Fractional Reserve Banking Made Simple

I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.

Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.

Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.

The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.

What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.

Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?

Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.

That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.

How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:

  • In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
  • If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.

That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).

20 thoughts on “Fractional Reserve Banking Made Simple

  1. bobroddis

    You continue to ignore the payee side of the FRB transaction. We can assume that the banker and depositor can come to some type of an agreement. The problem comes about when the borrower spends the new paper which looks just like (for all practical purposes) a warehouse receipt for specie. In reality, it is something quite different and is some form of a quasi-credit transaction. I have no problem with using such paper in transactions if the payee understands the significant difference between that paper and a true warehouse receipt. But if a warehouse receipt is deemed and valued as “a dollar” and the FRB note is deemed and valued as “a dollar” by the public, something is very wrong. The paper FRB note should be requred to contain language on its face explaining exactly what it is and what it is not. Whether such notes are accepted by the public and at what value will be an empirical question.

    1. Jonathan Finegold Post author

      One of the great thing about markets is that market institutions help us economize on knowledge and deal with knowledge asymmetries. I can have no idea about how the currency system works and what the differences are between different kinds of financial assets, and I can still be pretty successful at accomplishing my ends. Why is the case different here?

      And, on what basis should we question market prices?

    2. gcallah

      “The problem comes about when the borrower spends the new paper which looks just like (for all practical purposes) a warehouse receipt for specie.”

      Hilarious Bob! As if more than .01% of people alive today have ever seen a “warehouse receipt for specie,” and are thinking when they see US dollars that that is what they are looking at!

  2. Roger Sparks

    You did not mention risk in this post. It seems to me that banks fail when they are perceived as having “too much risk”.

    When banks lend depositors money, they also assume the risk that the borrower will not be able to repay the loan. When we realize that the original depositor may RECEIVE the borrowed funds (for example, when the original depositor is a contractor and the loan is for a new house), then it is easy to see that the borrower could find it very difficult to actually find money to repay the loan. Better matching of risk and lending is worthy of consideration.

  3. Jonathan Finegold Post author

    Roger: Risk is relevant in determining whether a bank’s portfolio is suboptimal, but risk is not necessarily relevant to fractional reserve banking. We could conceive of a riskless world where there’s FRB and maturity mismatching. But, you’re right, risk should (and it does) inform how a bank invests the assets it controls.

    Mick: Thanks. Fwiw, none of my opinion here is based on a banking theory textbook. I agree, in any case, that the picture painted by most undergrad textbooks is incomplete (I think this topic has received some recent blogosphere coverage).

  4. Platos Cave (@EscapePlatoCave)

    Please explain: In a system like ours where virtually all money is created as debt via FRB – how is there any other outcome but what we now see – workers, the Productive sector and government in debt to the Financial sector. The money to pay back the loan is created in FRB, but not the interest on the loan – that can only come from an exponential increase in more debt/money creation. An unsustainable exponential increase.

    And please if you are going to claim the $15 trillion+ created since 1971 came from somewhere other than FRB, cite your source.

    1. Jonathan Finegold Post author

      Not all fractional reserve banking systems are made the same. If the institutions differ, so will the outcomes. The current system is characterized by a currency monopoly, where Federal Reserve notes act as high-powered money. There is no adverse clearing system that effectively constrains the ability of the central bank to create money.

      And no, paying interest on a loan does not require an “exponential increase in…debt/money.”

      1. Platos Cave (@EscapePlatoCave)

        You don’t address my point – you think it’s fine for everyone to be in debt to the banks that create all money as debt? You say there is nothing to prevent banks from creating an infinite amount of money as if that is a good thing? Seriously?!

        So explain where the money to pay the interest comes from if not from more debt created money.

        1. Jonathan Finegold Post author

          No, I did not say that allowing banks to create an infinite amount of money is a good thing (they can’t, by the way). Re-read my post. I say the exact opposite, actually.

          I think that people should be able to choose on their own whether it’s a “good” thing to borrow money from a bank. I borrowed money to pay my education and my car, and so far both were excellent choices. How do I pay my interest without having banks create more money for me? Easy, I sell what I produce to others and use that revenue to pay interest. You don’t need to increase the total amount of money, you just need to produce so that you can exchange non-monetary goods (including labor) for money. This link provides a numerical example, which might clarify it for you.

