Fractional Reserve Banking

Fractional-reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder while maintaining the simultaneous obligation to redeem all these deposits upon demand.  Fractional reserve banking occurs when banks lend out any fraction of the funds received from demand deposits. Despite being a form of embezzlement and fraud this practice is universal in modern banking.

CREDIT EXPANSION

By its nature, the practice of fractional reserve banking expands the currency supply beyond what it would otherwise be. Because of the prevalence of fractional reserve banking the broad currency supply of most countries is a multiple larger than the amount of base currency created by the country’s central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators.

Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This both limits the amount of money creation that occurs in the commercial banking system and ensures that banks have enough ready cash to meet normal demand for withdrawals.

THE BANK RUN

Problems can arise, however, when a large number of depositors seek withdrawal of their deposits; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis. This is because the system is based upon a faulty fundamental premise:  lending out people’s hard earned money while at the same time having the obligation to return it.  To mitigate these problems, central banks and other government institutions generally regulate and oversee commercial banks such as with the Federal Deposit Insurance Corporation (FDIC).  But this only creates moral hazard.

The central banks, like the Federal Reserve, act as ‘a lender of last resort’ to commercial banks and also insure the deposits of the commercial banks’ customers.  But because the wealth is squandered by the banks lending the capital for poor investments the only solution is to debase the fiat currency through inflation or in other words, printing the currency out of thin air to bailout the failed financial institutions.

When bailment is used and enforced instead of fractional reserve banking the banks do not fail when depositors want their money unless there is overt fraud.  This type of bailout is not possible when a commodity currency is used and which is required under the United States Constitution.  When the bailouts are undertaken on a massive scale it is called quantitative easing.

EXACERBATION OF THE BUSINESS CYCLE

Under the Austrian School of economics interest rates regulate production over time.  Because fractional reserve banking expands the currency supply and lowers interest rates therefore it exacerbates the normal fluctuations of the business cycle.  This affects the role of interest rates as the price of investment capital which play a guiding for investment decisions.

The natural (free of government influence) interest rate reflects the actual time preference of lenders and borrowers. Government’s monopolistic control of the currency supply through central banks and regulations insuring fractional-reserve banking activities disturbs this natural market process such that the interest rates no longer reflects the real supply of and demand for investment capital.

For example, if the interest rate is artificially low then the demand for loans will be higher than the actual supply of willing lenders and if the interest rate is artificially high then the opposite situation will occur.

THE INEVITABLE CREDIT CONTRACTION

This misinformation leads investors to misallocate capital.  They borrow and invest either too much or too little in long-term projects. The result is periodic recessions.  Then, as it always happens, there are necessary “corrections” following periods of fiat credit expansion and the unprofitable investments stimulated by fiat credit creation are liquidated which frees capital for new sustainable investment.

It is during these inevitable credit contractions that the fictitious capital created during the credit expansion evaporate.  The central banks of the world are engaged in global quantitative easing in a vain attempt to stop the credit contraction.