The Myth of Fractional Reserve Banking

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Three Business Spectator readers contacted me directly about one topic last week – bank money creation, and how bank reserves work. Following an old journalism adage that three direct enquiries about a topic from the public means that everybody’s interested in it, I’m diving into wonkdom to answer their queries in detail here. Ignore this post if the adage isn’t true for you, but if it is and you haven’t yet had your morning Java, now’s the time for that stroll to the barista.

To read the rest of this post, click here

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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23 Responses to The Myth of Fractional Reserve Banking

  1. mikeh1980 says:

    Until economics students start demanding a refund of tuition fees I’d expect that the teaching this myth will continue.

  2. TruthIsThereIsNoTruth says:

    Certainly a big step adding the extra bank in there.

    The part about looking for reserves later highlights how banks are incentivised not to do that and we have the credit crunch as a contemporary example.

    If you’re balance sheet position is so weak that you are desperately looking for funds to fill your reserves, the market knows this and either makes you pay or not give you money at all, i.e. credit crunch. Well funded banks in Australia could sit on their hands for months during the worst of the credit crisis, while their American counterparts needed massive rescuing from the federal reserval. So how does it really happen? Depends on when and where you look.

    The two main directions in terms of increasing complexity, is defining different capital tiers to be consistent with the current reserve regime, and adding more banks creating competition for both deposits and loans.

  3. Steve Hummel says:

    Regarding: http://krugman.blogs.nytimes.com/2012/10/23/theory-and-the-thirties/?smid=tw-NytimesKrugman&seid=auto

    Economists sound so erudite and confident. And yet there is so much un-examined orthodoxy laying around all over the place and so much at stake that they should be much more humble and open to new thinking. The kind of thinking which considers factors that are not abstract, but as real as commerce itself. One such REALITY is the enforcements of cost accounting which invalidate velocity THEORY, and make incomes inevitably less in comparison to prices. Another factor/REALITY that economists are failing to consider is the increasing effect of technological innovation on unemployment. The inexorable march of Technological efficiency wed to profit making systems where there is an equally inexorable drive to reduce costs and hence increase profits is like the irresistible force meeting the immovable object. Technology reduces the RATIONAL need for human employment and the pursuit of profit is happy to accelerate their collision. The question is only whether the resulting impact will explode into a revolutionary socialism, a reactionary neo-feudalism or result in an evolution of profit making systems via a change in the consumer financial paradigm from loan only to citizen’s dividend and loan if desired and creditable. And the factor that will monitor which one of these results occurs is whether we choose to to think as homo economicus or homo sapiens, that is, wise and discerning man. Consider it.

  4. peteryogman says:

    The central bank must accommodate these transactions. But the central bank also can create or destroy money in separate money market operations and for an overall look at credit in the economy these operations must be combined with support of the private banking system. Therefore is money totally endogenous or is there room for central bank activity that is truly exogenous and is this large enough to effect the economy beyond private bank activity?

  5. TruthIsThereIsNoTruth says:

    Central bank influences the price at which money exchanges by setting the overnight rate. I think there is a natural misconception that endogenous money means explicit control by private banks. Endogenous money is a mechanism via which money volume is created, however it can be controlled or influenced by a wide variety of factors, including the central bank. Banks behaviour is mainly influenced by price and risk (still missing from the parsimonous model), both in turn influenced by many things, depending on when and where you look.

  6. TruthIsThereIsNoTruth says:

    Just thinking there is a natural extension of the model to vector space. So instead of having a buyer and seller bank, you have a vector of banks which are both buyers and sellers.

  7. alainton says:

    Well done in starting to model intra bank transactions.

    These are crucial of course in understanding how moneys ‘flows the other way’ and why reserves arnt drained by credit creation.

    It also exposes a flaw in the ‘chicago plan’ – full reserve banking – recently promoted by the IMF in that loans created from term deposits (which would be allowed) would create reserves of equal value in other banks which could then be lent out. From an email from Dirk Bezemer im sure he wouldnt mind sharing

    ‘ Here is another problem, Andrew:

    Suppose an alphabet of banks A,B,C,…Z. Suppose bank A can lend while
    banks B,C,…, Z are all ‘loaned up’ – they have lent just so much to
    the public as their reserves allow.

    What if bank A, with enough reserves to lend millions, does so, to the
    point where also bank A reaches its limit? And what if the borrowers
    draw down the loan and spend the money? All very likely to happen.

    Now millions in deposits find their ways through the economy and onto
    bank balances of banks B,C, …Z, all in excess of reserves.

    Meanwhile bank A still has the same capacity to lend – all its deposits
    have been transferred to other banks, after all.

    So it does the same thing again. And again.

    What will the central bank do to stop this? I cannot stop bank A – bank
    A is operating by the rules. It cannot destroy deposits in banks
    B,C,…Z. The deposit are not theirs.

