Fractional Reserve Banking: Con-Fus-Ing!
I recently ran into a discussion about fractional reserve banking. [FRB] There seems to be much confusion about it.
Basically, the definition is:
"Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties." [Investopedia]
Certain economists are vehemently against FRB, especially some in the Austrian school. But I don't always agree. Sometimes fault appears in one place when it is actually in another.
I see it this way: When you hold what you consider to be money, whatever that is (e.g., euros, dollars) you own them, period. When you decide that you don't want to take the risk of seeing them stolen from your home and you look around for a safe warehouse, you find that the service is offered by banks. The bank will hold that money for you, available upon demand, and if you want a little income it will even pay you interest, which it earns by lending your money out or using it as collateral. If you put your money in the bank, therefore, you will have, in effect, lent your money to the bank.
The risks will vary according to the type of bank you choose. I consider normal and safe banking to be the lending of my money to someone for, say, a home, as long as the bank is a good one and judges well its debtors. And it is my responsibility to see that I choose a good bank by studying its history. I would expect a reasonable amount of interest for my loan to this type of bank. And, depending on the interest I demand, I might expect to have free access to my money whenever I want it.
This is not FRB. It works as long as there are no economic panics, and even if there were, the banks can avoid money shortages simply by branching out into various states in other parts of the country. (See Canada's experience during the Great Depression.)
Or, to take another example, I could lend the money to a bank that wishes to lend credit (not my money this time, but credit created by the bank) to a company that produces, say, trucks. My money could be used as a small, say 10%, part of the reserve of the bank for that purpose. The bank would know the truck company well and would expect to be reimbursed for the credit loan within a relatively short period of time, say around 30-90 days. The bank would also hold, as collateral for the other 90%, documents called commercial paper for the trucks produced (basically a claim on the trucks). The credit, upon reimbursement by the truck company, would liquidate, and my money would be quite safe. I would receive good interest for this loan as well. This is what I consider to be Healthy FRB.
Today in our looser banking world, I could also consider lending my money to a bank that issues credit, again beyond the amount of my cash deposit, but without commercial paper or other type of collateral. This is much more risky, and normally I would expect to be paid a lot more interest in this case. This is also FRB, but I would categorize it as Risky FRB.
The problem is that today ,with Risky FRB loans that are not collateralized and that are loosely distributed by unexperienced bankers, we are not offered proportionate compensation for the high risk involved. If banks had to compensate us for the actual risks they are making us take, they would not make as many risky loans.
Furthermore, as it happens, we now have a number of government-instigated measures putting fuel on the Risky-FRB fire. The Fed, without a gold or other standard, is dishing out dollars to banks with one hand, and with the other giving the banks interest just to park their reserves at the Fed. This means that the banks have even less motivation to pay us any interest at all. Quite the contrary: Today savers receive at most 2% interest on their savings accounts, which is barely enough to cover the official price-inflation numbers. In other words people are lending money to banks in return for no interest at all.
Just to keep it safe from theft? Frankly, that IS theft.
In other words, it's not the FRB per se that is at fault. It is:
1. The unstandardized, loose fiat monetary system in which we live, where risky-type FRB without collateral has allowed banks to make many more loans and take many times more risk than they would otherwise; plus
2. The lack of proportionate compensation for the risk the banks are taking with OUR money; plus
3. The new practice of bailing out large banks, which takes away even more incentive to lend conservatively; plus
4. This new Fed policy of giving banks interest on reserves; plus
5. The lack of viable alternatives for safeguarding our money.
Basically, the definition is:
"Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties." [Investopedia]
Certain economists are vehemently against FRB, especially some in the Austrian school. But I don't always agree. Sometimes fault appears in one place when it is actually in another.
I see it this way: When you hold what you consider to be money, whatever that is (e.g., euros, dollars) you own them, period. When you decide that you don't want to take the risk of seeing them stolen from your home and you look around for a safe warehouse, you find that the service is offered by banks. The bank will hold that money for you, available upon demand, and if you want a little income it will even pay you interest, which it earns by lending your money out or using it as collateral. If you put your money in the bank, therefore, you will have, in effect, lent your money to the bank.
