Fractional reserve banking

Fractional-reserve banking (or FRB) is a banking regime in which banks accept base money from customers in return for demand claims on the same amount, without maintaining enough reserves of base money to redeem all of the claims at any one time. A bank maintains a fraction of the money it has promised in reserve, in the hope that it will be able to redeem all claims that occur in practice because only a small number of demands for redemption will be made at any one time. The difference between the money accepted and the money retained in reserve is invested in loans or assets, with the returns being legally pocketed by the bank. Although in modern banking law, the amount of base money (currency, or transfers of central bank reserves from other banks) tendered by the customer is not in any legal sense a deposit, by tradition the account balance is referred to as such. Fractional reserve banking, and the right to refer to what is actually a loan contract as a "deposit" contract are currently legal and practiced by all commercial banks.

The practice of fractional reserve banking expands credit and the circulating media (broad money). Due to the prevalence of fractional reserve banking, the broad money supply (so-called "deposits" plus cash) is a large multiple of the amount of base money--the amount of specie held in the banks' vaults in the case of a metallic monetary regime, or currency plus bank reserves in the case of a fiat monetary regime. That multiple (called the money multiplier) is regulated by a number of factors. Most importantly, each bank's owners are motivated to maintain sufficient reserves to handle any likely simultaneous rush of demands for withdrawal or drafts. In a liberal economy, the law respects a bank customer's property rights, shutting down the bank and distributing its owner's capital to make good on its contracts the moment it fails to make good on its contract. Even in a class-based society which grants bankers special privileges by legally sanctioning "suspension of payments of specie" like the early U.S., there are costs in terms of reputation lost. Secondly, they are highly motivated to maintain the trust of their stockholders and creditors. Finally, they may be limited by the reserve requirement or other financial ratio requirements imposed by financial regulators. Prior to 2008 in the U.S. banks were in practice regulated by this last factor, the reserve requirement. Since then it has been irrelevant.

In legal terms, instead of a deposit being considered a bailment contract with the bank being the custodian of the funds deposited as trustee for the depositor with fiduciary duties not to embezzle or misappropriate the funds, banks since the 19th century have been allowed to consider the deposit (available for immediate withdrawal) "their money", and they are able to do with the money as they wish, provided they recognize the deposit as a general liability on their books of account. In the current legal regime, the depositor no longer "owns" any money when the deposit is made. The depositor is merely an unsecured creditor, relying on the central bank to bail out the bank should a bank run occur, with no further recourse against the bank.

The alternative to fractional reserve banking is "100% reserve banking" or "full reserve banking" where banks treat deposits in a similar way to allocated gold accounts, where the money cannot be lent out for extended periods of time as the money is held in trust on behalf of the client. In this system, only those funds from depositors who volunatarily kept their money with the bank for an extended period (so called "time depositors" or "term depositors") would be available for lending to third party borrowers.

The Case Against FRB
There are moral, ethical and pragmatic economic arguments against the practice of fractional reserve banking.

Some ethicists and economists, such as Murray Rothbard, Jörg Guido Hülsmann and Jesus Huerta de Soto consider the practice to be a form of recursive embezzlement and therefore a form of theft against legitimate deposit-holders and a form of counterfeiting against the monetary and property interests of the general populace - in particular savers who are deferring consumption and trying to avoid indebtedness.

The Ponzi or pyramid-like dynamics inherent in fractional-reserve banking allow early participants in financial bubbles to profit at the expense of genuine savers. For example, bankers and property developers who moved their money into Treasury bonds prior to 2008 made significant profits from the 2000s property bubble, but small businesses in the real economy suffered very high inflation (due to high housing costs) and economic disruption when the bubble burst, without being able to profit from the bubble.

Aside from the criticisms relating to the dislocating effects of the Ponzi-like dynamics inherent in the practice of fractional-reserve banking, the primary economic criticisms relate to its alleged destabilizing effects through the Austrian Business Cycle Theory.

The reason that so many negative effects flow from fractional-reserve banking is that it necessarily distorts and confuses property rights over money.

By employing its excess reserves for the granting of credit, the bank transfers temporary ownership of those monetary reserves to borrowers, while the depositors (supposedly entitled to instant redemption) are supposed to retain their rights to claim redemption over the same funds - funds that no longer are in the custody of the bank and now appear in another bank's account.