    Ergo, their will de deposit=money creation in excess of reserves and
    loans will be funded by deposits – all the disasters that full-reserve
    money was trying to avoid.

    Dirk’

    So perhaps a better title would have been ‘The Myth of Full Reserve Banking’

  8. cyrusp says:

    Isn’t fractional reserve banking simply the opposite of 100% reserve banking?

    I don’t get why debunking the money multiplier theory means that FRB is a myth. As far as I can tell there is no conflict between endogenous money and FRB. When a layperson talks about FRB they simply mean bank money creation (which I agree with some Austrians is a form of fraud).

  9. Ian Wentworth says:

    Dear Steve

    Thank you for the detailed account of ‘The myth of the money multiplier’.
    I follow the reasoning down to the description accompanying Table 3, where the interbank transactions are intermediated by the Reserve Bank, however when a bank has insufficient Reserves to cover a specific transaction it become less clear.

    If in the first instance, a bank has insufficient liquid reserves to complete an interbank settlement, it presumably borrows against or sells other assets in the short and/or longer term to meet its obligation. However, you pose the situation where an individual bank is already at the limit of its reserves – either as determined by the capital adequacy requirements, or simply has no reserves at all (?).

    You suggest that in such situations the RBA is bound, in the interest of maintaining order or preventing collapse of the system, to provide further loans or make purchases in open market operations using additional issues of base money. In which case the capital reserves of individual banks are increased allowing the extended lending to continue.

    What I don’t understand is the difference between this situation, and a bank with no deposits or reserves whatever, loaning out any amount it choses, only to have this supplied by the Reserve Bank on request – in the name of system stability. Presumably not the same thing, but what is the difference?

    Also, this ‘money creation’ process resulting from commercial bank loans, in the absence of additional base money creation by the Reserve Bank, is actually credit creation, and you have spoken of this before as the creation of ‘credit money’. This combination of credit and the money base as the ‘money supply’ is confusing. For an individual, the potential spending power of his cash and bank credit would appear to be the same – he can spend both immediately. However, the sum of all credit balances in a system which also includes debt, appears to represent not just present spending power, but promised future spending power – realised only when outstanding debts are repaid by continuing economic activity. Thus the ‘money supply’ is largely a projection of potential future spending power, as only the monetary base is available to spend in the present – a small fraction of the composite ‘money supply’. Is this correct, and is this an alternative way of describing why the Reserve Bank issues more base money – in essence to meet ‘withdrawals’ of future spending power before its due time?

  10. mahaish says:

    “If you’re balance sheet position is so weak that you are desperately looking for funds to fill your reserves, the market knows this and either makes you pay or not give you money at all, i.e. credit crunch”

    think this whole thing started because it was the other way round titint,

    remember , the crash happened because there was a payments crisis in the secondary market, which most central banks dont supervise.

    the secondary market exists to by pass the balance sheet constraints within the banking system.

    the level of reserves is pretty meaning less, when we look at the size of the derivatives market, and thats where the crap happened.

    remeber the first rule of banking , the greater the leverage the greater the profit in a rising market.

    off course , it all goes to hell in hand basket, when someone cant pay or has insufficient collatoral to buy or swap there way out of stife.

    which is exactly what happened

    it would have been interesting to see how things would have turned out had lehman brothers kept their mouths shut, not called in the fed, and just went to the discount window

  11. mahaish says:

    “The central bank must accommodate these transactions. But the central bank also can create or destroy money in separate money market operations”

    central banks cant create money, or net financial assetts.

    the treasury can create reservable deposits or money(i hate this term)

    the central bank just adjusts the portfolio composition within the banking system through various unwindable credit/liquidity swap operations once treasury does the reserve add.

    even under a scenario of central bank credit, it still means there is no net financial assett being created

    it cant alter net worth either in or out of the banking system, just the composition of the assett base

  12. TruthIsThereIsNoTruth says:

    payments crisis in the secondary market?

    Mahaish, thanks for the reply. I’m not going to engage in a debate on textbook semantics. Primary market, secondary market… whatever. Maybe look up what they mean first.

    Anyway, banks like lehmans had credit risk positions which they were not evaluating properly, making their book look fictitiously balanced. When that unwound they were desperate for funding, as was every other US bank, they all hit the market at the same time as no one was willing to give them a penny (not even the Fed in case of Lehmans). If by discount window, you mean the wholesale funding market, there was no market big enough for them at the time.

    At the same time aussie banks could sit back and weather down the worst of the storm from a funding perspective. This is a contemporary example of how funding works. The latest version of Steve’s model is a really good tool to understand this as it provides a theoretical framework for how money flows around (gets created if you want). What I’m still not comfortable with is the attempt to infer some conclusions regarding actual banks behaviour from the framework. It is better used as tool to study the variety of ever evolving banking behaviour instead.

