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Fractional reserve banking (FRB) is fraudulent. It should be prosecuted
as a crime rather than accepted as normal practice under current banking laws. Any society that respects property
rights and the rule of law would not allow it. For those unfamiliar with
the term fractional reserve banking or not quite confident of its complete
meaning, let’s cover some basics.
What
Is Fractional Reserve Banking?
All financial transactions must be settled ultimately by an exchange of
standard money, otherwise known as "reserves". Reserves in the US are
composed of federal reserve notes (good old paper money in your wallet, piggy
bank, retailers' cash register tills, or bank vaults) plus reserve account
balances held by banks at their local Federal Reserve Bank that may be
exchanged for federal reserve notes on demand. The important point is that
reserves are not the same thing as the money supply. The money supply is
composed of cash outside bank vaults plus demand (checking) accounts at
banks. A financial transaction is not complete until reserves are exchanged.
For example, accepting a check from your neighbor for selling him your used car
is not final settlement, because reserves have not yet been exchanged. The
check might bounce. Or the bank upon which the check is drawn might become
insolvent ; i.e., it does not have and cannot raise the reserves with which to
pay you, the check's payee, even though the bank balance of the payor, your
neighbor, was at least as large as the check.
Most people assume that their money held at banks can always be
exchanged for reserves, but such is not the case. Under a fractional reserve
banking system banks are not required to keep one hundred percent reserves.
Rather, they keep a fraction of their obligation to you in reserve (thus, the name
"fractional reserve banking" system), under the assumption that not
all depositors will want their money back at the same time.
How can this be? If you deposit a dollar into your account at the bank,
isn't the bank required to keep that dollar in its vault or at its own reserve
account at its local Federal Reserve Bank? The short answer is NO! The bank is allowed to lend most of
that money to someone else and keep only a fraction in reserve in order to
satisfy your withdrawal request! This is fraud. Through the lending process the
bank has created money out of thin air. It is not backed by one hundred percent
by reserves. If too many depositors demand their money at the same time, the
bank would not be able to satisfy all withdrawal requests. It would not have
sufficient reserves to do so. It's as simple as that. Any other commercial
business that accepted your property with the promise to return it to you and
then lent that property to someone else would be guilty of fraud. But banks are
allowed to do just this! Hard to believe, isn't it!
Some present the argument that FRB should continue, because the
depositor should have the freedom to take the risk that, if the bank should
fail, his money might not be returned to him upon demand or perhaps not at all.
But the ethical issue is not about the depositor's choice but the payee's risk
in accepting a check drawn on an FRB bank. The depositor may have sufficient
funds in his bank account, but the bank itself might not have sufficient
reserves to honor the check. How is the payee to know? It is against the law in
most states for a payor to knowingly pass a check that exceeds the funds in his
bank account. Why then do we accept as part and parcel of the fractional
reserve banking system that the bank itself is not required to hold sufficient
reserves to honor all its obligations?
FRB
Gives Rise to Regulation and Government Money Printing
Volumes of bank regulation, armies of bank regulators, and government
money printing have arisen because banks are allowed the privilege of
fractional reserve banking. Bank runs were common occurrences before the federal
government forced all banks into its deposit guarantee program (the FDIC), itself
a fractional reserve institution in that it has a mere fraction of the reserves
to honor the vast deposit balances of American banks. During the so-called
subprime lending crisis of 2008, so many banks failed that the FDIC itself ran
out of reserves (which it had obtained via mandatory premiums from the banks)
and had to be bailed out by the Federal Reserve Bank itself, which resorted to
the time honored practiced of all counterfeiters by creating reserves out of
thin air.
Bank regulation, enforced by the above mentioned armies of regulators
(surely you did not think the government would have just ONE regulatory agency
for banks!), attempts to do the impossible, to wit, prevent bank loan losses.
FRB expands the money supply, which itself causes disruption to the structure
of production, an unsustainable boom, and the inevitable crash. This so-called
business cycle is not some sort of inevitable consequence of normal business exuberance
or lack thereof, but is caused by FRB credit expansion by banks, a phenomenon
well explained by Austrian school economists and labeled by them as the
Austrian Business Cycle Theory (ABCT).
In the absence of fractional reserve banking, the banks would not be
able to expand credit beyond the funds actually saved by its depositors.
(Wouldn't that be something!) There could be no disruption to the structure of
production; thus, there would be no need for bank regulations or regulators.
All funds placed in demand accounts would be secured one hundred percent by
reserves. Depositors who wished to earn interest on excess saved funds would
open savings/investment accounts with the banks or some other institution
specially formed for profitable investment of the public's savings. These investment
accounts would not be insured by anything other than the banker's capital
account and his reputation for sound lending. Loan losses would be borne by the
banker to the extent of his capital account and then the savings fund itself.
Naturally, the depositor's demand funds would be completely secured by the
bank's reserves. Only the funds placed in the bank's savings/investment
accounts would be at risk. Bankers with poor lending acumen would find
themselves quickly out of business rather than receiving bailout money from the
government. Such bailout money itself comes from Federal Reserve money
printing, which itself exacerbates the boom/bust business cycle!
Conclusion
Ending fractional reserve banking would restore the rule of law to the
banking system, end the need for expensive and harmful bank regulation, and
eliminate the boom/bust business cycle. Bank demand deposits would be backed
one hundred percent by reserves, which any competent local auditor could verify
at little expense. Banks found in violation of this law would be seized by
state authorities and the officers charged with a crime – the crime of
counterfeiting. Unnecessary bank regulatory agencies would be shut down,
because they would have nothing to do.
This reform to the banking system is so simple that it will be opposed
by all the parasitic government agencies now promising to prevent something
that they themselves cause; i.e., the boom/ bust business cycle and bank losses
that harm depositors and cripple the economy. Nevertheless, let us pursue this
reform with all the confidence and courage of Ludwig von Mises that we are
doing the right thing and will not be deterred.
Recommended reading:
The Mystery of Banking, by Murray N.
Rothbard
The Austrian Theory of the Trade Cycle and
Other Essays, by Richard M. Ebeling
The Essential von Mises, by Murray
N. Rothbard
