Thursday, February 27, 2014

Fractional Reserve Banking: Serene Surfaces, Turbulent Depths

By Wallace Eddington

There are many claims on different sides of the debate over fractional reserve banking. Doing the debate justice would require a book. And even then...

All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?

The basics are not especially challenging to express. Often, though, merely expressing them leaves their implications unexplored. A few sentences provide those basics.

Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)

In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families' life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.

Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.

On the face of it, the banks seem to be putting themselves in a precarious situation. After all, the depositors are not investors. Most regard their money as merely being stored at the bank: a bit like renting a mini-storage unit to stash away those boxes of keepsakes they can't bring themselves to trash. They can go fetch those boxes, though, any time they want. So, most expect with their money deposited in the bank.

Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.

To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source of the term fractional reserve banking.

Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.

Additionally, if their withdraw demands are over a certain threshold, the bank often reserves the right to interrogate them about their intentions regarding their own money. These are tools used by the banks to forestall the danger of withdrawals that exceed or make vulnerable the reserves they've kept on hand.

Usually, though, in the course of routine banking life, such measures are unnecessary. The banks' ability to anticipate reserve levels sufficient to cover expected withdrawals is generally effective enough to keep most people adequately contented with the arrangement.

Does this mean though that fractional reserve banking is uncontroversial or unproblematic? Far from it, claims many critics. In fact, it presents a constant threat of catastrophe for the bank and, given the interconnection of today's globalized banking system, even for the world economy.

And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.

For a fuller appreciation of the wider controversy over fractional reserve banking, and what's at stake, check out this elaborating article on the practices' pros and cons (and con jobs) .

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