmiths, of the fractional reserve system. 

Goldsmiths held money for the wealthy in vaulted storage. They issued gold certificates, paper claims on the gold, in exchange for the metal. These were used in trade far more than specie itself. Physical metal was too bulky and risky to transport.

The goldsmiths soon realized that no more than 10% of the metal on hand was ever claimed by the current owners. The goldsmiths began to loan out more paper certificates than they had gold against the claim.

They stabilized this at a ratio of 10 paper ounces loaned per ounce of physical. By storing 1000 ounces of gold, the goldsmith could loan, at interest, 10,000 ounces of paper gold. These certificates are now called bank notes – Federal Reserve notes, Euros, Yen and the like.

Bankers had found the power to create money out of nothing. Soon enough, the method expanded from issuing banks to depository institutions. Many checks simply moved funds from one depositor to another within the bank – no funds were withdrawn from the bank.

The use of checks allowed banks to simply create a deposit in the borrower’s name without putting out any real cash. Bankers, of course, seldom call it what it is – money from nothing. They also fail to explain the enormous power and benefit it confers on the bank – the right to take profits on thin air, based on a power no one else has.

The British war with the French illustrates the power. Military war is inevitably fought in large measure as financial war, too. England was the great purveyor of credit, money from nothing.

Napoleon was convinced his system of sound money would defeat the vaporous credit creation of the British. He lost, of course, and part of that is the testament to the awesome power of fractional reserve banking.

The rest is history. The Federal Reserve was created in 1913 and managed to institutionalize itself. The public ceased questioning and it put up a staid and boring façade. The banking system was clouded in a fog of opaque terminology and the public mind simply turned off.

After the Great Depression and WWII, the system seemed to work very well, especially for the US. No one wanted to wag fingers at a system that seemed to benefit the entire nation.

Then as now, when the government wants money, it asks the Federal Reserve. The Treasury creates bonds and sends them to the Federal Reserve in exchange for Federal Reserve Notes. This increases the national debt, of course.

There is no particular reason why the government cannot simply create its own currency. In fact, the Constitution specifically disallows the current situation, according to many interpretations. 

Modern Fractional Reserve Banking

Most modern systems of banking are fractional reserve. When a bank takes money by deposits or borrowing from the Fed (base money), it can loan out 90% of the money. Doing so, it creates the new money to loan out, keeping the original money on its balance sheet.

That new currency created by the credit loan is then deposited into the next bank, which can repeat the process. Often the money is deposited right back into the initiating bank. An initial $1000 of base money can turn into $18,000.

The ‘money multiplier’ formula is M=1/R. R is the reserve requirement, so a requirement 10:1 means supply can be increased by 10 times. Banks have many means to stretch the reserve requirements.

Monetary Base
Holy Cow – Look at Covid’s borrowing rate -Impressive!

An important concept is iterations – the number of times money is cycled through the system. There is an expansion limit defined by the formula: Loans = (Initial Deposit ÷ Reserve Requirement) − Initial Deposit.

In real numbers, $9,000 = ($1,000 ÷ 0.1) − $1,000 = $10,000 − $1,000. It’s a pyramid scheme. Banks only hold 10% (depending on reserve requirements) of depositor money. When depositors all want their money, due to lack of confidence, there’s a bank run.

uh, wha-a-at? the fcuk?

Banks cannot pay in a run because they are out of money. They cannot call in loans because they have no right to change the time requirements on loans.

For the system as whole, interest is the real killer. While the money for the debt is created at the time of the loan – the interest is not. Because the principle is extinguished when paid, there is always a formal shortage of currency.

The money supply must be constantly expanded to account for this. Over a 15 year (or longer) loan, at 5%, the interest exceeds the principal, and both must be paid back. Since most loans are of this long-term variety, the amount owed is about twice the amount that exists.

The debt can never be repaid, no matter what. It is impossible and the system is constructed that way. Compound interest eventually eats up all the real wealth of society. It creates an engorging banking system that has no utility other than to loan money out and suck more back in.

That’s why people are angry and that’s why interest is illegal in certain religions – like Islam. In fact, total global debt is $170 trillion, but global GDP is only $90 trillion.

This creates the fundamental bind of the modern system. Because of the nature of the fractional reserve system, there is always more money owed than exists. The principal is created by the banks, but the interest owed is not created.

The system demands perpetual growth in order to maintain the worldwide debt service. The chart shows debt creation going parabolic. That’s a major part of the reason for $1 trillion plus federal deficits. 

How the crap does that work?