It is physically and practically impossible that a depositor and borrower are entitled to exclusive control over the same physical cash resources. Two individuals cannot be the exclusive owner of one and the same thing at the same time. Accordingly, any bank pretending otherwise - in assuming demand liabilities in excess of actual reserves - must be considered as acting fraudulently and should be considered to be engaged in a straightforward act of embezzlement. Its contractual obligations cannot be properly fulfilled and it is technically trading whilst illiquid and therefore (arguably) trading whilst insolvent as it cannot pay all its debt as and when they fall due (the due date for payment of demand deposits is always now). From the outset, the bank must be regarded as inherently bankrupt - as revealed by the fact that no bank can ever withstand a sustained bank run.

According to Rothbard, fractional reserve banking should be considered to be embezzlement, but it is legal now. The bank is technically insolvent, because it cannot pay its debts as and when they fall due - the deposits being due instantaneously at any time. However, unless the customers (depositors) demand too much money at once – or too many loans fail – it can continue running, without the customers ever noticing that their money was gone. If the bank's customers lose confidence in the chances of the bank's repayment, they can decide, en masse, to cash the deposits in. This loss of confidence, if it spreads from a few to a large number of bank depositors is called a bank run. Unless the central bank intervenes or other banks come to its rescue, a bank run is always fatal, because, by the very nature of FRB, the bank cannot honor all of its contracts.

Banking cartels
If a lone bank engages in FRB, it can be ruined by a bank run, or people, who are not its customers, or other banks, demanding redemption of their receipts. A group of banks can agree to accept each other's receipts and not call for their redemption. This would limit the weaknesses of FRB, but in turn introduce the problems of cartels. The banks would need to expand in proportion, otherwise some will enjoy greater profit, while the rest will pay for it. Regional and seasonal differences may also come into play. The difficulty of coordination rises with the number of banks in a cartel.

However, cooperation in a cartel is much easier if the members are forced to it by law. A Central bank can enable all the banks to expand together so that one set of banks doesn't lose reserves to another and is forced to contract sharply or go under. A central bank is the lender of the last resort, bailing out the banks if necessary – this also increases the trust of the public in the system.

The Case For FRB
However, not all hold to such a stringent view of legality. In particular, the Free banking school asserts that the Principle of Adverse Clearing, a market signal by which banks can settle upon an equilibrium interest rate with respect to consumer demand for banknotes (and analogous to David Hume's Price-specie flow mechanism), is sufficient to prevent a fractional reserve system from becoming inflationary or unstable. Bank runs under a fractional reserve system can also be prevented by contract features such as an option clause. Indeed, so long as the banks' contracts make clear such activities beforehand, a legal or natural rights case against FRB cannot be made.

The amount of loans a single bank may make under a free, fractional reserve system is limited by the size of its clientele, by the confidence of the public in its solvency, and by the demand of the public for banknotes (as opposed to specie). An increase in any of these allows the bank to hold lower reserves. Conversely, smaller banks, riskier banks, and banks in a climate that demands specie (these factors may be interrelated) must hold a higher fraction in reserves in order to attract clientele. In this way, fractional reserve banking - far from theft or embezzlement - is a beneficial market signal and the result of voluntary human action that in itself poses little risk of systemic instability.

Others argue that, regardless of the ethical or legal implications, fractional reserve banking has allowed capital investment and economic growth in excess of what a full reserve system would have allowed.

Legal aspects
Roman law recognized that bankers were often tempted to use the deposits for themselves. To penalize these actions, they should be not only charged with theft, but to pay interest "so that, in fear of these penalties, men will cease to make evil, foolish and perverse use of deposits".

In early medieval Europe, the bankers preserved their deposits fully at first, but later began to use them for their own purposes, creating deposits and granting credits out of nowhere. Since the canonical law banned the charging of interest on loans, borrowers would instead pay "penalties" for "delays" in payment and in effect pay interest on a disguised loan, and justified any misappropriations on this basis. This practice was defended by some scholars, while others wanted to expose all hidden loans and equated all deposit contracts for loans. As a result, the distinction between them was obscured. Experts failed to clear up the resulting legal chaos until the end of the nineteenth century.

The authorities failed to enforce sound banking practices, and often granted banks a government license to operate with a fractional reserve, while taking advantage of easy loans to finance governments and public officials. Some rulers created government banks to reap the profits. But banks were still required to guarantee deposits.