  13. F. Beard says:

    We’d have an interesting social system the instant after the Central Bank did such a thing, but it wouldn’t be called capitalism. Steve Keen

    I don’t see why not. Why should the money lenders have government to stand behind their check kiting? That’s more akin to fascism than a free market.

    The monetary sovereign (e.g. US Treasury) itself should provided a risk-free fiat storage and transaction service that makes no loans and pays no interest. And after that service is provided then government deposit insurance and the legal tender lender of last resort should be abolished. People could still choose to deposit with the banks but with the firm understanding that they might lose those deposits.

    As for endogenous private money creation, common stock and other private money forms (futures contracts, store coupons, etc) could fill the need but in an ethical manner and those money forms, like limited credit creation, do NOT require government priviledge.

  14. Steve Hummel says:

    Regarding IMF paper and Coppola’s critique:

    The problem is not fractional reserve it is the monopoly (actually triopoly) on credit. ONLY the CONSUMER financial paradigm need be changed from loan ONLY to Dividend and loan if desired and creditable, the business/commercial one remains the same and simply requires the few regulatory mechanisms like limiting the percentage of leverage on speculative activity and then also the institutionalization of a compensated retail discount to to deal with any cost push/demand pull inflation. Shadow banking system of course being the utterest of economic destabilization needs to be unwound in a sane and equitable manner and then banned or straightjacketed because its just unworkable stupidity and invitation to monetary deadly sin. C. H. Douglas had the solution nailed 90 years ago. Economists and the financial system just need to get over it.

  15. Steve Hummel says:

    If the consumer economy is 70% of the total economy how much less debt and more stability would be accomplished by changing the consumer financial paradigm to Dividend? Lots and lots is the answer. Combine this with the rapidly accelerating fact of the inexorable march of technological innovation which is making human input into production RATIONALLY unnecessary….if you want to maintain a profit making economic system….and the Citizen’s Dividend and General compensated Discount are the LOGICAL SOLUTIONS. MESST (Monetary/Economic/Spiritual Synthesis Theory) can be found and derided by economists and financiers, but recognized as the obvious solution by anyone with a truly open mind…here:

    http://www.amazon.com/dp/B009QGFX6U/ref=rdr_kindle_ext_tmb

  16. vk says:

    A bit of trivia: not every central bank is as sanguine as RBA or the FED when it comes to the balances of the commercial banks. 20 years ago I spent (wasted?) some time working in the Bulgarian banking system. Each interbank transfer had to be confirmed by the central bank. Occasionally the system would “clog up” and banks would receive messages about incoming transfers but without the confirmation message from the central bank no accounting entries could take place. The situation is still pretty much the same as per http://www.ecb.int/pub/pdf/other/ecbbluebooknea200708en.pdf , page 27:
    “A payment in RINGS can be settled individually in accordance with the FIFO principle within its priority level, provided that there are sufficient funds on the account of the payer’s bank. Payments are placed in a queue and remain pending until sufficient funds are received to cover the outstanding payments.”
    Customers naturally hate it when their funds aren’t been received because a dealer in the payees bank couldn’t project the cashflow accurately enough but the central bank there maintains tight grip and does not allow overdrafts on the commercial banks’ accounts.

  17. Steve Keen says:

    Not trivia at all vk–quite interesting in fact. Yes of course that is an option for a clearance settlement system, and it would require banks to hold much more substantial reserves to minimize the odds of a payee not having his transfer settled.

  18. csr says:

    Hi Steve,
    In the last table 7, even though the Buyer Bank has borrowed reserves from another bank & lent (LendB) it to a non-bank entity, new bank money equal to LendB is created, isn’t it? If this understanding is correct, I’m wondering why then prior to 2008 financial crisis did the US central bank even have to create $20B of reserves & not lower. Is it because of a history of interventions during previous financial crises when the number of banks looking for reserves was higher than the number of banks who are capable of lending them (only the scale of problem is lot bigger in 2008)?

    Also is the lending of reserves between banks occur through some special types of bonds?

    Thanks.

  19. vk says:

    Hi Steve,
    I am glad you found the Bulgarian case interesting.
    Actually the commercial banks there did not need to hold substantial reserves. In fact if a bank was a net recipient of transfers it wouldn’t need any reserves at all because the incoming transfer would be more than sufficient to cover the outgoings. However it would be prudent to keep some reserves as one never knows how much transfers the bank would receive.
    The central bank there introduced this system soon after the fall of the Berlin wall. There were all sorts of problems, including inflation, and the central bank figured out that inflation could be caused by a commercial bank sending lots of transfers to other banks.
    Amusingly even with such a restricted system in place Bulgaria went through a hyperinflation in 1996-1997. I am curious to see how your endogenous theory of money would explain that little fact.