The risks will vary according to the type of bank you choose. I consider normal and safe banking to be the lending of my money to someone for, say, a home, as long as the bank is a good one and judges well its debtors. And it is my responsibility to see that I choose a good bank by studying its history. I would expect a reasonable amount of interest for my loan to this type of bank. And, depending on the interest I demand, I might expect to have free access to my money whenever I want it.
This is not FRB. It works as long as there are no economic panics, and even if there were, the banks can avoid money shortages simply by branching out into various states in other parts of the country. (See Canada's experience during the Great Depression.)
Or, to take another example, I could lend the money to a bank that wishes to lend credit (not my money this time, but credit created by the bank) to a company that produces, say, trucks. My money could be used as a small, say 10%, part of the reserve of the bank for that purpose. The bank would know the truck company well and would expect to be reimbursed for the credit loan within a relatively short period of time, say around 30-90 days. The bank would also hold, as collateral for the other 90%, documents called commercial paper for the trucks produced (basically a claim on the trucks). The credit, upon reimbursement by the truck company, would liquidate, and my money would be quite safe. I would receive good interest for this loan as well. This is what I consider to be Healthy FRB.
Today in our looser banking world, I could also consider lending my money to a bank that issues credit, again beyond the amount of my cash deposit, but without commercial paper or other type of collateral. This is much more risky, and normally I would expect to be paid a lot more interest in this case. This is also FRB, but I would categorize it as Risky FRB.
The problem is that today ,with Risky FRB loans that are not collateralized and that are loosely distributed by unexperienced bankers, we are not offered proportionate compensation for the high risk involved. If banks had to compensate us for the actual risks they are making us take, they would not make as many risky loans.
Furthermore, as it happens, we now have a number of government-instigated measures putting fuel on the Risky-FRB fire. The Fed, without a gold or other standard, is dishing out dollars to banks with one hand, and with the other giving the banks interest just to park their reserves at the Fed. This means that the banks have even less motivation to pay us any interest at all. Quite the contrary: Today savers receive at most 2% interest on their savings accounts, which is barely enough to cover the official price-inflation numbers. In other words people are lending money to banks in return for no interest at all.
Just to keep it safe from theft? Frankly, that IS theft.
In other words, it's not the FRB per se that is at fault. It is:
1. The unstandardized, loose fiat monetary system in which we live, where risky-type FRB without collateral has allowed banks to make many more loans and take many times more risk than they would otherwise; plus
2. The lack of proportionate compensation for the risk the banks are taking with OUR money; plus
3. The new practice of bailing out large banks, which takes away even more incentive to lend conservatively; plus
4. This new Fed policy of giving banks interest on reserves; plus
5. The lack of viable alternatives for safeguarding our money.
Labels: fractional reserve banking; Federal Reserve; real bills
posted by Katy Delay at 8:24 AM
2 Comments:
You are correct Sybil concerning the banking system. I am in my seventies and have known about this and the Federal Reserve System since early adulthood, but have had my hands tied and no real way to fight back. Gold and silver plus other precious metal is a great way to go but requires you to have protections (guns, safes, and the like). I just paid off my home because of the large amount of interest I was forced to pay. Usery. What is your opinion concerning the steps to take?
Chuck
Thanks for your comment, Chuckmadere. I assume you mean the steps to take to protect ourselves from the follies described above. If my father were alive, he would probably be advising the public to hold some proportion of gold, probably physical bullion coins in a really solid safe or in a safe deposit box. Then one might consider gold ETFs, although I have trouble really having confidence in these. A few seem to be sound. Then you need to decide how much risk you want to take with the rest of your disposable income. (Note "disposable," don't play around with your monthly budgeted funds and income.) Some recommend diversification; some like real estate, especially rental real estate. But prices of both are high at the moment. Some like cash, or bonds.
I'm not an investment professional, so I don't dare advise anyone on specifics. Read commentators such as John Mauldin and Doug Noland, two of my personal favorites. As Mr. Mauldin says, I believe we are headed for a "Great Reset" – an event that will be very painful. This is basically the next recession (and of course there will be one), which will be worse than the last, and during which the Fed will be trying desperately to right things that they will not see coming. Whether they will be successful or not remains to be seen.
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