…or should that be ‘Fractional Reserve Debunking’?
Fractional reserve banking (FRB) has received much coverage over a long period, yet it remains a contentious area prone to misunderstandings. Probably because it is usually presented in overly complex terms. In reality the subject is simple.
FRB is when banks do not keep all their deposits on hand. They keep only a fraction of the funds that are deposited with them – hence fractional reserve.
This is sometimes presented as a scandalous practise, but if banks did not lend out a proportion of their funds then they would not be banks, they would be warehouses.
The first point to be understood is that the practise of fractional reserve banking is… banking. There is no other sort of banking. The prefix ‘fractional reserve’ is surplus to requirements.
The difference between a warehouse and a bank is that a warehouse charges people for storage, while a bank pays people for storage. How is it that a bank can offer payment for a service for which the warehouse has to charge?
If a bank takes a deposit of 10oz of gold and pays an interest rate of say 2%, and lends out the money at 2.5%, then the bank makes a profit. This is the essence of banking – a bank takes deposits and lends them out at a greater rate of interest than they are paying. The warehouse cannot lend out your furniture without there being a bit of an upset.
Traditional banks provide a very valuable service; savers gain a return on what would otherwise be an unproductive hoard, and entrepreneurs gain access to capital to begin new ventures, or expand existing ventures.
Bankers are brokers of money. They join together two parties who would otherwise find it difficult to meet.
A bank by definition only has a fraction of its money on hand at any one time. That it only has a fraction is a given, it is the amount of the fraction and how it is calculated that is crucial to the real story.
In an honest and traditional banking situation, the fraction maintained is a constantly changing figure that is determined on a moment-to-moment basis. It is dependent upon the periods for which the customers opt to deposit their money.
This can range from thirty days to ninety days, or a year or five years or whatever. The whole process begins by a contract being established between the bank and each individual customer based on the customer’s time preference.
The bank has to ensure that its reserves are sufficient to be able to pay out all these deposits as they become due. In other words, its reserves must match the time stipulations of their deposits. If money is deposited for 30 days, then the bank can lend that money out for up to 30 days, but not a day longer. Ensuring that these durations are always matched is the principal job of a bank.
This is all so obvious as to seem like it is not worth stating. It is worth stating though because this is not what has been happening. It is what has been happening that has given FRB its bogeyman status.
A very serious problem can occur when banks take money deposited for say 60 days and then lend it out for 90 days – when they take a deposit for one period and lend it out for a longer period. The problem is a mismatch of duration.
This is fraud, pure and simple.
Where is the money to pay the depositors when they return for their funds? The modus operandi of modern banking is to assume that customers will either redeposit their money, or that new money being deposited will make up the shortfall.
The whole modern banking system is built on mismatch of duration. Banks have been borrowing at short-term interest rates and then lending at higher long-term interest rates (borrowing short to lend long).
It is the glaring flaw inherent in this practise that has led to the damning of FRB, but it is not FRB that is the problem; it is solely the mismatch of duration.
It cannot be stressed enough that FRB is beneficial to all parties concerned; a healthy economy could not exist without this service.
Today’s banks have profited from short-term interest rates being lower than long-term interest rates. They have profited from short-term greed trumping long-term wisdom and banking ethics. They did this and continue to do so because government regulations provide an incentive for it.
As things now stand, government regulators decide on a one-size-fits-all fraction of funds that is applicable to all banks. The durational needs of the depositors are wholly ignored. The necessity to ‘recapitalise banks’ and ‘bail-ins’ are beginning to demonstrate the scale of this error.
The fraction held as bank reserves can only honestly be determined by the needs of individual depositors, and by banks lending in accordance with those needs. Thus the percentage changes at each bank with every deposit made.
The government guarantees that are supposed to backstop the banking system are worthless. No government has the wherewithal to do this. Governments are financed solely by the taxation that they extract from their citizens. How is it possible for the people to guarantee their own money that the banks have already lost?
Any mismatch of duration will eventually lead to a problem of credibility and a run on the banks.
By the process of drawing money out of hoards with the lure of interest rates, banks facilitate saving and through their lending, greatly enhance the circulation of money. These are the lifeblood of an economy. To be anti-FRB, is to be anti-savings, anti-investment and anti-jobs.
That is it; the essence of the story in a nutshell. Once the core function of banking is understood, the fantastic claims about FRB and ‘banks creating money’ can be laid to rest. Bogeyman is entirely innocent of all charges. The real guilty party is government that steps into the middle of free market transactions with a legislated, one-size-fits-all ‘we know best’ attitude.
Needless to say they never do know best and one size never does fit all.
FRB is a red herring; a distraction that serves to hide the real culprit; the true bogeyman who lurks in the shadows. A truly free market will always produce banks, but its natural disciplines would never tolerate mismatch of duration.
Banks have much to answer for, but FRB should not be on the list of charges. As in all situations, unless there is clarity with regard to the problem, there can be no clarity with regard to the solution.