The Central Banks, in the standard narrative, exist to manage the system – to oversee the risk of bank runs, to be the lender of last resort, and to set up situations for depositors insurance. CB’s have increasingly parlayed the monetary control function to individual banks, attempting to control through interest rates.

Most, but not all, Central Banks mandate a reserve requirement. This limits the overall money supply, allows the CB to control the supply by raising/lowering rates, and (supposedly) keeps the banks solvent and liquid – having the money to meet depositors’ demands. Loan creation of new money by multiplying reserves creates systemic risk when leverage gets too high.

Most systems go at 10:1, a system that seems to work for a while until it hits the wall, which is why it exists. Most banks have found the means to increase leverage dramatically through the shadow banking system.

Non-depository institutions (investment banks like Goldman Sachs) have no reserve requirements. G-Sax is several hundred to one. The entire Euro-bank system is 25-1, much worse than the overleveraged US system. MFGlobal was 100 to 1 when it blew up. 

The upside of huge leverage is spectacular profits. At 100 to 1, a 2% rise in the investment triples the base assets – a 200% profit. The downside is that a 2% drop in the investment pushes the bank deep into the red. Insolvency can happen literally in a few seconds to even fairly large funds of tens of billions, if their risk is bad enough.

The problem jumps up the scale from institutional to systemic risk in a number of ways. In 2008, it happened through large insurance firms. When AIG insured CDO’s against decline for less than .5% of the redeemable value, the downdraft rendered them insolvent.

Counterparties were twisting in the wind until the government stepped in to backstop the situation. The Treasury made a number of banks good with a haircut. Only Goldman Sachs was made 100%. The situation is much worse today – a ticking bomb. 

To explain it in simple terms – if Bobby loans Johnny a million dollars and he blows it in Vegas, Bobby owns a million dollar asset he will never collect on. Johnny can’t get the money. If hundreds of Bobbies loan a handful of Johnnies a million, then the system is at risk through systemic instability.

Fractional Reserve Creates Systemic Instability – Minsky

Minsky’s instability hypothesis arose to prominence in 2008, especially during the failure of Lehman Brothers. The phrase Minsky moment was coined. Hyman Minsky was an economist inspired by the Keynes school.

The basic premise is quite simple – “Capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement–inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.”

His theory is notable in breaking from classical, Adam Smith doctrine. Smith believed that capitalist systems inherently moved toward stability. Minsky believes that the instability problem is a modern one, created partly by government.

Government tries to perpetually goose the markets, keeping the economy growing, at least nominally. This lessens downside business risk, but it increases the inflationary problem. Debt and its systemic validation are important aspects of the hypothesis. It also takes into account the profit-seeking nature of banks, which Keynes Quantity Theory of Money ignores. 

Minsky is right, of course – banks try to make money. As creators and holders of money, this makes their leverage upon the system inherently larger than other institutions. More importantly, innovation is a key approach to profits.

Since banks are primarily creators of the money supply, that innovation leads to constant change in the character of money. What money is cannot be stably defined in a profit system of banking. This is a very notable concern with shadow banking, where much of what counts as money is not what the man on the street would call money. In fact, with many of the complex derivative structures, there are some forms of money completely beyond human comprehension.

Banks, trying forever to increase the money supply, are in conflict with regulators, trying forever to constrain it. When the banks go overboard, expanding the money supply through extreme innovation, the CB is sorely tempted to step in and stabilize the system through intervention. This has the perverse effect of legitimizing the innovation. Ever-more destabilizing innovations become the norm, pushing a stable system into instability.

Therefore, the ‘income-debt’ relationships break down into three: hedge, speculative and Ponzi. Hedge units are the most conservative – they meet payment obligations based on cash flow. Speculative units need to roll over principal debt as it matures in order to maintain financing. A Ponzi unit cannot even finance interest payments on its cash flow. It must borrow more and more just to keep even, watering down its equity. 

One of the main sources of stress in fractional reserve banking is the duration mismatch. Lenders take in deposit money of zero term duration – it can be immediately withdrawn. They then use it to back long-term loans which will not be paid back for decades sometimes. When a CD used to back a loan matures, the money loaned out on top of it has not been paid back.

The bank develops massive liquidity problems. In recent years, there have been enormous defaults on loans. This creates solvency issues on top, because the loans are no longer worth anything.

Since most capital for these loans comes from savings accounts, the banks cannot pull in the money in the event of a bank run. The mismatch is between zero time versus 15 years. The ratio approaches infinity in theory, but realistically is about 1000 to 1. It takes a few days for a real bank run to crest. 

