Financial Fragility and Fractional Reserve Banking

This post touches on one of the fundamental attributes of banking systems in the present day, and how it contributes to financial fragility. I've known about the fractional reserve system since my student days, but never really thought about it much in terms of the impact on systemic risk or stability. The thinking really started when my brother in law pointed me to Web of Debt by Ellen Brown, which purports to show the problems with the monetary system we use today, and how it can be solved. I wouldn't recommend reading the book - it's a polemical tract that had me choking with laughter at some of its attempts at “analysis”. Nevertheless, despite the flaws Brown's book does point out some of the essential problems with the fractional reserve system.

If you're not familiar with the term, or how money is created under the modern monetary system, here's a short narrative. Let's say we have person A, B and C. A owns a bank, B has $100 in cash, and C has nothing. B puts his money with A, who now has $100 in assets (the cash from B), and $100 in liabilities (B has a claim on A's assets). That $100 is now the sum total of the money supply.

Now assume that the central bank places a 5% reserve ratio on the banking system and this reserve has to be placed at the central bank- in other words, A is required to hold only 5% of any liabilities in cash, and can lend out the remaining 95%. C then approaches A for a loan which is granted, the maximum of which is $95 (95% of $100). A gives a $95 loan to C who promptly deposits the cash with A, thus creating on A's books a $95 asset (the loan), and a $95 liability (the cash owing to C). A's balance sheet, and thus the money supply, has been inflated to $195. Assuming B and C are irrational and don't mind paying A a whole bunch of interest, this round-robin of borrowing and depositing can be carried out ad nauseum to the point where the money supply has now increased by a factor of:

m = 1/r = 1/0.05 = 20

...where m is the money multiplier, and r is the reserve ratio. Using our $100 initial cash position, the total amount of money at the end has grown to $2,000, with B and C owing A $1,900 in loans, but A owing B and C $2000 in cash, which from our example doesn't actually exist - only the original $100 cash is available.

Money is thus created or destroyed as if by "magic" - because all money under the current system is fiat money, there is no intrinsic value to money save for its functions as a medium of exchange and (with qualifications) a store of value. The fractional reserve system evolved over the centuries from a behavioral characteristic that bankers and money lenders have observed - people don't really use all their cash at once, even under the metallic system. Under normal circumstances, it was thus profitable to lend out the excess cash.

From the example, we can see how such a system contributes to instability:

1. If B or C default on any of their loans, that will reduce A's assets but not his liabilities. This is a solvency problem.

2. If either B or C withdraw the cash due to them from their deposits in excess of $100, then A doesn't actually have sufficient cash on hand. A corollary is that, if either B or C suspect that A may not be able to meet his cash obligations both will attempt to withdraw the total cash owing to them, which leads to a bank run. This is a liquidity problem.

In either case, A is in deep trouble, and has to run to the central bank for help. I think you can see the relevance of the two scenarios above to the situation in the global banking system today. To be fair, central banks now regulate fractional reserve money creation through the liabilities side of the balance sheet, rather than the reserve or asset side. Based on Basle I risk-weighted capital requirement of 8%, the maximum money multiplier (irrespective of reserve ratios) is about 12. In accounting terms, this is analogous to the gearing ratio.

In addition, there are some systemic issues that are intrinsic to fractional reserve banking:

1. There is no doubt that the fractional reserve banking system actively encourages taking on debt. In my example, from a zero debt and $100 asset position, the system creates $1900 in debt with the same $100 in assets. If any of the debts are not honored, the system has a solvency problem.

2. Then there is the issue of inflation and deflation, where money supply and real output are not in equilibrium with each other. If money supply is greater than real output, then you have the phenomenon of inflation (assuming money velocity is constant). If money supply is lower than real output, you get deflation. Both change the relative value of money with respect to real goods and services, making money less trustworthy under a fiat money system. Under the fractional reserve system central banks can at best influence the supply of money to support economic growth, but not directly control it. On the other hand, it is very easy for central banks to trigger inflation or deflation, by supplying too much or too little cash into the banking system.

Further, there are some philosophical and religious objections to fractional reserve banking:

1. Banks get essentially a free ride through the money creation process. Profits through lending are gained not through the production of real goods or services, but through recycling (non-existent) cash. This issue is disputable - the intermediation process does require performing a service, which is vetting borrowers for credit risk. There's understandably more angst over this issue in light of the origination-securitization model now prevalent, where the performance of this service has been passed on through the securitization process to rating agencies and investment banks, who obviously dropped the ball.

2. Relating to the above, since money held in deposits is a claim on cash which doesn't exist, fractional reserve banking can be likened to fraud perpetrated by banks on the public.

3. An additional claim of fraud can also be attached to central banks and governments. The money supply can be raised to cause inflation, which has two effects: reduce the claims of monetary units on real goods and services, as well as reduce the future real value of debts (including that of the government). Since fiat money represents an obligation of the government which guarantees its convertibility, inflation can be construed as an act of fraud by monetary authorities.

Both Christians and Muslims thus have serious problems with the modern banking system as it stands. From an economics point of view however, the only opposition to fractional reserve banking comes from the Austrian School. These disparate groups prefer full-reserve banking (or alternatively free banking as argued by some in the Austrian School), as well as tying money to some object of intrinsic worth such as gold. This would have the following effects:

1. Full reserves means bank runs would be avoided, as there is no issue of liquidity. However, potential solvency problems will remain.

