Fractional Reserve Banking: How Banks Loan Out More Money Than They Have

(Friday, January 6, 2012, 8:33 p.m.)

I wonder how many people really realize that when they put their money in a bank (a) the bank loans out their money to other people, and (b) they don't keep enough money to pay everybody back, should all of their customers go in and ask to withdraw everything. When too many people withdraw their money, it causes what is called a "run" on the bank in which the bank is unable to pay everybody back and therefore "fails" and legal processes have to sort out who will get their deposits back and how much. This has happened all too often with banks, even before the Great Depression that started in 1929.

Why do banks do something that seems so obviously unsafe and unsound for them as businesses? The answer is that banks make most of their money on returns from loans they make. If a bank were to make sure that all of the depositors could withdraw their money at once, they wouldn't have nearly as much money to loan out. Keeping only 10-20% of what people deposit available in reserve is not uncommon for banks. Being able to loan out 80-90% of the money they have in their coffers from their depositors means they receive a lot more profit.

When I first learned many years ago that banks did this, it struck me as fundamentally dishonest. What it's most like to me is when airlines overbook flights. The airline is selling more tickets than they have seats on the plane, on the assumption that some of those travelers will cancel and they can (if the tickets are non-refundable anyway) pocket their money even though they are no longer traveling. Sometimes the airline miscalculates, though, and there end up being too many people booked on the plane, so they have to inconvenience someone by "bumping" them, though to be fair, they do try to financially compensate the person generally for that inconvenience.

Bank loans under fractional reserve banking are like that. The bank is giving out more "seats" than it really has while hoping not everyone will claim them (the limited deposited reserves) at once. This is considered standard and fair banking practice, but it seems fraudulent to me in principle. As it turns out, as I discovered reading a book called Money, Bank Credit, and Economic Cycles by an Austrian school economist, Jesus Huerta de Soto, in ancient times up until the late Middle Ages, this practice was considered, in fact, fraud and misappropration, and in some cases bankers that went bankrupt after doing this were severely punished, even to the point of being executed if they could not pay back their creditors. But from at least the time of Ancient Greece, the practice has always been a temptation.

What happened basically according to de Soto was that governments eventually granted banks the exclusive privilege of holding fractional reserves of deposits and loaning the rest out, legalizing what was once considered fraud. They did this because they often rely on banks for loans for their deficit spending. This collusion of banks and government has lasted a number of centuries at this point and the fractional reserve banking has become standard practice.

de Soto argues not only that this practice is dishonest and that it makes banks inherently risky as businesses, but this loaning out more than they have leads to an expansion of the money supply even without government meddling that causes the dreadful "business cycle" of booms and busts that have plagued Western economies since even before the birth of the United States. The mechanisms are very complex, but Roger Garrison, a Professor of Economics at Auburn University, has a fairly short PowerPoint presentation Ivan and the Brickyard giving the analogy about Soviet-style resource allocation and how it leads to poor results. Where this ties in with banking credit expansion is that when banks lend out more money than they have, they tend to drive interest rates down and these low interest rates signal entrepreneurs (in this case incorrectly) that there are a lot of actual financial resources available to fund new ventures. The interest rate plays the role of Ivan, the brick czar who overestimates the number of houses that might be built with the limited bricks available. Low interest rates, in the absence of real increased savings, lead to poor investment choices by entrepreneurs that blow up in their faces and end up taking the economy down into recession with them. de Soto goes into a great deal of detail about the specific mechanisms in the economy (from the Austrian school perspective) that cause bank credit expansion (i.e. loaning out more money than they have) to lead to both an economic boom and a resulting bust.

deSoto goes on to argue that, even without government intervention, fractional reserve banking automatically leads to the perils of bank runs and the business cycle. The ever-present threat of bank runs is why the bankers have clamored to have central banks and the government available to bail them out (as happened recently in 2008). de Soto goes on to suggest that central banks (like our Fed), even assuming they are being completely honest and trying to prevent economic disasters, have an essentially insoluble problem trying to manage the dynamics of the money supply. (I've not read that far yet in the book at this time of writing.)

If the Austrians are right, we can thank fractional reserve banking for much of the mess we are in now as well as the pain people endured during the original "Great Depression." Just because a business practice is a time-honored habit doesn't make it right or financially sound.

The way banks should manage deposits by customers is that they should store them for safekeeping and charge a storage fee for the service rather than loaning out the money and paying interest to depositors. If a bank customer wants to actually loan their money out, they should explicitly do so through certificates of deposit or some other loan vehicle and with the understanding that this money will be unavailable to them for a period of time and that there will be some risk of loss. When a customer merely deposits their money, rather than loaning it out, that money should be kept safe and untouched. Banks will still be able to make profits, both by money loaned to them by customers and by the storage fees they would have the right to charge. If this state of affairs were to prevail, i.e., full reserve banking, then all banks would be proof from runs and they would be unable to generate out of nothing the "bubble money" which leads to monetary expansion (and thus inflation) and, as the Austrians argue, to the debilitating booms and busts of the business cycle.

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