“The little cardboard shoebox we keep your money in—”
What does the bank do with your money? Whose is it? Can it really just give it to anyone?
A correspondent posted this gem from Not The Nine O’Clock News yesterday. It prompted me to dust off and finish an article on fractional reserve banking.
Fractional reserve banking sounds like the dullest subject on earth, except that it is utterly fundamental to everyone’s economic life.
What is money?
When you stick it in the bank, whose is it?
Can it be right that the bank can just give it away?
This is a subject that excites passions, especially if your tastes run to anarchocapitalism, whose high priest, Murray Rothbard, was of the view that a bank deposit is a safekeeping arrangement; it is your money, and a bank who lends your money out to someone else without telling you is committing fraud.
This seems nuts. So, I have gone a little deeper. Thanks to @PatrickSquirrel on X for bringing this up.
Fractional reserve banking
/ˈfrækʃᵊnᵊl rɪˈzɜːv ˈbæŋkɪŋ/ (n.)
A system of banking under which deposit-taking banks keep only part of their deposit liabilities in liquid assets as a reserve and apply the remainder to the capital requirements of their business, for example by lending them out to borrowers. Banks hold that part (the fractional reserve) in cash or liquid assets or as balances at the central bank.
Fractional reserve banking describes the existing banking system, in which banks must hold a fraction of their deposits as capital reserves — hence, a fractional reserve — but can lend out the rest.
It works as follows:
Depositors deposit money with the bank. Their deposits represent loans to the bank that must be repaid on demand. They pay interest at a floating rate.1 The bank can deploy this capital investment towards earning money which, classically, it does by making term loans to its borrowers.
Banks face two main risks here: “credit risk” and “duration risk”: loan repayments depend on the borrowers’ ongoing solvency, and bank loans tend to have a longer fixed term than the bank deposits that fund them. Loans may not be repayable for years; deposits tend to be repayable overnight.
Banks are naturally vulnerable to borrowers going bust, and to sudden spikes in depositor withdrawals.
Bank regulations dictate how much of its deposits the bank can lend to borrowers. It must keep enough in liquid cash (not invested) to manage ordinary float or deposits and withdrawals, and also to manage any market stress situations and unexpected losses on loan commitments.
This is what bank prudential regulations are all about.
Murray Rothbard’s critique
The late Murray Rothbard’s disciples will tell you — well, they seem to like telling me — that fractional reserve banking is a “fraud”. As described by the Foundation for Economic Education’s Malavika Nair, the argument runs as follows:
Money deposited in a checking account that can be withdrawn at any time represents a bailment or a safekeeping device. A redeemable IOU thus issued to the depositor represents a warehouse receipt or a property title. If the bank now lends out this money—either through issuing more IOUs or by lending out money proper—it is breaking the terms of the initial contract with the depositor. Doing so amounts to fraud or overissuing of property titles and results in the bank keeping fractional reserves.
This is, in the vernacular, horse-shit. I felt bad about saying that, by the way, but Claude put my anxieties at ease:
In your face, anarcho-capitalists.
Why is it nonsense? The clue is in the text printed on banknotes. Take two genre classics: the Greenback and the British pound sterling.
US Dollar: “This note is legal tender for all debts, public and private”
Pound Sterling: “I promise to pay the bearer on demand the sum of twenty pounds.”
These phrases have different historical implications: the dollar is a final payment means in itself — hence it is a “fiat currency” that sits on nothing — whereas sterling purports to be an IOU promising to pay a fixed quantity of precious metal. Since exiting the gold standard in 1931, the Sterling legend has been an anachronism.2 In any case, both formulations establish these instruments as bearer instruments whose title passes by delivery.
This is vital for efficient commerce. It means a merchant need not enquire into a counterpart’s title to a tendered cash payment. The merchant can be certain that whatever the bearer bears, the bearer has title to.3
That being so, a cash instrument cannot be “bailed”. Bailment — a fancy word for “safekeeping” or “custody” — implies possession without legal title.
Currency, whether “fiat” (“this note is legal tender”) or “promissory” (“I promise to pay the bearer”), is designed to circulate freely, with title instantly and automatically passing to each new holder.
One cannot possess currency without taking title to it.
Full reserve banking
fʊl rɪˈzɜːv ˈbæŋkɪŋ (n.)
A system of banking where banks do not lend out demand deposits but instead only lend from time deposits. It differs from fractional reserve banking as fully reserved banks would be required to keep the full amount of each customer’s demand deposits in cash, available for immediate withdrawal.
Full reserve banking is sometimes proposed by horror-struck economists in knee-jerk reaction to banking crises such as the Great Depression and the Global Financial Crisis. But the moment usually passes.
Today, no country in the world requires full-reserve banking across primary credit institutions.
There is a theoretical alternative to fractional reserve banking. It is popular with anarcho-capitalists.4 But when you gently prod it, it collapses like a half-baked cake.
Let us call a “deposit” a cash transfer that does not discharge a debt, but is made in expectation that it will be later reversed. I am giving you money and expecting you to give it back. This might seem like safekeeping but, as mentioned above, due to the basic nature of money, it can’t be: it is necessarily a loan. (Phooey to Rothbard’s bailment notion.)
A “reserve” obligation to hold some or all of that money back is a contractual or regulatory imposition on the deposit taker — the bank. It is a bilateral contract between banker and customer. It is not embedded in the cash instrument itself.
In a “full reserve” system, the bank would be bound not to reinvest any deposit — yours, or any other customer’s — that was expressly placed on call.