  20. Stamatis Kavvadias says:

    @alainton

    Regarding the IMF paper, a full-reserve banking system may have 2 types of banks (or banks can have 2 types of accounts). One for deposits-only, that are fully backed by reserves. Depositors may have to pay some fee to the bank, in this case.

    ?n the discretion of depositors to use their money otherwise, there may be another type of bank (or another type of account) that give(s) interest (or dividend –that’s orthogonal), and “deposits” in this case are used for lending by the bank. In these banks (or type of accounts), money of “deposits” are not safe, and they may also suffer losses. In fact, in this case “depositors” are actually *lenders* of the bank, as is the implicitly and compulsory case today with main-stream banking. This means that “depositors” carry risk.

    For a contemporary proposal on full-reserve banking, see http://www.positivemoney.org.uk/

  21. Tel says:

    Steve Hummel, you might want to take a look at “Lending Club” which is indeed an alternative to the banks, and also works on a dividend basis.

    So if you want a mortgage, they set you up very similar to a company IPO where you offer a prospectus and float your proposition for investors to buy into. The investors own shares in your mortgage and they cannot have their money at all but they get dividends when you make your payments. The facilitator company take a small percentage and the investors accept most of the risk (but they can choose exactly who they decide to invest in).

    Ultimately it’s a much more stable business model that FRB and because the investors are in effect buying shares in your loan, they don’t need to even worry about money creation or that other reserve banking crap. Many people forget the fact that issuing share certificates is (secretly) exactly equivalent to money creation, but perhaps as this crisis gets worse new ideas will float to the surface (that’s a good thing, even if the new ideas are just old ideas rediscovered).

  22. cliffy says:

    VK,

    If we regard money as no different to anything else, which I do, then hyperinflation is simply a measurement of prices at shops that is changing rapidly when compared to other periods of examination.

    If perceived value of thing A reduces in relation to thing B, then if the price tags [to the extent their are price tags] we are measuring to conclude ‘yes their is inflation” are those of thing B then we might conclude there is inflation when in fact all is square.

    Lets however restrict ourselves to the case where “hyperinflation” means people handing money backwards and forwards amongst them handing over stuff backwards and forwards.

    In that case their are only two options for prices to increase:

    A. The amount of money able to spent grows

    B. The range of goods that all individuals buy reduces and the value of particular goods in the eyes of individuals increases, those particular goods being different for each individual, resulting in lower transaction volumes and higher prices.

    Did the volume of sales in the hyper-inflationary period reduce?

    If that all be true then you might hypothesize that the larger the range of goods regularly sold in an economy the less likely for hyperinflation to occur given the occurrence of an event that could lead to hyperinflation?

  23. Aaron Smith says:

    I think it is important not to toss out the baby with the bathwater.

    Yes, FRB doesn’t perfectly match our modern society because the monetary base is not static and can be induced indirectly into creation/destruction from private banks through open market mechanisms. However, if say the Fed were to freeze MB, then FRB would hold true. The one way around this would be for banks to move more deposits into ‘near-deposits’ or market their short term assets/long term debt to the public and let them bear the short/long liquidity imbalance.

    To say however that FRB is a myth however, implies that (even if not intended) that banks don’t create money which they do. The use of the St Louis Fed graphs is deceptive because of course M1/M2 don’t include bank reserves. So yeah, M1/M2 can look smaller than MB because MB actually includes the reserves. If you were to count cash outside of the banks + reserves + deposits made in excess of reserves at individual banks) than it would be positive. The reason the Fed doesn’t do that of course is where are the reserves applied? To M1 deposits? M2? M3? It’s just easier to exclude reserves even though it creates confusing graphs.

    Lastly, I don’t like the idea of considering the reserve ratio useless just because banks can move deposits into ‘near-deposits’ or they borrow the reserves they need indirectly from the Fed to cover their reserve ratios. Sure they can do that, but that is not the whole story. With the latter, the money market can indeed shutdown during scares and we’re back to FRB basics. As a public policy consideration, demand deposits should be considered separate and more secure than interest and time deposits. And government should be more apt to protect checking deposits over time/interest deposits because the latter is more implicit in its risk. With a higher RR (our ‘myth’), bailing out demand deposits becomes much easier to do.

    I mean you can take the reserve ratio logic to it’s extreme and argue that 100% reserves wouldn’t matter. This is false of course…yes, banks would increase interest rates to induce people into near-deposits, but your regular Joe who deposits 1000 dollars in a regular bank account will absolutely be guarenteed his money (unless the bank commits fraud) and he will not need one penny of bailouts (indirect or direct) from the government should there be a banking crisis. From a public policy standpoint, that is a very positive thing.

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