The Ills of Fractional Reserve Banking

Two academics over at the International Monetary Fund (IMF) have come up with an interesting idea. Oddly enough, it requires you to assume something that is far more important and revolutionary than the idea itself. But the assumption barely gets a mention.

This is going to require your thinking cap, by the way. But it’s probably our favourite and most important point we make in the Markets and Money every now and again.

At hand are two different issues. The IMF authors have shmooshed the two ideas into one proposal and confused everyone in the process. Split the two issues apart, take out the bad bits, and you are left with a game changing idea for the future of the financial system.

The first issue is fractional reserve banking (FRB). If you put your gold coins into storage at the bank, the bank can’t just go and lend out those gold coins to someone else with interest, hoping you won’t come and claim them before the borrower returns them. If the bank did do that, it would be fraud.

But in a fractional reserve lending system the bank does just that with your deposited money. It lends out what you’ve handed over for safekeeping, and only holds onto a small part in reserves. It is illegal to engage in fractional reserve lending if you don’t have a banking license, and even then, you can only do it with bank deposits.

This is an absurd exception from the law given to bankers. And it’s the source of their remarkable profits, because they lend out money that was never theirs in the first place. The depositor deposits the money. It’s not lent or given away to the bank.

Because of FRB, bank runs can happen. People want their deposits, but the bank has lent them out to borrowers. Bank runs cause a type of financial crisis, which have been a big part of the economic instability we’ve faced ever since banks have existed. That’s more than a few thousand years, in one form or another.

Remember, taking deposits and then lending them out without a banking license is illegal. Somehow bankers get an exemption from this basic legal principle. It’s quite amazing to see an IMF paper admit this. They call the permit ‘an extraordinary privilege that is not enjoyed by any other type of business.’ People have called us all sorts of names for pointing out the same thing.

The second issue in the IMF paper is about who creates, or issues, money. It might seem odd, but through much of history money was created by banks, not governments. A historical remnant of this is that there are still around 10 note issuing banks in the UK. They all issue British Pound Sterling now, but they used to issue their very own currency. Even today, the bank notes they issue look different.

This practice of privately issued money, especially once combined with FRB, made banks immensely powerful. They could issue money and create vast amounts of it for lending out, because they only needed a small amount in reserves for the loans they made. As long as depositors didn’t figure out their deposits weren’t safely in the bank, but had been lent out, the bankers make a huge amount of money in interest.

But there was one limit. Under the private sector version of issuing money, banks needed to give the impression that their paper money had value. Nobody was willing to accept that a piece of paper had value.

So the banks made every bank note redeemable, usually in gold. But the banks quickly figured out that people never redeemed the gold. Instead, they just handed over the bank notes when they wanted to buy something.

So the banks realised they could issue far more bank notes than they had gold, and nobody would notice. They got free spending power each time they created a bank note without any gold to back it up. Just another fraud bankers pulled off as a core part of their everyday business.

The government saw the immense benefit of getting free spending power by issuing secretly unbacked money, known as seigniorage, and decided it wanted a share of it. By taking control over the issuance of money, the government was able to grab part of the financial sector’s immense power.

But the financial sector held onto its FRB rights. So it gave up seigniorage, but continued to lend out what was meant for safekeeping.

The banks also figured out they could create a new type of money – credit money. Essentially, credit money is just an IOU to pay real money. The easiest way to understand the difference between real money and credit money is to think about the difference between a debit and credit card. The first uses existing money and the second is an IOU created by the bank in the moment of the transaction.

The key question is, can you tell the difference between the two if you’re the one being paid? You can’t – you don’t know if you’ve been paid credit money or real money. They look the same because they are a number in your bank account. And you don’t really care that credit money is just an IOU, because the bank backs up credit money with its ability to pay real money.

The problem with this is that the amount of credit money depends on whether the banks are willing to create IOUs. A huge amount of credit can be created and then disappear quickly depending on lending and borrowing preferences. What seems like real money can suddenly dry up. That’s what happened in 2008.

Although the IMF paper goes into credit money, let’s leave that aside. The same goes for precious metal backed money. What’s important here is fractional reserve banking and who creates the ‘real money’.

Two Issues, Four Solutions
 

So if there are two issues at hand, there are four ways you can combine them. You can allow FRB or ban it, and you can have the government or the private sector issue the money.

Our trusty adaptation of game theory will explain it:

 

If you’ve never seen this way of showing a problem before, take a look at the box in the bottom right hand corner of the matrix – ‘the right system’. This is a system without fractional reserve banking and with privately issued money.

In this scenario, the government is out of the money creation business and in the law enforcement business (it stops banks from engaging in dodgy FRB). This is the right system according to your editor’s views.

Our current system has government created money, with FRB. That means bank runs can happen, but the government, or its central bank, come to the rescue with freshly printed cash. That’s what you’ve seen happen over the past few years.

A system of privately issued money and FRB, the bottom left hand box, is a little odd. But it existed for much of western history. Many people blame the problems of this system on the fact that the money was privately issued by banks.

But the problem was really FRB, which makes the banking system unstable and liable to bank runs. If normal laws had been enforced on bankers, FRB wouldn’t have existed, because you can’t lend out money that someone has given you for safekeeping.

The IMF Plan to Deal With Fractional Reserve Banking
 

Last but not least is the system the IMF paper suggests we should give a go. It’s based on a theory worked on during the Great Depression. And it supposedly fixes a large amount of the problems we’ve got today. It suggests that government should continue issuing money, but it should ban credit created money and FRB.

In other words, when you deposit a dollar in your bank account, the bank can’t go and lend it out. It must have that dollar, and all other deposited dollars, ready and waiting for you at all times. That stops a bank run from happening. As for credit money, that would simply be banned.

So how would the bank get the money it needs to lend if it can’t create credit or lend out some proportion of deposits? This is where scepticism of the plan kicks in. Banks must borrow from the government treasury to lend. The treasury gets to create the money… as much as it wants to.

What’s interesting about this system is that money for lending comes into creation by being borrowed from the government. Under our current system, it’s sort of the opposite. Money the government currently creates is a liability, not an asset, for the government.

According to the IMF authors and the economists who came up with the idea in the 1930s, this change allows government debt to be reduced dramatically. The politicians can simply create money and pay back their debts.

A Forest Without Trees
 

The annoying thing about this IMF proposal is that it acknowledges that fractional reserve banking is a major problem, but deals with it as a secondary issue. In our opinion FRB is the biggest fraud ever contrived. But that’s another story.

If fractional reserve banking is a problem, as the paper acknowledges, why don’t we solve that problem before rejigging the entire financial system in all sorts of other ways? Why don’t we make banks operate under the same laws the rest of us do? We’re not allowed to lend out what isn’t ours. You don’t see Kennard’s Storage lending out their customer’s garden furniture.

Anyway, it’s quite amazing that this idea has traction at the IMF. Ending FRB, even if you mess about with other parts of the financial system at the same time, would destroy a huge part of the power of the banks. Unfortunately, the IMF plan hands power to the government at the same time.

If the plan moves forward, it’s a win and a loss at the same time. It gives government too much power, and takes unfair power away from the banks.

It’s not likely this idea will ever make it to the financial system though. But it is remarkable that a criticism of FRB is published by a mainstream institution. We’ve been ridiculed for making this argument for years. Now we’ll have to find something more ridiculous…

Regards,

Nick Hubble
for Markets and Money


Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.


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