As late as twentieth century, court decisions in Europe have upheld the demand for a 100-percent reserve requirement. In 1927, the Court of Paris convicted a banker for the crime of misappropriation for having used the funds deposited with him by a client, confirmed in 1934. After the failure of the Bank of Barcelona the Spanish Supreme Court also pronounced, that "the depositary does not acquire the right to use the deposit for his own purposes".

Fractional reserve banks never informed their depositors that some or all of their deposits would actually be loaned out and so could not possibly be ready for redemption at any time. (Even if the bank were to pay interest on deposit accounts, and hence it should have been clear that the bank must loan out deposits, this does not imply that any of the depositors actually understand this fact. Indeed, it is safe to say that few if any do, even among those who are not economic illiterates.) Nor did fractional reserve banks inform their borrowers that some or all of the credit granted to them had been created out of thin air and was subject to being recalled at any time.

Legalization
The landmark decisions came in Britain in the first half of the nineteenth century. In the first important case, Carr v. Carr, in 1811, the British judge, Sir William Grant, ruled that since the money paid into a bank deposit had been paid generally, and not earmarked in a sealed bag (i.e., as a "specific deposit") that the transaction had become a loan rather than a bailment. Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued correctly that "a banker is rather a bailee of his customer's fund than his debtor,. . . because the money in . . . [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up." But the same Judge Grant again insisted that "money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount." In the final culminating case, Foley v. Hill and Others, decided by the House of Lords in 1848, Lord Cottenham, repeating the reasoning of the previous cases:

"The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted."

These decisions were taken over by the American courts and so was FRB legalized. However, an interesting development occurred in grain warehouse law, which has developed in precisely the opposite direction, despite the conditions of depositing fungible goods were exactly the same, and grain was a general deposit and not an earmarked bundle.

In the history of the U. S. grain market, grain elevators several times fell prey to this temptation, spurred by a lack of clarity in bailment law. Grain elevators issued fake warehouse receipts in grain during the 1860s, lent them to speculators in the Chicago wheat market, and caused dislocations in wheat prices and bankruptcies in the wheat market. Only a tightening of bailment law, ensuring that any issue of fake warehouse receipts is treated as fraudulent and illegal, finally put an end to this clearly immoral practice. Fractional-reserve grain warehousing, that is, the issuing of warehouse receipts for non-existent goods, was clearly seen as a fraud.

Securitization
Known since 18th century, securitization as it is known today was created in 1970, when the Government National Mortgage Association (Ginnie Mae) issued a mortgage-backed security (MBS) in the form of a pass through. Securitization has had an exponential growth since.

Economic actors can obtain rights to future payments of money - for instance, a car dealer that sells his cars on credit for five years in exchange of his cars. Such credits are relatively illiquid because their characteristics tend to be sector and client specific. Their owners may prefer to exchange them for an amount of money that is available now. Each of these claims can be passed to an economic actor that has the opposite preferences. Or, relatively similar claims, possibly coming from different owners, could be grouped together within a single holding entity that could then create standardized claims to be sold to investors on the financial markets. This process of putting together relatively illiquid assets and using them is called securitization - "... the process of pooling and repacking loans into securities that are then sold to investors."

Securitization allows FRBs to withdraw from the market the credit they have created and lent out. It reduces the money supply by the amount of liquid assets used to purchase the asset-backed securities. Therefore, it hides the increase in the money supply, i.e., inflation. It makes the economic environment appear less inflationary than it should be, given individuals' growing indebtedness to banks. Securitization portrays a bank-credit driven boom as noninflationary, savings driven growth. Also, securitization insulates lending activity of banks from the central bank's monetary policy. It contributes to the widespread illusion that more factors of production are available than in reality, and so becomes a factor in the generation of the boom-bust cycle.

Links

 * "Legal Tender Laws and Fractional-Reserve Banking"(pdf) by Jörg Guido Hülsmann
 * Fractional Reserve banking and boom-bust cycles by Frank Shostak
 * The Fractional-Reserve Banking Question by Robert P. Murphy, June 2010
 * The Form of Saving Matters by Robert P. Murphy, August 2010
 * Taking Money Back: Part I by Murray N. Rothbard, September 1995
 * Fractional Reserve Banking: Part II by Murray N. Rothbard, October 1995 (reprinted at LRC here)