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In economics, particularly in financial economics, fractional-reserve banking is the near-universal practice of banks retaining only a fraction of their clients' deposits and notes as reserves to satisfy demands for withdrawals, investing the remainder in loans to generate income. Clients would normally receive a proportion of this income via interest on their deposit. Inflation, partly caused by fractional-reserve banking increasing money supply, would reduce a client's capital growth in real terms.

Overview

The key financial ratio used to analyse fractional-reserve banks is the cash reserve ratio, which is the ratio of reserves to demand deposits and notes. For example this could be 10%, which would mean the bank has 10% reserves for all funds deposited at the bank, with the remaining 90% used for loans. Term deposits such as certificate of deposit are ignored when calculating this ratio because the bank only needs reserves to pay the term deposit at its maturity, and not during its term. The 'reserves' part of the reserve ratio, can be most narrowly defined as legal tender, i.e. assets that can be directly paid out as withdrawals, and do not have to be exchanged or sold. However, banks and financial analysts use other liquidity ratios and methods to measure and monitor liquidity in order to capture other cash outflows and sources of liquidity (such as early redemptions of term deposits, and lines of credit with other banks, respectively).

The reserve ratio should not be confused with the capital ratio, which is the ratio of the bank's capital to its assets. The capital of a bank includes the net worth of the bank (assets less liabilities), and subordinated debt, which ranks behind the claims of general depositors and other unsecured creditors, and thereby provides similar protection from loss. The capital ratio is adjusted by risk-weighting the assets of the bank, and the result is called the risk-adjusted capital ratio. The opposite of fractional-reserve banking is full-reserve banking.

History

At one time, people deposited gold coins and silver coins at goldsmiths for safe keeping, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.

As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.

Government regulation

Banking has been subject to generally a greater extent of government regulation and controls than other forms of business, and banking law has in many countries been the subject of extensive political debate.

Government controls and bank regulations related to fractional-reserve banking have generally been to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

Minimum required reserve ratios (RRRs)
Minimum capital ratios
Government bond deposit requirements for note issue
100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
Sanction on bank defaults and protection from creditors for many months or even years, and
Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counter-act bank runs and to protect bank creditors.

Influence of central banks

Central banks are government owned and/or sponsored banks that issue notes and typically receive special privileges in the form of exemption from restrictions or taxes on note issue, or whose notes are made legal tender by government fiat (hence the term fiat currency -- the notes are current (legal tender) by government fiat (law).

Central banks also operate as fractional-reserve banks, and the reserve ratio policies of the central bank influence specie flows and credit conditions, making the control of fractional-reserve banking a political issue, with financial and economic impacts. Also involved with reserve ratios is the interest rate, because the primary method of attracting reserves of specie from within a country and from abroad into the central bank treasury, or stemming their outflow, is to offer higher interest rates on deposits (central banks take deposits as well as issue notes).

Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking in reference to fractional-reserve banking by central banks in particular, where the nation's central bank holds fractional reserves of gold bullion or specie (gold coin). This occurred before the adoption of irredeemable fiat money in most developed countries in 1971 with the collapse of the Bretton Woods system, when the US government ended the convertibility of the US dollar into gold. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partly-reserved currencies as a form of fractional-reserve banking may create more confusion than it alleviates. Mainstream economists do not generally make this analogy.

Criticisms

Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the financial risk note holders and depositors bear, and the impact bank notes and demand deposits have on the stock of money, and allegedly thereby, its exchange rate. Fractional reserve banking started with reserve of gold and silver, but still continues in current fiat-money based banking, where money is no longer backed by precious metals and therefore has no inherent value.

Risk

Fractional-reserve banking allows for the possibility of a bank run in which the demand depositors and note holders collectively attempt to withdraw more money than the bank has in reserves, causing the bank to default. The bank then would be liquidated and the creditors of the bank would suffer a loss if the proceeds from the bank's assets were insufficient.

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run.

Responses to the problem of financial risk described above include:

Opponents of fractional reserve banking who insist that notes and demand deposits are 100% reserved, and
Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below) and
Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors and creditors would result in effective risk management.
Terms and Conditions of some bank accounts place a limit on daily cash withdrawals and may require a notice period for very large withdrawals.

Increased money supply and inflation

When banks issue notes and accept demand deposits, the bank's liabilities can be used as a means of payment to buy goods and services, for example by tendering bank notes and by writing cheques on demand deposit accounts. Bank liabilities therefore act as a substitute to legal tender, and allows banks to create the inverse of their reserve ratio in legal tender substitutes. For example, if the bank's reserve ratio is 5%, it can create 20 times its reserves of legal tender in notes and demand deposits that are used as money, and for this reason the inverse of the reserve ratio is called the money multiplier.

Some monetarists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as reducing the exchange rate and causing inflation. In fact quantity theorists often call the issue of bank-money 'inflation' and consider a falling exchange rate merely a symptom of inflation. However, this view is only held by those who use a broad measure of money supply in the quantity theory of money. Those who hold that that the price level is only affected by base currency (minted coin), or base currency and government-issued paper currency, do not see fractional-reserve banking as having an inflationary effect.

