Fractional Reserve Banking: The Pros And Cons

Are there deleterious effects of fractional reserve banking? While many insiders defend the practices, others point to a host of potential and certain damages that directly ensue.

This article assumes a basic familiarity with the practices. For those unfamiliar with them, it's suggested that you start with this introductory article instead.

The defenders of fractional serve banking point to the liquidity benefits of greasing the gears of our large, complex economy. By means of such liquidity, obtained through lending, sufficient funds are made available for entrepreneurs to start new enterprises and consumers to purchase big ticket items like houses and cars. All this is said to stimulate demand, production, and employment.

Even though if one grants all those claims (which not all critics do), it is the worst failure of economic thinking to ignore the trade-offs. What are the costs of fractional reserve banking?

Three potential costs are considered below: risks 1) to the individual bank; 2) to the overall banking system; and 3) to the monetary system - increasing the vulnerability of the economy and thereby increasing the dangers of the first two costs.

1) Then, let's be precisely technical about this. In fact of the matter, all fractional reserve banks are at every moment bankrupt. This is not an ethical judgment, but an economic fact. They are, at any given moment, unable to fulfill their financial obligations. Fortunately, for the banks, the majority of depositors don't understand this fact. Consequently, the banks get by.

Occasionally, though, something happens to alert depositors to the fragility of the bank's accounts and large numbers of them start demanding their money. This is called a bank run. And we've seen that it can even happen in the digital world. (See the recent Mt. Gox run.) Such events can put a bank out of business. At the very least it can prove extremely costly for the taxpayers to bail the bank out of its liquidity shortage.

2) In our heavily interrelated banking world, banks borrow from and deposit with each other. That is banks can be the creditors of other banks, either long or short term. Such banks are of course more sophisticated about the reserve system than are most depositors and appreciate the cascading effects of a bank run.

However, even the bankers' increased sophistication and knowledge is no warrant against a bank run. Heavily indebted banks, with too many poor loans on their books, facing high danger of systemic default, will be abandoned by lender and depositor banks. Concluding that further credit is throwing good money after bad, they cut their losses. The bankers effectively instigate a bankers' bank run.

The problem though is that there is so much inter-bank borrowing that a banker's bank run can set off a chain reaction of default. This was one of the circumstances leading to the 2008 financial crash. So the entire global financial system can be put in peril.

3) It is also important to consider the contributions of fractional reserve banking to destructive inflation. The lead culprits in that story certainly are central banks and governments, who employ their police powers to enforce the fraudulent fiat currency. Fractional reserve banking though also contributes considerably to the mess.

A description of the precise mechanics of this inflationary process would exceed the space limits, here. It should be enough to grasp the obvious fact that, as long as we're taking the laws of physics seriously, the same money cannot be both in a depositor's bank account and a borrower's loan portfolio. Somehow this bit of financial black magic is precisely what we're supposed to take seriously.

This bit of fractional reserve voodoo creates an illusion about the level of savings, which erroneously lowers the interest rate on borrowing, increasing demand for borrowing and incentives for banks to further stretch their reserves. The result is the crushing valleys of the business cycle: recession or depression. And of course such economic downturn reduces the prospects of borrowers being able to repay their loans, hence heightening the dangers of 1 and 2, above.

Given these numerous affects of fractional reserve banking, it is understandable that some have called for the outlawing of the practice. However, even if one believes that the costs considerably outweigh the benefits under current conditions, it's not at all clear that such a prohibition is sound either as government legislation or as social norm.