The Fractional Reserve Banking system in theory and practice, and arguments for and against it being used

Author: Ken L. White

The fractional reserve free banking (FRFB) system came into existence following the

realisation that not all bank deposits needed to be repaid simultaneously. Individuals or

firms that deposit money at a bank receive a deposit account, which is a liability to the bank

on their balance sheet. With these deposits, banks could lend out the money to individuals

charging interest from lenders and paying interest to and depositors.


Legally banks have authorized to provide loans that exceed the deposits it holds by a certain

multiple because it is accepted that depositors will not withdraw at the same time. The

loans that it gives out in theory come back to the bank and they can do the process again. In

contrast to other goods and services, money is not used up in consumption or production; its

ultimate use lies in the fact that it is exchanged for other goods (Davidson 2012 pp. 198).

Central banks set and regulate the reserve ratios and hold some of the commercial banks

deposits as security against the possibility of bank runs. In the case of providing confidence

to depositors, central banks insure deposits (insurance) and are a lender of last resort to

commercial banks in the event of a bank run.


FRFB was seen as a monetary and a fiscal framework for economic stability (Warburton

1952 pp. 523). There is constant debate within the Austrian School of economics as to

whether FRFB should be allowed to take place. Many have argued for the benefits of this pre

and post 2008, and the evidence provided by all parties must be analysed.


The Austrian School economists prefer a gold standard (all bank issued media fully backed

by gold) to one where banks can generate redeemable IOU’s (Selgin 2000 pp. 93). Selgin and

White (1996) argued for fractional reserve banking; however are not defenders of fiat money.

Economist like Rothbard have long argues that FRFB is inherently fraudulent (Selgin 1996

pp. 86).


Many critics condemn FRFB for three main reasons, firstly, the practice is inherently

fraudulent and it only survived because of banker’s dishonesty or government mandated

deposit insurance (Selgin 2000 pp.94).

 Secondly, critics of FRFB say that under a gold standard, any bank created exchange media

not backed by gold will fuel the business cycle. In issuing spendable IOU’s to borrowers,

banks reduce interest rates below their natural levels, promoting investment at the expense

of other producers and consumers who find themselves bidding against bank borrowers for

scarce resources. The bidding war forces up prices and interest rates, restoring the purchasing

power of the money stock to its pre-expansion level. However, when this happens resources

would have already been allocated to unsustainable projects, given the amount of voluntary

savings available from the public (Selgin 2000 pp.94).

“The collapse of unsustainable projects (subprime mortgages), followed by the consequent

restoration of a pattern of resource use something like the pattern that proceeded the issue

of fiduciary media, marks the bust and recovery stages of the business cycle” (Selgin 2000

pp.94).


Thirdly, FRFB is vulnerable to bank runs when their customers lose confidence in them,

such as in Cyprus after a proposed bailout charge on savers. Fractional reserve banks by

definition are not able to meet the demand of its depositors at a given time (Selgin 2000

pp.94). Confidence plays a great role in the banking system, as we will see later.

My belief is that most individuals are blissfully unaware of the fact that their deposits are not

backed one hundred per cent by reserves; however, with the payment of interest on accounts,

they can figure out why they are being paid for the bank to safeguard their holdings.

Borrowers, such as those who took out subprime mortgages in 2008 were to me unaware that

in an efficient, non-FRFB system, the money that savers deposited would not be available to

them.


Economists who have critiqued the FRFB system have been looking at the fraud issue from

the banks perspective, however most of my analysis will be focused on the system’s ability to

affect economic growth and the reasons HSBC faired out better than its contemporaries since

the crisis.

The ability of the banking sector to affect the business cycle, not only domestically, but also

internationally was evident in 2008 driven by continuous globalisation and the expansion of

financial institutions.  Additions to the money stock are able to aggravate the business cycle.

However, this is dependent on whether there is a pre-existing increase in the public’s demand

for money at the going rate.

Austrian Business cycle tells us that if the expansion of supply of money creates an overall

excess of money, people will spend the excess (Selgin 2000 pp.97). This increased spending

will not be offset by a reduction of spending of other individuals and this stimulation to

overall demand for goods and services together with the pattern of spending prompted by an

artificially low interest rate will have adverse business cycle consequences described by the

Austrian theory (Selgin 2000 pp.97).