The run is currently slow-motion. Large investors are letting CD’s mature, but not renewing them due to the abysmal returns. Most CD’s pay less than 1%. As investors continually pull money out of the system, banks have to sell assets to cover this problem and get their reserves up.

This is a seemingly obvious problem of allowing a bank to use customer funds as bank reserves – it’s not the banks money, but they use it as if it is. The first assets sold are often sovereign bonds. Banks like these because they can hold a lot of money and have a liquid market. They’re easy to sell. And government debt is considered safe.

This isn’t all that true – governments can default. There is also the lower order of risk – loss of bond values. If the system experiences massive stress, all banks dump bonds. The bid disappears and the price tanks.

This has been happening with Southern Europe, especially Greece and Spain. In the US, the Federal Reserve has been taking up the slack, but this only turns the risk into an inflationary one, where every paper asset loses value even as it goes up in nominal price.

The effect is hugely amplified, however. The bank first takes a loss on the sold assets, but because the value of such assets is linked to Treasuries, the unsold assets lose value as well. Their asset side of the balance sheet starts to bleed worse and worse, but the liabilities do not go down.

So the banks take a double hit. The selling assets go for less and the held assets are priced down. However, mega-banks can legally use fraudulent accounting – permitted by a Bush administration executive order suspending Federal Accounting Standards Board rule 157 for entities deemed critical to national security. 

The banks are more insolvent than we are being told – probably by a very wide margin. The banks are limited to a 10:1 fractional limit. As their asset base declines, they cannot loan money because their reserve limits are already exceeded. Borrowing short and lending long creates inevitable stresses. There is a limit to how many balls can be juggled.

To bring this back to Minsky – if most institutions are hedges, then the economy tends toward stability. As it moves into more speculative and Ponzi organizations, the economy moves towards instability. Such situations amplify deviations, rather than suppressing them.

Most hedge funds, for example, are no longer hedge funds. They have increased leverage to frightening proportions. In a downdraft, their balance sheet suddenly goes negative. All the world’s largest banks operate in this manner now.

The largest sources of capital are Ponzi, or at best, highly speculative. The indication that they are actually Ponzi-financing is the 2008 bailouts. None of the banks were able to make payments on their obligations and had to ‘borrow’ enormous government sums to stay afloat. It’s a classic Ponzi tactic. Even if investment is profitable, leading to increased demand, this merely pushes the system toward greater speculative frenzy and hence, increased instability.

Theorem 1: any system has stable ‘financing regimes’ and unstable ones. Theorem 2: Extended prosperity pushes a system from stable to unstable forms. Government actions worsen this. If the system has high speculation and regulators try to contract the money supply, then speculative units instantly turn into Ponzi units by the decrease in available money.

The sudden forced sales of assets cause a deflationary asset price spiral. If government expands money supply to cover obligations, the new money goes quickly into parabolic speculation – gambling – turning the volume on the problem much higher, but pushing it down the road a few months or years. 

The hypothesis places the problem squarely inside the system itself, unlike other theories which rely on exogenous shocks. It is internal to capitalist economies, like a law of nature. Government and regulatory systems always serve to exacerbate the problem once it arises.

This compelling and seemingly prescient theory misses a crucial point. Fiat currencies are the very stock in trade of instability economics. The gold standard, while not a cure-all for economic ills, definitely has a highly stabilizing effect. It can create deflations, to be sure.

These are typically moderate, and – due to balance of payment realities when money is restricted by natural law – self-correcting. A deflation causes a nation’s goods to be more attractively priced, drawing gold inwards in exchange for goods. An excess of gold (money) causes an increase in price of goods.

Neighbors have attractively priced goods, causing gold to flow away. The system is self-balancing. Fiat currencies have no restrictions on monetary creation, annulling the self-correction and leading to amplified imbalances.

When the fixed relationship of other currencies to the dollar ended, floating exchange rates came into being. The massive Forex market of currency speculation was born. Tens of billions of dollars, euros, and other currencies flow back and forth, seeking a favorable exchange rate advantage to eke out a tiny percentage profit on great sums every day. 

Floating exchange rates create horrendous situations for small and developing nations. If they are caught in the eye of the world, then ‘hot’ money floods in. By investing in the local banking system, $10 billion becomes $100 billion or more. This upends the economy of a small country – Thailand is an example. Inflation rates go astronomical.

Millionaires are made, most by too much leverage, and will go bankrupt. Many citizens are impoverished by an inability to keep up with the inflation rate. Development goes through the roof. Local resources are purchased by foreign corporations, the government goes up for sale to the neo-liberal economic establishment, corruption and graft become extreme.

