A Revisionist Critique of Fractional Reserve Banking

The conventional account of fractional reserve banking describes how bankers originally accepted precious-metal coined money deposited with them for safe-keeping but then learned that, since the depositor:

a) was indifferent as to whether the same coins or different ones to the same value were returned, and

b) called for return of deposits only infrequently,

the coins deposited could be secretly lent out at interest for the benefit of the banker, with only a fraction of those deposited being retained in reserve against calls for withdrawal. A further development was, when requested by depositors to make their money available to pay a creditor, for the banker to persuade the creditor to leave the payment on deposit and accept instead a deposit receipt. These receipts, when drawn up in the form of a promissary note or a bill accepted by the banker, started to circulate as means of payment in lieu of coinage.

It is customary among money reformers to decry these banking practices as morally reprehensible and inherently destabilising.

Reprehensible because depositors neither had necessarily agreed that the money deposited for safe-keeping should be put at risk by being lent, for the banker’s benefit, to a borrower who might default nor were often, nor ever adequately, compensated for this risk. Destabilising because the banker would never have sufficient funds on hand to meet an unexpectedly high call by depositors for return of their money, which would disrupt the financial arrangements of those depositors and potentially trigger failure of the bank to the detriment of all of its other creditors.

The remedy under this critique is full-reserve banking, where all money deposited, other than for the purpose of lending out at interest, should be retained by the bank in cash or cash-equivalent liquid assets.

This critique and its remedy runs into problems when applied to modern banking.

1. Two millenia of legislation and jurisprudence have consistently legitimised the use of depositors’ money by bankers for their own benefit. This is documented in excruciating detail, and to the author’s own great discomfort, in the first three chapters of Jesús Huerta de Soto’s magnum opus. It is a legal fact that money deposited with banks becomes the property of the banks to do with as they please. This is not a banking reform issue, it is a property rights issue on a par, perhaps, with slavery or women’s suffrage. It’s that big in terms of the historic inertia to be overcome. It’s that big, but is it really that important? Is it really going to be the issue around which multitudes will clamour for fundamental reform?

2. Modern banking practice simply no longer conforms to the fractional reserve narrative. Under that narrative, precious-metal coin was the final means of settlement for payments and bank customers deposited such coin for safe-keeping. Nowadays however, the final means of settlement for payments is no longer precious-metal coin but state-issued base-metal tokens and central bank liabilities in the form of banknotes and the reserve accounts held there by banks. Less than 1% of customer deposits at banks now represent receipts of deposits from customers of the final means of settlement (coins and banknotes held by banks as a percentage of total demand deposits). The remaining 99% represent the transfer from other banks of liabilities to their own customers, to accept which the receiving bank requires a balancing transfer of assets in the form of central bank reserves owned by those other banks. Not only do depositors not own the money that their deposits represent, they never once, at any time, had in their possession 99% of that money. All they own is a promise by the bank that the bank will use its own money to settle payments which the depositor wishes to make. It is thus hardly a stirring rallying cry that banks lend out money, without depositors’ consent, that depositors don’t own and never possessed.

The critique of fractional reserve banking on the grounds of moral reprehensibility is thus a treacherous foundation on which to build a campaign for banking reform. The grounds of inherent instability remain, however, but to exploit these requires a revisionist narrative of fractional reserve banking, one which acknowledges its historic economic benefits and justifies its legitimisation over two millenia. Fractional reserve banking is inherently unstable, has resulted in major bank failures with sickening frequency yet has been consistently upheld as the model for banking by judges (who were presumably honest and impartial), and legislators (who were equally probably not). Why? Was it just that judges enforced laws even if enacted for corrupt purposes or did they, acting independently, discern the merits of the system?

A new narrative is required.

It used to be thought that the means of final settlement of payments had to possess intrinsic value, had to be a medium of exchange – value given for value received. Since media of exchange had to be physically limited in supply in order to possess intrinsic value, methods had to be devised to economise on their use and distribution. Thus banks came to be charged with the task of accumulating stocks of the medium of exchange and using these for settlement of payments on behalf of their customers. Demand deposits became promises to use these stocks to settle customer payments. These promises were given in exchange for stocks delivered to them by depositors. Banks then found they could get away with issuing more promises than they had stocks, they could promise to settle current payments in exchange for a promise to deliver future stocks, and fractional reserve banking emerged. Fractional reserve banking maximised the availability for payment purposes of limited stocks of the medium of exchange by concentrating them in the hands of banks who freely exchanged them with each other, rather than hoarding them as would have been the propensity of the public.

But the world economy no longer relies on a medium of exchange to settle payments. Payment no longer involves the exchange of value for value received, nor even the promise of value, since currency no longer possesses intrinsic value. Payments today are settled with state-issued means of payment, not with a medium of exchange. But banks still monopolise the means of payment as if they were scarce resources whose use had to be optimised. Commerce still depends upon the banks to settle from their own resources the payments that their customers wish to make, and the whole world economy is thus hostage to the liquidity of banks. Banks have evolved an elaborate, expensive and failure-prone mechanism to sustain this liquidity through inter-bank borrowing buttressed by the central bank as lender of last resort, and authorities have implemented elaborate, expensive and inherently and ultimately ineffective regulatory systems to reduce the risk of failure, warn of impending failure and minimise the damage caused by failure.

And none of this is necessary. There is no physical limit on the availability of the state-issued means of payment as there must be on an intrinsically valuable medium of exchange. There is no reason, whether on the grounds of efficiency or prudence, why those who have earned or otherwise legitimately acquired the ability to make payments should not hold the state-issued means of payment directly, rather than in the form of promises from banks. This is the key paradigm shift.

The fractional reserve banking system with its administrative and regulatory overheads is designed for a world which no longer exists and which hasn’t existed since 1971 when Nixon uncoupled the US dollar from gold and states consequently abandoned the Bretton Woods system of fixed exchange rates. Until then there were constraints imposed by the availability of gold to back the dollar on the ability of sovereign states to issue their own currency at a fixed exchange rate against the dollar. Since then, although those constraints have been lifted, the central banks of sovereign states have failed to take the lead and left it to private enterprise banks to issue their own currency by expanding their balance sheets, a technical term which simply means creating deposits, promises by the bank (its liabilities) to make payments on the deposit holder’s behalf, in exchange for loans, being promises by the deposit holder (assets of the bank) to make payments to the bank equal to those promised by the bank, plus interest.

The reform that is appropriate for today’s world is not more regulation of banks’ balance sheets but removal from the banks to the payers themselves of the means for final settlement of the payments they make. And that is the reform proposed by Positive Money.

Under the Positive Money proposals, a person’s current account will constitute a legal claim on a fund held at the Bank of England for the purpose of settling payments, and a payment by that person will consist of the transfer of that claim, via the processes administered by that person’s bank, to the payee. The Bank of England fund will contain one pound for every pound that is entitled to be spent, whether or not the entitled owner intends to spend it now, sometime or never. There will be no daily scramble, as at present, to ensure that banks have sufficient funds available for spending to settle the amounts that customers wish to spend. Every customer has their own fund from which their spending is financed.

The primary responsibility of banks will no longer be to ensure that they have sufficient liquidity to settle customers’ payments, but to persuade customers who do not intend to make in the near future all of the payments to which they are entitled to make instead their unused money available for lending to others.

But isn’t that what we thought banks did all along, before we found out the truth?