  5. Platos Cave (@EscapePlatoCave)

    I can’t believe you are talking about ONE loan in an attempt to address my point. We are talking about a huge interconnected system. Millions of loans are made, every one requires more money be paid back than was created. No matter how productive an individual or nation may be – ALL THAT PRODUCTIVITY IS REPRESENTED BY MONEY CREATED AS DEBT – there is no other source of money in our current system. The money in your paycheck you are using to pay back your loans was originally created as debt by someone else. Even if an individual has no debt, as a citizen you owe over $200k of the national debt, not to mention your share of whatever city, state and county debt applies to you.

    Thanks to technology, our economy now has a productive potential ~400% higher than 50 years ago, yet we see an economy drowning in debt with a Financial sector growing like a cancer on the once powerful American free enterprise system and out of control income disparity ripe for another Great Depression. Given that you believe the MS view of FRB, you probably also believe the MSM BS about “growth”, low unemployment and inflation and oh yeah let’s all just ignore that the economy contracted by over 2% in the first quarter of 2014.

    So every day thousands of loans are made, each one requires more money to be paid back than was created in making the loan. Want to try again to explain were all that money is going to come from? And of course you’ll have to ignore the Fed’s own chart of the M3 money supply from 1971 through the 2008 contraction – it shows an exponential increase in the money supply, which of course was unsustainable – and boom – recession.

    1. Roger Sparks

      I can only find two sources of new money: bank loans and loans to government. Of course government can and does borrow from banks.

      If we agree that there are only two sources of money, then we can add government debt and bank loans to learn how much money is available. I agree that someone first earned this money and now it is just circulating among the economic players.

      Now for interest payments, I don’t see how they can affect the money supply. The amount of interest due certainly can be a big factor in how much work a person must do to repay the loan plus interest, The amount of work necessary to repay the loan plus interest also has to do with how much the borrower earns per hour.

      We often see government borrowing from individuals. I think that increases the value of the currency but also delays lender spending. Of course government then spends MORE for the purposes of government.

      We can argue that government debt DOES NOT measure the money supply because the government DOES borrow from individuals as well as banks. I would point out that the individual acts the same as a bank in the fact that borrowing from individuals and banks both result in the same product for the borrower — cash to spend. The only difference is that individuals must earn and save their money first while banks lend the money that others have earned. Government has the luxury of simply printing money; no need to earn it first.

  6. Platos Cave (@EscapePlatoCave)

    If by “government borrowing from individuals” you mean when people by bonds, yes that is the same as a loan. BUT unlike banks, when I buy a $100 bond, I don’t get to pretend the $100 is also still in my bank account. So no new money is created in that loan, unlike FRB.

    So we’re back to the fact that virtually every dollar in circulation was created as debt – loaned into existence via FRB.

    When you earn $1000, yes, you get that $1000 dollars from someone, but if you trace it back to its creation it had to have been created as debt since there is no other way it could have been created. In a barter system when you create a product, the “money” to trade with is automatically created – it is the thing you are trading. But in our fiat money system productivity and money creation are divided by the smoke and mirrors of FRB. You are not *creating* money when you earn it.

    You can argue that government debt does not create the money supply if you want, you just have to ignore that the Fed’s own charts and stats show the two to be almost identical.

    So you seem to be agreeing all money is created by FRB, and in a loan only the amount to pay back the principal is created, with the interest required to be paid back often more than the principal.

    So millions of loans made, all requiring more money to be paid back than was created. ONCE AGAIN: where will that money come from? And how is there any other outcome but what we now see – workers, the Productive sector and government in ever increasing debt to the Financial sector?

  7. Roger Sparks


    I agree with you that when we have “government borrowing from individuals”, the money must first be earned by the individuals. The key to increasing the money supply with this action is that government NEVER pays the money back. It just keeps rolling the debt ahead so you get your money back but some other individual delays HIS spending.

    Government is caught in a debt trap. It wants to keep the spending level that CAUSED the borrowing, but now it must either repay the debt (raise taxes) or roll the debt over. This puts a greater demand on the money supply, what ever it is, as it must turn over through more hands than was the case before the borrowing occurred.

    It seems to me like if government has a balanced budget, then rollover of the individual debt would just be one individual substituting for another and no additional money would be created. However, if government borrowed MORE money from individuals, then there would be another increase in the money supply as the receivers of government spending laid claim to the money.

    So to my way of thinking, the government can increase the money supply by increasing the number of people laying claim to dollars that have come from the government. And of course, government always makes good on it’s money promise by printing money if necessary.

    Yes, I ignore the money supply charts from the FRB. I think they are good for making sure that the banks do not run out of money but they are not even close to what the public thinks it has in the way of money supply. I would include treasury bonds in the money supply because they are easily traded for cash. Treasury Bonds are better than the bank if you plan to store money for more than a short period.