Eventually, the economy is seen as a bubble and the hot money withdraws, leaving an enormous debt burden and a crushing deflation. The lack of currency leads to a currency printing binge and borrowing from the IMF to prevent economic collapse. After, the best companies are foreign owned. Lesser companies are bought and dismantled for quick sale. With a fixed exchange rate, this problem would not exist. Likewise with fractional reserve banking.

The fractional reserve system has been legally tested and, at least once, lost. In 1967, the First National Bank of Montgomery, MN tried to foreclose on Jerome Daly. The case went to county court as First National Bank v Daley.

Daley’s defense was curious – the bank could not foreclose because it had not created anything of value in order to purchase the house. The $14,000 was not silver or gold, i.e. constitutional money, but merely a bookkeeping ledger. The banks response was that it was standard practice. The bank could not cite a statute authorizing its right to create money in such a manner. The judge issued a statement after the case:

There was no material dispute in the facts for the jury to resolve. Plaintiff admitted that it, in combination with the Federal Reserve Bank of Minneapolis, who in the law are to be treated as one and the same bank, did create the entire $14,000 in money or credit upon its books by bookkeeping entry.

The money and credit first came into existence when they created it. Mr. Morgan (for the bank) admitted that no United States law or statute existed which gave him the right to do this. A lawful consideration must exist and be tendered to support the note. [There can be] no claim based upon or in any manner depending upon a fraudulent, illegal or immoral transaction or contract to which plaintiff was party. No complaint was made by plaintiff that plaintiff did not receive a fair trial. The path of duty was made clear for the jury. Their verdict could not reasonably have been otherwise.

The bank appealed, paying $2 in Federal Reserve Notes to the court. These notes were refused by the judge who cited article 1, section 10 of the Constitution: “No state shall make anything but gold and silver coin as tender in payment of debts.” The bank abandoned its claim at that point. A number of other claims have gone to court, but Daley is the only successful plaintiff against the banks to date.

Conclusion to Fractional Reserve Banking Explained

Fractional Reserve Banking is a bizarre animal. It does lead to rapid growth, but the debt problems eventually come back to haunt us all. The instabilities mount, as we are seeing in 2008 and again in 2020. The Covid-19 money printing will carry knock-on consequences. What are they?

Why is the Fractional Reserve Banking System Necessary

Fractional Reserve Banking is not necessary, but it’s very useful for expanding (and theoretically contracting) the money supply.

Should Fractional Reserve Banking be Abolished?

Not necessarily, but it should be more transparent. Bank bailouts are a dangerous potential of FRB and lead to extreme moral hazard. Most importantly, it allows the most-connected, closest to the money to profit from inflationary funds first by accessing the money before inflation occurs.

Who invented Fractional Reserve Banking

No one actually invented it, per se. It came about through goldsmiths, primarily, who held customer gold, then loaned out various notes of credit backed by the gold they held. Some were less scrupulous and loaned out more than they held, thus increasing interest income. Eventually, these early ‘bankers’ discovered that a ratio of 10:1 (loans out:gold held in trust) was a workable ratio because far fewer than 10% of people ever demanded their money during the same period.
Here is an explanation of a very early record of bank accounts, probably among the earliest examples of (likely) Fractional Reserve Banking.

What is the purpose of fractional reserve banking?

Fractional Reserve Banking was invented by Banks, then adopted by Central Banks as a means to 1) control the money supply via inflation and deflation and 2) to increase interest earnings through increased loan capacity.

Is Fractional Reserve Banking Bad?

Some think it is very bad. The risks are real – bank runs and moral hazard among the worst of them. The system does have a significant plus in that it allows for rapid expansion of capital for business and entrepreneurs.

What are the risks of Fractional Reserve Banking?

1) Bank runs – if there is a panic about the banks solvency, depositors can pull out more money than is available, pushing the bank into insolvency. this is due to duration mismatch of time-deposited funds versus loaned out money. (ie, loans are not instantly callable).
2) Moral hazard – banks can artificially increase their loaned out amounts through various methods to increase profits. But this also increases loss risk. The Federal Reserve or other central bank then will backstop the bank to prevent failure. This causes the moral hazard of high risk because the risk is publicly offloaded.
3) Inflation – Fractional Reserve Banking almost inevitably increases the money supply, leading to steady inflation, punishing savers.

What is the Reserve Ratio

The Reserve Ratio is the amount of capital banks must retain versus the amount loaned out for optimal solvency. Various countries have different requirements. Canada has no regulatory ratio. The US ratio is 1:10.