Fractional Reserve Banking with a Central Bank

Fractional reserve banking is not inherently immoral or more unstable than other industries by itself. The real problem of fractional reserve banking is that the Federal Reserve can influence banks by influencing the MB (bank reserves, physical or electronic) money supply or by always offering a failsafe mechanism in case banks overextend on loans. It is the introduction of new money into the economy, altering MB, by the Fed that allows banks to extend credit (and also creates a business cycle). Furthermore, banks have the implicit (if not explicit) protection of government in case they fail (“too big to fail”).

Is Fractional Reserve Banking Immoral?

If banks had no guarantee by government and no influence by the Fed, they will set their own reserve ratio and subsequent lending standards. Banks will be more cautious about lending because if they fail to redeem the deposits of their clients, they will go bankrupt instead of getting bailed out. Bad banks will lose their reputation followed closely by their clients. The more cautious banks will remain.

Suppose we move from an economy from a pure banking system (100%) to a fractional reserve banking system. Though fractional reserve banking may extend the money supply at first, there will be a limit to extending credit via loans. There is no Fed influence of increasing the stock of reserves by fiat.

Though the banks may overextend the money supply, it will be overextended by the same proportion at every point in time. Without the Fed increasing the money supply or being available as a “lender of last resort”, banks cannot extend beyond their ratio without risking their own bankruptcy. The banks have an incentive to be cautious and not to overextend beyond their means.

I find nothing inherently wrong in fractional reserve banking (assuming the absence of central bank), so long as:

  1. Consumers are aware and consent to their deposits being loaned out while deposited
  2. Depositors can redeem their deposits from banks immediately upon request and at an agreed upon parity
  3. The failure by banks to redeem deposits is recognized and enforced as an infringement of the property rights of the depositor by the bank (breach of contract)
  4. Banks are not given special privileges (bank holidays, government loans, etc.) in the case of insolvency or emergency

The real problem then is not fractional reserve banking itself. The real problem is a central bank expanding or contracting the money supply, that is, the monetary base (MB). The fractional reserve banking system is merely a vehicle that the Fed uses to enact their monetary policy. It is the Fed controlling the money supply that affects bank reserves, which are then multiplied by the fractional reserve system. Banks by themselves are not the problem; the central bank is the issue.

As mentioned previously, fractional reserve banking operates like an inverse pyramid, where the MB (physical money and bank reserves) stock determines “money equivalents” (accepted as money and indistinguishable from true money) based on the banks’ reserve ratios. M1 includes MB + demand deposits by clients held at banks. M2 includes M1 + time, savings, and longer-term deposits held at banks. An explanation of fractional reserve banking and the MB, M1, and M2 stocks can be found here.

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The proportion between MB, M1, and M2 will remain relatively fixed. Banks will determine their own reserve ratios that balance profit with the risk of insolvency. They can only lower their reserve ratio and overextend with greater and greater risks for doing so. Without any changes in MB, M1 and M2 will be more or less fixed in proportion to MB.

Though M1 and M2 are inflationary, they will always be limited by MB, which would remain unchanged in the absence of a central bank. M1 and M2 will be limited by the best risk/reward ratio for banks’ deposits. This is what I mean when I say that though the banks may increase the money supply, it will be overextended by the same proportion at every point in time.

It may be that a fractional reserve banking system is unable to survive in the free market, but only the market can determine that and not myself.

Fractional Reserve Banking + Central Banking

Fractional reserve banking is merely a vehicle, and the Fed is the driver. The vehicle itself can only do harm by harming itself (overextending and risking insolvency). On the other hand, the Fed, by manipulating MB, causes great fluctuations in what we consider money and similarly prices expressed in terms of money. The driver ceaselessly feels the need to drive the economy off a cliff. But who cares? “In the long-run we are all dead” (1).

The M2 money supply is what determines prices as it is universally accepted as money and indistinguishable from true (MB) money. But the Fed cannot control M1 or M2 directly; it can only directly control MB. The Fed determines the reserves of all banks by either creating physical money or crediting it electronically. It is up to the banks what they do with their reserves.

Commercial banks by law must hold some fraction of reserves to back up loans they have lent out. There are 2 ways the bank can hold reserves (2):

  1. As physical cash in their own vaults
  2. As Federal Reserve Deposits (The bank’s reserves electronically held at the Federal Reserve)

Only 3% of money exists as physical money. That means the vast majority of money is held electronically, and created electronically. As previously mentioned, the Fed can only directly change the MB stock of money. Suppose the Fed decided it wanted to inflate the money supply, it would increase the stock of MB by crediting the Federal Reserve Deposits of commercial banks. By increasing MB, banks can then increase the total supply of money equivalents M1 and M2 by making more loans.

This is depicted by the following graph:

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By increasing MB, the total stock of money equivalents can increase in greater proportion than the increase in MB due to fractional reserve banking and the Money Multiplier. With a reserve ratio of 10%, banks only need to keep 1$ on reserve for every $10 lent out. This means that for every $1 of new money created by the Fed (as MB), banks receiving new deposits can increase the total money supply to $10.

Altering MB is not the only way to increase the money supply. If the reserve ratio of banks is lowered, then the proportion of M2 to MB will be greater. In this case, MB remains the same, but the amount of M1 and M2 that can be created from the same amount of MB increases. The Fed has the power to set the reserve ratios of banks.

We can then attribute the dangers of a fractional reserve banking system to 2 causes:

  1. An alteration of MB
  2. A change in the reserve ratio

Without a central bank, MB will change independent of the whims of bureaucrats, by some fixed or slowly increasing stock of commodity (gold, commodity reserve, etc.) that comprises the stock of MB. Furthermore, in the absence of a central bank, the banks themselves will set their reserve ratios, at some point that would minimize the risk of insolvency. Thus a fractional reserve system in a free market would be checked by the physical cost of producing more money (such as mining gold, producing a commodity, etc.) or by the solvency of the banks themselves limiting their own reserve ratios.


How the Fed performs the increase of the money supply with credit expansion will be discussed in the next article.