2. Tying money to gold removes government interference from the money supply. Since the Austrian School sees inflation as purely a monetary phenomenon, inflation (and deflation) would not be possible.

From my point of view however, to paraphrase Winston Churchill, fractional reserve banking is the worse form of banking, except all the others.

Let’s contrast the two systems:

1. Solvency is and remains an issue whatever the system of banking, so I will not touch on it here.

2. Liquidity problems are resolved in the fractional reserve system in two ways: first is recourse to the interbank market; and secondly the function of lender of last resort that central banks typically take on. Banks who are short of liquidity can borrow liquid assets from banks with excess reserves. If this is not possible, banks can borrow directly from the central bank, but typically under sanctions such as penal interest rates. If the liquidity problem is really severe, central banks can in extremis take over the bank concerned. Under the full reserve banking system, of course, liquidity is never an issue.

3. In terms of debt creation, because of the requirement for full reserve backing money can only be lent out if depositors agree to it, i.e. waive their claim to their money for a certain period. This is analogous to today’s time or fixed deposits. Since money available for loans is limited, debt creation never exceeds the total amount of available reserves.

4. Under a full reserve system, the money supply is independent of real output and it follows therefore that inflation and deflation cannot be artificially created. Which sounds good until you realize that counter-cyclical monetary policy is also impossible – in fact monetary policy of any kind is impossible. I’ll expand on this point later.

5. The banking business model is quite different. Whereas under fractional reserve systems interest is paid to depositors and charged to borrowers, under the full reserve system banks act more like custodians so depositors pay banks for keeping their money in the system, except where deposits are allowed to be lent out. Interest (or profit, if you prefer), continues to be charged to borrowers.

Now, going through the above it would appear as if full reserve banking is a viable replacement for fractional reserve banking. It reduces the level of debt possible, takes care of liquidity problems, and removes the temptation for government to inflate their debts away.

Here’s the gotcha…full reserve banking also definitely removes support for economic growth. It is no accident, in my view, that fractional reserve banking (and by extension fiat money) has facilitated the explosion in real economic growth and the substantial increase in human welfare over the past two centuries.

Since money can be created and destroyed on demand, the fractional reserve system fully accommodates economic activity. In other words, money supply and money demand will always adjust to equilibrium. The process can be helped along and smoothed out by application of monetary policy, i.e. influence through the creation or destruction of high-powered money, or through changing the price of money (the interest rate). It is therefore possible for monetary authorities to apply counter-cyclical policies to reduce the impact of booms and busts in the economic cycle, although this is predicated on how much trust you can place in monetary authorities (for counter-examples refer to the Weimar Republic and the current government of Zimbabwe).

This adjustment isn’t possible under a full reserve system, as money demand must adjust to a relatively fixed money supply. If the Fisher identity holds, then assuming the velocity of money is constant real output growth must always converge to the rate of growth of the money supply. While the velocity of money is never a constant as I demonstrated before, it does vary within a range. For excess economic growth to persist and be supported by a full reserve system, the velocity of money must always be ever increasing, which is not plausible. I won’t repeat here the arguments for limited resources (i.e. the supply of gold will run out), but the rate of increase in gold supplies has historically been very low (evidence to come in a future post). A further implication is that under the full reserve banking system deflation and depressions are not only possible but probable, since there is no scope for using counter-cyclical monetary policy. The argument that inflation and deflation are not possible at all under a full reserve system is complete bunk as far as I’m concerned. This is borne out by the historical record, as the discovery of the New World in the 15th century along with its gold and silver mines, caused a long period of inflation in Europe.

More dangerously, tying money to gold or any other object of intrinsic value can give rise to the conflation that money=wealth. If that sounds innocuous to you, look up mercantilism. I think that there is no doubt that free trade (or at least, freer trade) has had a positive impact on global prosperity. Just as important, removing the link between money and wealth (and thus the applicability of mercantilist theory) reduces the impetus towards war, colonialism, and imperialism. If real output growth on a global basis is restricted to the rate of growth in money (i.e. gold), then the only way an individual country can raise the welfare of its own citizens is through appropriation (i.e. steal wealth from others) or annexation (i.e. take over and oppress others). Despite the fact that two massive world wars were fought in the last 100 years, the latter half of the 20th century has been amongst the most peaceful periods in recorded human history – yes, even with the conflicts in the Middle East, Asia, Africa and the Balkans. Incidentally, this ties in rather nicely with the shift from the Gold standard to a full fiat money system – you can draw your own conclusions.

The only way I see a full reserve banking system being even remotely attractive is if the monetary base is convertible into an asset which has a higher rate of growth than real potential output. This will of course apply a moderate amount of inflation, which is not necessarily bad as it allows for a low real interest rate as well as providing the correct incentives to borrowers and producers. But that still doesn’t allow for discretionary monetary policy, or remove the logic of mercantilism.

In short, at the present time, I see no real alternative to the fractional reserve banking system despite its many flaws. There is no doubt that the current global financial crisis represents a failure of the system on a wide scale, but I believe there is a case to be made that the fundamentals of the system has been short-circuited over the past ten years by the origination-securitization model, as well as the rise of the shadow-banking system. On the whole, I would rather have a system that generally supports increases in human welfare rather than one that restricts it, even if it means lots of bumps along the way.

As far as an Islamic financial system goes, I don't believe a debt-based banking system is the best way to intermediate between savers and entrepreneurs - but that's a post for another day.