Others, however, hold that the exchange rate of money is governed by factors other than the quantity of money. An alternative to the quantity theory considers the notes and demand deposits to be holding and representing the value of the non-reserve assets as well as the reserve assets. For example, if a bank issues notes and holds 10% of the funds as reserves and 90% as commercial loans (disregarding bank assets supported by owner equity and term debt), then the value of the currency is unaffected, since when counting all the assets it supports, there is no deficiency. Another complementary theory is that the monetary standard of legal tender creates an anchor on the value of money, independently from the quantity of money. For example under a gold coin standard, since all notes and demand deposits may be redeemed in gold coin, and gold coin has its own price relative to other goods and services, notes and demand deposits payable in gold coin cannot affect the exchange rate of gold coin, and therefore of notes and deposits payable in gold coin.

Quantity theorists, understandably are typically either hostile to fractional reserve banking, or supportive of minimum reserve ratios, and other government controls on the quantity of money created by commercial banks. The process with which commercial banks practise fractional-reserve banking is explained at deposit creation multiplier.

Incompatible with a gold standard

Many critics of irredeemable fiat currency see fractional-reserve banking as incompatible with a return of the gold standard, through fractional-reserve banking leading to exhaustion of reserves, prompting governments to make the notes of government-favoured banks legal tender, even though the issuer is in default. If such defaulted bank notes are made legal tender by government fiat, as they trade at a discount to their face value in terms of gold coin, will be a cheaper way to discharge debts, driving out gold coin.

However, other critics of irredeemable fiat currency, from the free-banking school, support fractional-reserve banking, and view the threat to the gold standard as originating from central banking and government controls on the formation and winding-up of banks and the business of banking.

Inadequate government regulation

Critics of current bank regulations argue that:

Minimum reserve ratios put reserves beyond reach in a time of need
Minimum capital ratios are poor regulators of financial risk, as they ignore other portfolio risk drivers such as scale and diversification and come at a heavy compliance cost
Government bond deposit schemes distort government bond prices, bank portfolios and finance methods, and create inflexibility
100% marginal reserve requirements can be met even if the bank has no reserves
Protecting insolvent banks from their creditors creates moral hazard, and increases the losses bad banks make, and is inequitable, and
Central bank support and government protection of creditors creates moral hazard and socializes credit risk.

Further to this critics also argue that the Federal Reserve System did in the past and still does currently operate above and beyond the scope of the federal government.

This can be explained in the abstract:

The ability in the past to issue money which was then used to bribe the congress and individual politicians to consolidate the power and position it currently holds.
The semi private nature in which the bank operates.
The longer terms of contract to the federal reserve board members.
The deceptive name Federal Reserve System, as it is semi federal and has little reserve (which has never been questioned by the congress).

And with the direct effect:

With the ability to expand or shrink the money supply and thus cause a deflationary or inflationary recession.
Which is achieved by selling bonds (deflationary)
Buying government bonds (inflationary)
Interest rate control.
Discount Rate control

Critics claim this method of creating a purposeful recession has been used in the past to "fear" the public and governments into a semi or totally private Fractional Federal Reserve System, which in turn compounds the problem (as they see it) by further consolidating the issuing power with the central fractional semi private Federal Reserve System.

Critics also claim the ownership and monopoly of the major print and visual media was a major factor in the consolidation of the federal reserve power, this has been achieve they say by the power to stay semi invisible, which is disproportionate to the immense power that federal reserve bank holds, and in contradiction to democratic human rights, which state that a representative of an economy must have a duty of care and engagement to the citizens who participate in that economy.

References

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,
Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965-970.
Parliament of Tasmania, Monetary System, Report of Select Committee, With Minutes of Proceedings, 1935.
John F. Kennedy vs The Federal Reserve
More John F. Kennedy vs The Federal Reserve

External links

Rothbard, M. N. (1983) The Mystery of Banking, Richardson & Snyder, 1983, pp 87-110

Narrow banking

Money upside down

Libertarian viewpoint

These links discuss "fractional-reserve banking" using Libertarian terminology, from a Libertarian point of view. They are cited here because as of 2003 Libertarians are a group that has been vocal in attacking the practice.

Fractional-reserve banking Murray N. Rothbard uses the term "fractional-reserve banking" in reference to both commercial and central bank practices. He characterizes the customary modern-day practices with terms such as counterfeit, swindle, and "creating money out of thin air," and asserts that "the general public, not inducted into the mysteries of banking, still persists in thinking that their money remains 'in the bank.'"

Money, Banking, and The Federal Reserve, afs video stream from The Ludwig von Mises Institute. Good presentation of the Misesean case against the Federal Reserve System.

The Libertarian Case Against Fractional-Reserve Banking is a critical analysis of Rothbard's views by Gene Callahan, who finds them unconvincing, and asserts that banking practices are compatible with Libertarianism, or could be made so with only minor alterations. He discusses at length (but inconclusively) the question of what depositors actually believe, which he sees as relevant to the charge that fractional-reserve banking is fraudulent or deceptive.

[[Category:Banking]] [[Category:Currency]] [[Category:Money]] [[he:יחס הרזרבה]]