Fractional Reserve Banking Risk + Reward
Fractional Reserve Banking: Definition, Benefits, and Drawbacks
This course will give you a better understanding of fractional-reserve banking by looking at what precisely fractional banking is, how it came to be, how it works, and its pros and cons. For crypto enthusiasts, we hope it becomes apparent once we understand what fractional-reserve banking is that we need to move away from fractional-reserve banking into a more sustainable, inherently fair, and secure means of exchange and wealth management. *1
History of Fractional Reserve Banking
Historically, deposit-taking grew out of the coin-changing and safe-keeping businesses. Medieval Italian money changers would swap coins from one city for those from another for a fee. Some traveling merchants, who brought in coins of one type, would choose to hold balances “on account” for the time being, preferring to receive coins of another type later when it was more convenient. The earliest deposit-takers in London were goldsmiths, artisans who made gold jewelry, and candlesticks, who were also coin-changers. Like the Italian coin-changers, they provided safekeeping in the vaults where they kept their silver and gold. *2 *3
A key to the development of fractional-reserve banking was that moneychangers and goldsmiths began to provide payment services by deposit transfer. The earliest record of payment by deposit transfer is from Italy around 1200 AD. Before deposits became transferable, suppose Leonardo wanted to pay (say) 100 ounces of coined silver to Bartolomeo, both customers of the same vault keeper. Leonardo would go to the vault keeper, have him weigh out the specified number of coins, and transport the cash to Bart, who would then have to transport the coins back to the vault keeper to have them weighed again and placed back in the vault. Not only was this inconvenient and time-consuming, but there was a high risk in transporting the coins across town and back. Additionally, there were fees to pay for weighing the coins. Leonardo’s account balance or claim on the vault keeper would be down by 100 ounces (plus transaction fees), and Bart’s would be up by 100 ounces (minus transaction fees). *3
A less burdensome and safer way to accomplish such payment was for Leonardo and Bartolomeo to meet at the bank and tell the banker to transfer 100 ounces on his books by writing Al’s account balance down and Bart’s up. Coins didn’t have to be weighed, moved, or touched. The payment was made by handing over claims instead of coins. *2 *3
Other methods for authorizing deposit transfers were often more convenient and soon displaced the three-party meeting in the banker’s office. For example, Leonardo could sign a written authorization, what we now call a check. Today we have electronic funds transfer, but all these methods accomplish the same end: transferring funds from one account to another. *3
What are banking reserves?
Banks aren’t allowed to loan out all the money deposited in the bank. By law, they must hold a specific percentage of their deposits in a reserve as hard currency, and those making the deposits must have access to these reserves.
How banking reserves work
The central bank manages a country’s currency, money supply, and interest rates and holds central bank reserves. The Central Bank sets the reserve requirement for commercial banks. The reserve requirement is the minimum percentage of total deposits banks must hold as an actual currency that can be withdrawn. The reserve amounts of hard currency may be stored on-site in a bank vault or held by the central bank in the form of deposits. The number of reserves held in the bank is about 10% of its total deposits. The remaining 90% can be loaned to its customers. Lending money can help create economic wealth, but the bank could not honor the withdrawals if all its customers requested to withdraw all their funds at once. The commercial banking industry counts on this improbable scenario, but they can ask the central bank for additional reserves. *4
The central bank manipulates the reserve rate to influence how much money commercial banks can loan, and in theory, a low reserve rate is supposed to make it cheaper for banks to lend money and vice versa. Banks earn interest on their reserves at the central bank.
Central banks often focus on regulating other specific economic targets like the rate of inflation.
There are 19 countries in the European Union that share a single central bank: the European Central Bank. The reserve interest rate rises when the demand for central bank money is high.
When the demand for central bank money is low, the reserve interest rate falls.
Swedish Riksbank was established in 1668 and is the oldest central bank in the world.
Today, there are more than 200+ central banks worldwide and eight global central banks:
- U.S. Federal Reserve Bank (U.S.)
- European Central Bank (EUR)
- Bank of England (GBP)
- Bank of Japan (JPY)
- Swiss National Bank (CHF)
- Bank of Canada (CAD)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
What is a bank run?
The banking business is constantly in flux. Earlier, we discussed banks are taking on the risk and only holding a percentage of depositors’ monies while lending out the rest. The banks must protect themselves against the depositors withdrawing all their funds at once, otherwise known as a bank run. They do this by offering competitive savings rates in notice accounts. As the name suggests, account holders of notice accounts typically must give 30-180 days’ notice before withdrawal.
