Today’s banking system operates on a system called Fractional Reserve Banking. It’s the same interlocking system all over the world, and you might be surprised when you look under the hood and see how it actually works.
What is fractional reserve banking?
Fractional reserve banking is the system used by the world banking system, from retail banks to the major commercial banks. It’s called fractional reserve banking because banks hold in reserve only a fraction of their deposit liabilities. In layman’s terms, this means the bank doesn’t actually have your money, which at first glance seems alarming.
Central banks require banks to hold a certain proportion of their deposit liabilities in reserve; in the USA, the reserve requirement is 10%, in France 1%, in Japan 0.8%, and in Hong Kong there is no reserve requirement. Banks typically hold slightly more than the amount they’re required to have in reserve, and this is known as “excess reserve”.
How did we get here? A history of fractional reserve banking
Fractional reserve banking grew out of the difficulties encountered by a fragmented and underregulated banking sector in the nineteenth century. But this banking sector itself was a solution to the previous generation of problems. Let’s start at the beginning.
The beginning of all transaction is barter. People with access to different resources swap those resources. This has obvious difficulties: buying a range of different consumer goods with a single farm animal is obviously complex and inconvenient, storing wealth is difficult, investing it in new projects even more so, and agreements to deliver later (say, at harvest time) must somehow be formalized and adjudicated.
The solution to barter is money. Precious metal money, silver and gold, speaks for itself: such a weight of gold is worth so much, everyone knows its value, and — at least when compared to cattle or hay — it is portable and durable, scarce, with a strictly limited supply and reliable value.
However, when gold speaks for itself, it might be lying. Another merchant might have his thumb on the scales, or a goldsmith might have mixed other metals in with the gold — which is fine as long as you aren’t the one left holding it when the facts come out, and so long as it isn’t so common as to destroy faith in money. The solution to this is franking: coin-making. Goldsmiths struck coin, under commercial or state authority, to show that their coins had a certain weight and purity. The label on the coin now spoke for the gold. You now trusted, not the gold, but the goldsmith or his employer.
If you’re familiar with this subject, or you’ve read our previous post on fiat currency, you know where this is going. The natural result was to separate the label from the metal, creating paper money, an innovation which dates to the seventeenth century in Europe and to the seventh century in China. Transactions were made with these notes, analogous to a gentleman’s “note of hand” representing a promise to pay. Laws increasingly required them to be treated as money.
Banks enter commerce
From here, banking entered into everyday and major transactions and never left. Now, rather than take coins from his house to the vendor’s, a purchaser took money to the bank. When the time came to pay someone, he had the bank move money from his account to the other person’s. In fact, no money is moved; the bank debits one account and credits another. For merchants, and eventually for ordinary consumers, the advantage is that the bank now guarantees the transaction; initially, transactions involving banks rather than coin carried a premium for that reason.
This separation of metal and its transaction value created two problems. One was that issuing authorities were often smaller than trading areas. In the Italian renaissance, merchants kept enormous tables for converting city-state currencies into each other; German states issued their own currencies too, meaning buying things from a few miles away might require several conversions. Each cost time and money; this was a new form of friction attendant first on coinage and then paper money. The solution was to implement larger and larger common currencies, replacing smaller regional and city-sized issuers with first gold-backed and then fiat modern state currencies.
The other was the beginning of fractional reserve banking. Accept gold as a deposit, write a receipt or note for it, and lend the same value of gold again to someone else. Initially this was a simple bait-and-switch, in which goldsmiths accepted gold with one hand and lent it with the other. But now that the label and the metal were separate, goldsmiths, and their replacement institutions, banks, were subject to an obvious temptation. Lend the same gold twice — issue two sets of receipts, banknotes, for one deposit — and you could make twice the profit, while financing twice the economic growth. The problem would come only if the holders of the notes for that gold both came and asked you for it. This is the history of the eighteenth century and nineteenth century bank in a nutshell.
In America in particular, small private banks accepted gold deposits, lent and issued banknotes based on them, and turned out to have less in reserve than their deposit obligations. When too many customers simultaneously wanted their gold the result was a run on the bank. Its reserves were emptied, it went out of business and its remaining banknotes had to wait a century to become collectors’ items and recover some value. Savers and investors relying on the bank were ruined along with it, through no fault of their own and with obvious negative effects on the economy. In replacing cash with credit (literally “belief”, from the Latin credo), banking had replaced certainty with instability.
One solution was to impose 1:1 reserve requirements; another would be to create a pool of banknotes sufficiently large that a run was nearly impossible. These took the form of a single currency based on the reserves of a single bank and issued by a single bank. Central banking had begun.
The central banks
A central bank would act as guarantor of value to the consumer and guarantor of solvency to the banks. So long as they followed the rules the central bank would back their deposits. The money, spent, lent, saved or invested, would soon reenter the banking system and wind up back with the central bank. So long as there was no run on every bank in the country at the same time, or a run on the currency, central banks could stabilize fractional reserve banking.
Modern central banking started with the Bank of England in 1694. However, the story of central banks really begins in the twentieth century when they acquired the powers they now have after the end of the gold standard.
During the first world war, belligerents abandoned the gold standard for a currency that was simply an “economy token”. Rather than entitling the bearer to a certain sum of gold it entitled them to a certain proportion of the economic product of the issuing nation. Its value was backed only by government say-so and there was no choice but to accept it, and only it, as payment. Fiat currency (from Latin fiat, “act” or “do”) had arrived.
It soon became apparent that a return to the gold standard left the banking system inflexible and the economy undercapitalized. A new problem, inflation, attended the existence of a currency pegged to the economy that transacted in that currency. The new equivalent to a run on the bank was hyperinflation, which destroyed the value of money by making too much of it. If there was to be fiat currency it must be managed.
This became the role of central banks. Central banks now created physical money — coins and banknotes — either according to government plans or according to their own methods of economic planning. Spending money into existence, buying economically nonviable assets (such as mortgage-backed securities during the subprime crisis) and both backing and managing commercial banks through interest rates became the business of central banks.
Now, when you borrow money from a bank, they’re not double- or triple-spending gold deposits. They’re lending out ten times their dollar reserves, which in turn are backed by the central bank — which, if called on, will print the necessary banknotes or call the necessary deposits into existence.
From intermediary to originator
Fractional reserve banking initially sounds like an unstable system, opaque and confusing, and with no real value at bottom. (Similar complaints are levelled at digital assets.) In fact, it is an ingenious system for creating money to cover real economic value.
Banks used to be intermediaries: they would offer to guarantee that your money was good, and their guarantee was as good as gold. But now they create money, and commercial banks create significantly more than central banks.
Central banks print money or spend it into existence to manage the economy, increasing the money supply to stimulate economies in recession. But 97% of the money supply is in bank deposits, and this money is overwhelmingly created by commercial banks which create money by issuing debt. When a bank gives a loan, it simply creates the money it lends. It doesn’t transfer the loan into the lendee’s account — it writes a given sum into its internal ledger under that lendee’s name. The money, which is to say, the bank’s word that the money exists, has been created as a debt to one of its customers.
Obviously there are dangers in creating money without reference to value; inflation continues to be a real risk, but it is less dangerous to most of us than a banking system that cannot lend money to two businesses at once because there isn’t enough gold. The money created by banks finances the creation of real value.