Superficially, a full reserve bank would be less vulnerable to duration risk and less likely to go bankrupt than a fractional reserve bank. It would still be possible, though, if its loan assets failed, or it mismanaged the duration mismatch on its term deposits. The theory is that term deposits are a small portion of the deposit base — 20% or so — so this is a minimal risk. But hold that thought.
The legal conditions for customers placing call deposits at full reserve banks would be different than those at fractional reserve banks.
Firstly, depositors would have to pay the bank consideration for the deposit service. Fees, in other words.
Secondly, depositors would probably have to also pay fees on any account operation: deposits, withdrawals, transfers. Running a bank and maintaining client accounts is an expensive business.
Thirdly, the full reserve deposits would not earn interest. Why should they? Customers have directed the bank to put their money in a shoebox under the floorboards. Where would this interest come from? Interest is the compensation a borrower pays a lender for capital to fund its lending operation: a borrower who insisted the lender was not allowed to use its funds as lending capital would get no such compensation.
Now, cash is a wasting asset, so the longer a customer maintained such a “full reserve deposit” the more its value would erode, even before the bank chiselled out its fees.
Recall that term deposits are a relatively minor portion of funds placed with fractional reserve banks.5 That attitude might change were customers penalised for holding call deposits. Many would convert their call deposits to short-dated, interest-bearing term deposits. They might even seek an “overnight” term for their deposits. Another name for an “overnight term deposit” is a “call deposit”.
“If you want to be disinvested from the economy while holding a depreciating instrument, you don’t need a bank: you need a safe.
Effectively, a full reserve bank charges its customers a large running premium to insure against its own failure. But bank failure is an extreme tail event. There are much more efficient ways of hedging against it, such as reading the papers and monitoring your bank’s management and performance. Most customers would rather run that risk themselves and save the cost.
Full reserve banking would therefore be likely to collapse into a system where customers allowed their banks to invest their call deposits, subject to an overriding requirement to prudentially manage liquidity and duration risk to minimise the risk of bank failure.
That system is called fractional reserve banking.
Ultimately, few would accept the implied cost of “full reserve banking”. If you want the privilege of being disinvested from the economy while holding an inherently depreciating instrument, you don’t need a bank: you need a safe.
Fractional reserve banking evolved
Bear in mind that fractional reserve banking is not some clever a priori scheme engineered by clever fraudsters to rug-pull a million guileless grandpops. No-one designed fractional reserve banking: it evolved.6
Cash is freely transferable and negotiable, so if one merchant has more than it needs, and another needs cash for immediate investment, one may buy the other’s excess cash. This is simple business optimisation. Let us call a merchant with too much cash a “lender” and one with too little a “borrower”.
Now, “buying” fiat currency in the spot market is nonsensical — who would pay a dollar for a dollar? — so there must be a “time value” to any transaction: the lender delivers the cash now, but the borrower only pays for it, plus an uplift, later. The uplift represents the lender’s expected capital return over that period.
You could call this transaction a “sale on credit terms” but in common parlance, it is a loan: lender lets borrower have cash for a time, borrower then gives it back, plus some “interest” for the lender’s trouble.
In their way, cash loans are deeply weird: if a banknote is a receipt for an undischarged debt, then to lend that receipt is to create an undischarged debt for the purchase of an undischarged debt. We are generating a return by deferring a return. To lend is to trade the opportunity cost of holding cash.
A new class of merchants arose in the market whose sole business comprised efficient cash allocation: on one hand, collecting excess cash from those with too much — paying them a modest interest amount for their trouble — and on the other, aggregating and lending that cash to those in the market with a need for immediate capital investment, charging them a greater interest rate.
These businesses we now know as “banks”. In their first guise, there were no restrictions on how much capital they should hold in reserve. As successive banking crises have engulfed the ever more tightly-coupled financial system, so those regulations on fractional reserves and how they are calculated have grown.
But there is no (systemic) fraud. This is just perfectly ordinary investment risk.
Cryptocurrency
Bitcoin maximalists will tell you how Bitcoin fixes the “capital strip mining” mentality that fractional reserve banking incites, but that is a long and tenuous story addressed at length elsewhere: See Bitcoin is Venice.
Have a nice weekend.
A demand loan is effectively a rolling term loan with a term of one day, with fixed interest set for its term (overnight) and reset on each roll date (every day). A floating rate is really just a rolling fixed rate with a term of one day.
Sayeth the Old Lady of Threadneedle Street:
“The words ‘I promise to pay the bearer on demand the sum of five/ten/twenty/fifty pounds’ appear on all of our notes. This phrase dates from long ago when our notes represented deposits of gold. At that time, a member of the public could exchange one of our banknotes for gold of the same value. For example, a £5 note could be exchanged for five gold coins, called sovereigns.
However, the value of the pound has not been linked to gold for many years, so the meaning of the promise to pay has changed. You can no longer exchange banknotes for gold. You can only exchange them for other Bank of England banknotes of the same face value.”
There are some caveats around fraudlent and bad faith dealing sounding in constructive notice, trusts and so on but these illustrate, rather than falsify the point: the banknote itself transfers: the law has to manufacture fictional contract and trust arrangements to restore the economics. The actual bank note itself is gone.
Murray Rothbard was a leading anarcho-capitalist theoretician.
Demand deposits typically constitute around 70-80% of total deposits, with time deposits making up the remainder.
See the anthropology of money.
Are you familiar with the work of Perry Mehrling?