    So where is all the money to pay the government debt to come from? It can only come from those who have it, AND, if they paid it back, all the money would be gone. I think it is just like you say; our money all comes from debt, and if the debt is paid off, the money is gone.

  8. Platos Cave (@EscapePlatoCave)

    You say “And of course, government always makes good on it’s money promise by printing money if necessary.” It seems you like most people suffer from the delusion that because the government prints dollar bills, it is creating money when it does so. That would be true if the government printed money and spent it into the economy, but that is not what happens. First of all only a tiny percentage of money now exists as paper currency or coin, the vast majority is electronic – numbers on computer screens. More importantly when the government prints currency, they are simply providing a service for the banks, which pays the government only pennies for each bill, no matter whether it’s a $1 bill or a thousand dollar bill. It’s not much different from the printing company that prints the checkbooks we use. In both cases they are pieces of paper used to represent money for transactions.

    But you do seem to understand the death trap of FRB: the government must keep the system going by borrowing more and more money, to create the money needed to service the old debt+interest and enough extra to drive the real productive economy. Unfortunately the mathematics of this demands an exponential increase in borrowing, which means it must eventually approach infinity, and that cannot happen in a finite world. The Fed stopped providing stats and charts of the M3 money supply in 2006, precisely because the curve made it so obvious it was heading for an infinite expansion, and a crash was inevitable.

    Defenders of FRB look to the fact that so much money (Trilllions) has been created since 2008 but inflation has not gone through the roof. They say this proves critics of FRB wrong. But the reason this is happening is because according to recent analyses, over 95% of the new money created, of all new wealth in the last few years has gone to the top 1%. So much of the money created is going to service old debt and prop up the banks that there is not enough left over to drive the real productive economy.The middle class still has no money to spend, and so prices are not increasing the way they would if all that new money had gone to workers instead of banks.

    Europe and the US are currently frantically trying new versions of smoke and mirrors to keep this system going. We can now see in practice in Europe that imposing austerity and decreasing government spending to try to balance a budget will collapse the money supply and make things even worse. You are correct that in this insane system as debts are paid back the money supply collapses and kills the economy. Only taxpayers/consumers going deeper into debt can keep the economy going. But even then the amount of debt will reach a point that it is so obvious it can never be paid back that BRIC countries will stop buying US debt and that will trigger a collapse of the dollar and a massive run on the banks.

    The IMF had been forcing FRB on the world for most of its history, so when their own expert economists, mathematicians and computer modelers came out in support of the Chicago Plan for monetary reform it was earth shaking. But so far propaganda like this blog has kept the public from catching on to the massive debt trap scam that is FRB and the bankers are still having a good laugh at what saps we are as our governments continue to create Trillions that go directly to the Financial sector elite 1%.

    1. Roger Sparks


      I like this blog because the author seems to me to be taking an independent analysis of the subject of the day. Some authors place a bias on their analysis which results in more of a sales blog than a fresh view of the subject. I tend to skip a biased author and blog as soon as I realize the consistent bias.

      Shifting the focus to government printing, of course I agree that most of modern money is held and transferred electronically. The key words “government printing” carry the idea that government is creating money in some fashion and then spending it. The actual money expansion occurs because of the spending which places new money into the hands of people who have worked for it.

      I wrote in a comment recently that money should be considered not as a government obligation but as a Certificate of Appreciation. The idea here is that someone has traded labor or material to government and received in return a piece of paper (or electronic increment) that indicates appreciation of the help to government. How the government came to possess the Certificate of Appreciation (or the authority to electronically increment) is a different issue. The fact remains, that if someone works for government or sells material to government, the supply of money (or Certificates of Appreciation) in the hands of the private sector of the economy increases.

  9. thraddash

    >When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

    I thought FRB worked without actual deposits. Ie, you don’t need $10k worth of deposits (or even collateral) as a bank to give out $10k worth of loans. Am I misunderstanding you here?

    1. Jonathan Finegold Post author

      When an individual bank practices fractional reserve banking it only holds a fraction of its customers’ demand deposits for withdrawal. So, if a customer deposits $1,000, a bank would have only fractional reserves if it decided to lend out $200 — or whatever the amount may be — and keep $800 of a demand deposit in reserve. If banks expand in concert, and depending on the specific rules that constrain banks, the banking system as a whole may ultimately extend more credit than what was originally deposited by its customers.


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