Fractional-reserve banking

In macroeconomics, fractional-reserve banking is the practice according to which a portion of a national money supply is not backed by an equivalent value in an asset (such as gold) that is generally considered a store of value. In most modern states this occurs in two ways: one at the level of the country's central bank, and one at the level of the commercial banking system.

The central banks of most countries choose to store only a very small fraction of their countries money supply as gold, silver, foreign currencies, bonds, or promissory notes. Instead their currency is backed by the economic potential of their economy. The greater the future potential of an economy, the more faith people will have in the countries economic and financial system, and the less concern central bankers will have over financial backing.

As with all matters involving the backing of money and public faith in money, the specific ways in which fractional-reserve banking is practiced and regulated represent political and social decisions which are intrinsically controversial.

In most countries, commercial banks also play a role in altering the amount of backing given to the money supply. By granting loans to customers, they increase the amount of the money supply. The amount of loans a bank is allowed to grant depends primarily on the amount of deposits it has and the proportion of these deposits that governments demand that banks hold back in reserve.

Historical background

At one time, people deposited their precious metal valuables at goldsmiths, receiving in turn a note for their deposit. As these notes began to be used directly in trading, participants no longer needed to redeem their gold to perform the trade. Thus an early form of paper money was born. Goldsmiths became known as money changers.

As the notes were used directly for trade, the money changers realized that people would never withdraw all their deposits at the same time. Thus money changers saw the opportunity to issue new bank notes and lend them at interest. Often they didn't have enough reserves to back up the note and so fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the money changer to back up their note, they would try to redeem the note. This was called a run on the bank and many early money changers either went broke or refused to pay up.

When the central bank of England was created in 1694, its main purpose was to manage the governments debt by selling notes; however, it was not long before it started to engage in fractional researve banking. By the end of the 18th century the war with France had created a formidable drain on the countries finances and in February 1797 there were rumours of imminent financial collapse. On Feb 26, an Order in Council "temporarily" suspended the convertability of the pound.

The controversy that ensued has come to be called the Bullionist controversy. For more than 20 years economists and politicians debated. Commitees were established and in 1810 the Bullion Report was released. In 1821 the pound was again fully backed by the Bank of England and continued that way until the first world war.

A related controversy was the Banking school controversy. It occured primarily in England, but also in the US, and lasted from about 1820 to 1850. It dealt with the relative roles (and power) of the central bank and the commercial banks. There were three general schools of thought. The Banking school felt that central banks should be free to issue notes as they felt necessary. The Free banking school felt that it should be the commercial banks that should be free to issue notes in a competitive banking industry unincumbered by central banks or government regulations. The Currency school felt that the issuing of notes should be closely regulated by government through the tight contol of central banks. In England, the issue came to a close with the Bank Charter Act of 1844 which limited the ability to issue notes to the central bank of England.

In the United States of America several presidents and founding fathers fought against privately owned banks having the right to perform fractional-reserve banking. They opposed a privately owned bank having the right to issue new currency. See Thomas Jefferson, James Madison, Andrew Jackson and Abraham Lincoln. Also John F. Kennedy prior to his death signed a Presidential decree, Executive Order 11110, to strip Federal Reserve Bank of its right to loan money at interest to the United States Federal Government.

In the modern world, foundations such the World Bank, European Central Bank, the US Federal Reserve System, and other central banks have the sole right to print new money.

The deposit creation multiplier

We have said that fractional-reserve banking implies that the amount of the asset in reserve, that the money is based on, amounts to only a fraction of the money in circulation. For example if a central bank has $100 worth of foreign currency or gold in a bank's reserves and $500 in circulation, then the bank would be practising 1/5 fractional-reserve banking.

Commercial banks operate in a similar way. The system starts with an initial deposit at a commercial bank. Because of this deposit (called a primary deposit), the bank is holding currency. To make a profit for it's investors, the bank loans this money out. The person that gets the loan spends the money which will eventually be deposited in a bank. This second deposit is refered to as a derivative deposit or secondary deposit. Any of these additional derivative deposits increase the amount of the money supply.

Governments (or their central banks) generally restrict the proportion of primary deposits that can be lent out. This is called the cash reserve ratio. For example, lets assume that a primary deposit of $1000 is made into bank A. If the cash reserve ratio is 12%, then $120 must be kept on hand by the bank and $880 is available to be lent to someone else (called the excess reserve). Now if bank A uses its $880 in excess reserve by lending it out, and that is deposited in bank B, it represents a primary deposit to the second bank. Bank B must keep 12% of $880 on hand but can lend out $774.40. If that $774.40 is eventually deposited in bank C, the third bank must keep $92.93 on hand but can lend out $681.47. The process continues until there is no excess reserve left (For simplicity we will ignor safety reserves.). By adding all the derivative deposits we can calculate the amount of money created. Alternatively we can use the deposit multiplier equation:

TD = ID / crr

Where:
TD=change in Total Deposits
ID=Initial change in Deposit
ccr=cash reserve ratio

The initial change in deposit of $1000 will increase total deposits by $7333.33 given a reserve ratio of 12% (1000/.12=7333.33).

In actual fact, the money creation multiplier is more complex than this simple description. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system),the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold - usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different reserve ratios.

The opposite of fractional reserve banking is full reserve banking, but this is not used in practice.

Criticisms of fractional-reserve banking

Some people are unaware of the existence of this banking practice and have been known to call it the 'fractional-reserve banking system scam' when they find out about it.

The mechanism of fractional-reserve banking may cause inflation or even hyperinflation if minimum reserve ratios are not maintained.

See also

• The Money Masters
• Fiat money
• Credit money
• gold standard
• Bretton Woods
• bimetallism

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External Sources

• John F. Kennedy vs The Federal Reserve
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• Parnel, H.B. (1827), Observations on Paper Money, Banking, and Overtrading, London, James Ridgeway, 1827.
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• Scrope, G.P. (1833), An examination of of the bank charter question, London, John Murray, 1833.
• White, L.H. (1984), Free banking in Britain: theory, experience, and debate, 1800- 1845, Cambridge, Cambridge University Press, 1984.
• Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
• Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191-202.
• Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
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