Benefits and drawbacks of fractional reserve banking
Fractional-reserve banking is a system by which banks lend out their customers’ deposits to generate a profit through interest. You may think your money is being stored in some vault in your bank of choice, but that’s not the case. Roughly 26% of respondents in a recent survey of 1,000 US consumers believed that banks are required to keep 100% of deposits in their reserves, according to resources. *1
Proponents of fractional reserve banking argue that this is critical to powering the American economy. At the same time, critics are more concerned with bank runs and other risks arising from the flaws in the fractional-reserve banking system. This system expands the money supply and encourages economic growth, but it also requires strict regulations and safety nets to remain steady through a financial crisis. In the United States, the Federal Reserve System oversees this approach to ensure banks maintain a three to ten percent reserve, at a minimum, and acts as a lender of last resort in the event of a bank run.
According to sources, in the spring of 2022, six banks in the rural provinces of China are running into trouble, and their savers are at risk of losing everything. Peter had put his life savings of about $6 million into accounts at three small banks in China’s central Henan province. He says he hasn’t been able to access them since April. *5
In China, local banks are only permitted to obtain deposits from their home customer base. Still, authorities say that 3rd party platforms were used to acquire funds from depositors outside the region. In Peter’s case, for example, his hometown is over 700 miles away from the banks in Henan. *5
The national banking regulator has accused many shareholders of the four banks of illegally attracting money from savers. One of the shareholders has unlawfully absorbed the public’s funds through internal and external collusion, third-party platforms, and fund brokers,” the China Banking and Insurance Regulatory Commission told state-run Xinhua News Agency. *5
According to CNN, runs on small Chinese banks are becoming more frequent. Some have been accused of financial improprieties or corruption. Still, experts worry that a much bigger economic problem could be looming, caused by fallout from a real estate crash and soaring bad debts related to the Covid-19 pandemic.
Fractional reserve banking has many upsides. Here are three of the most essential to consider:
An expanded money supply: Some economists argue the greatest benefit of the fractional reserve banking system is its ability to act as a money multiplier. By turning deposits into loans and keeping only a small amount of reserve cash, banks can continuously lend out funds to help further grow the economy. In turn, this allows a more significant number of people to deposit more money in banks, shoring up the system further.
Backing by central banks: Fractional reserve banking is generally part of a wider-monetary policy set by central banks. For instance, in the United States, the Federal Reserve Bank (colloquially known as the Fed) sets interest rates and reserve requirements and ensures banks will act as a lender of last resort to keep this system running. This sort of guidance and reassurance from the entity issuing all banknotes in the first place helps keep the fractional approach on track even through difficult economic times.
Interest gains for consumers: Bank money accrues interest, whereas simply storing your funds at home can leave you at the mercy of increasing inflation. As a result, savers can often get a better return on their personal savings accounts by allowing banks to utilize their money for fractional reserve lending. This comes with a potential risk of the bank not having excess reserves to cover its losses in the event of a financial crisis.
What are the disadvantages of fractional banking?
Critics of the fractional-reserve banking system don’t hold back: it’s a Ponzi scheme. You’re robbing Peter (the depositor) to pay Paul (the borrower), which is not sustainable. Whether you agree with this perspective or not, there are glaring downsides of fractional-reserve banking that are difficult to refute. *1
For one, the money-multiplier effect of fractional-reserve banking results in a growing money supply. As the money supply grows, especially in the exponential manner created by the lending of financial reserves, the value of a dollar becomes less, which we also call inflation. A steady rise in inflation, say three percent, is to be expected and is generally associated with a healthy, growing economy. But over time, the rapidly increasing money supply has seemingly resulted in a massive decrease in the U.S. dollar’s purchasing power. *1
Bank runs are also of concern. Say that signs of economic trouble cause 50%, or 100%, of a bank’s customers to withdraw their deposits. The bank only has 10% of those funds, let alone 50% or 100%. This scenario can cause widespread panic resulting in a depression.
Similarly, if banks lend their money out unwisely (an example is sub-prime mortgages), money may never be repaid as unqualified borrowers default on their loans. This means you’ve flushed bank customers’ deposits essentially down the drain, and doing this can precipitate a recession or worse, as we witnessed in 2008. *1
Critics of fractional-reserve banking argue that the system contributes to destroying money’s real, intrinsic value. Combined with the rejection of the gold standard in 1933 and 1971, fractional-reserve banking has rendered currency truly fiat.
Many see cryptocurrencies as a viable alternative with real, intrinsic value and systems that prevent straying too far from the genuinely collateralized medium of exchange. *1
