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There’s An Obvious Answer To Fractional Reserve Banking – It’s A Useful Fraud

It’s entirely true that fractional reserve banking is a fraud, a Ponzi, it’s simply outrageous how credit, or wide money, is created. Murray Rothbard was entirely correct:

In The Mystery of Banking (1983), the anarcho-capitalist economist Murray Rothbard called fractional reserve banking “a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.”

Nowt wrong with that statement.

That is not, however, the end of it. What we actually want to know is whether fractional reserve banking is a useful fraud. Which it is.

As we all know all economics is either footnotes to Adam Smith or wrong. And Smith touches upon this in Wealth of Nations. It’s an exercise for the reader to find the exact passage but there’s a bit about commercial banks issuing a bit more paper than their capital or deposit bases would justify. This being a rather useful thing they’re doing.

So, that’s that then, Smith says it’s fine and we need think no more.

There are those occasional reprobates who do not understand that all economics is only footnotes to Smith or wrong. So, for those who are proven to be hard of thinking as a result of that mistaken belief, an explanation.

The big thing that fractional reserve banking does for us is maturity transformation. Yup, dontcha’ just love the jargon?

So, think about a world without it. 100% reserve banking as it’s called. A bank can only lend out the money that it has on deposit (plus it’s own capital of course). Further, it can only lend it out for the same period of time that the depositor has lent it to the bank. That’s what the absence of fractional reserve does mean.

There’s going to be a hell of a shortage of mortgages in this world, isn’t there? We desire to borrow money for 30 years to pay for that des res. How many people save money in a bank account for 30 years? OK, now qualify that, how many not mad people leave money in a bank account for 30 years?

What fractional reserve allows is the bank to collect up all of the short term deposits that we put in there and then lend it out in long terms loans. Bercause they’ve not got to have deposits which exactly match the loans they make. Sure, this creates problems:

A fractional reserve system is subject to the possibility of bank runs. And that’s what 2008 was, it was a wholesale bank run.

Another way to put this is that fractional reserve banking allows banking. As Brad Delong continually points out, if you borrow short and lend long then you’re a bank. If you’re not doing that maturity transformation then you’re not doing banking. Maturity transformation requires fractional reserve. And yes, we really, really, want to have maturity transformation.

So, there’s a simple enough answer to this debate question:

Does fractional reserve banking endanger the economy?

Yes and it’s worth it.

Fractional reserve banking means the entire financial system is at risk of falling over. The very same bug that gives us this also delivers maturity transformation – that second making the first risk reasonable.

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6 years ago

One need not require that a specific loan be matched with a specific deposit to insist that a person, or a bank, loan no more than than the total amount entrusted to it. The fraud of fractional reserve is that I get a loan from the bank that has nothing backing it. Now, yes, there are deposits backing it, but they are also backing seven other loans at the same time. This is thought to be all right, as not all seven loans will go bad at the same time. But once a generation, they all seem to be ready… Read more »

bloke in spain
bloke in spain
6 years ago

It is hard to see why FRB is required to do maturity transformation, in a properly run banking system. One presumes there will always be a pool of short term deposits to draw on and as long as the bank doesn’t lend out from that pool too high a proportion as long term loans, it should be secure. This how the building societies used to operate The question has to be asked, why is the bank making long period loans in the first place? To benefit who, apart from the bank? Where does the risk go? Under FRB, it’s socialised.… Read more »

6 years ago
Reply to  bloke in spain

Agree. Deposit insurance is not really a risk-sharing arrangement but a tax, with the understanding that, if the bank takes excessive risks and fails, the taxpayer makes depositors whole. “Too Big To Fail” is not the same thing but a declaration that, if a bank is large enough that its failure would “endanger the system” through those large craters and disappeared staff and stuff, the government can engage it in a ruinous scheme of prior restraint with the goal of “preventing” what other aspects of regulation encourage. (The only remaining bill in this Congress with bipartisan support sufficient to surpass… Read more »

Ralph Musgrave
4 years ago

Tim Worstall’s point is simply that maturity transformation enables commercial banks to create liquidity / money. Unfortunately as Messers Diamond and Rajan point out in the abstract of an NBER working paper (No 7430) banks have to have …”a fragile capital structure, subject to bank runs, in order to perform these functions.” I.e. money creation by private banks involves risks, as if that is not blindingly obvious given the 2007/8 bank crises. But those risks are ENTIRELY UNNECESSARY, given that central banks can create any amount of money WITHOUT the above risks! And not only that, but commercial banks are… Read more »

4 years ago

There is one simple reason fractional reserve banking is wrong

Maturity transformation = moral hazard.

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