Note: This is the latest entry in the Acton blog series, “What Christians Should Know About Economics.” For other entries in the series see this post.
The Term: Fractional Reserve Banking
What it Means: Understanding fractional reserve banking is easier if we separate what it is (which is rather simple to explain) and the effects the system produces (which is slightly more complicated).
Let’s start by taking the term fractional reserve banking and working backwards.
First, there is the banking part. For our purposes we mainly need to focus on two services banks provide. The first service is to provide a safe place for people to store currency (cash and coins). This is known as a “deposit”, or currency deposit, and there are two main types, a demand deposit and a time deposit. With a demand deposit you can remove the money you deposited with the bank at any time without prior notice (as with a checking account). With a time deposit you can only take your money out of the bank after a specified time (3-months, 6-months, etc.) and/or after giving the bank prior notice (as with a Certificate of Deposit (CD)).
Second, there is the reserve, or bank reserve. This is simply the amount of a deposit—from 0 to 100 percent—that the bank is required to keep on hand so that when people ask for their money back, the bank has the currency to give them.
Finally, there is “fractional” part. This simply means that the bank only has to keep some “fraction” of the reserve and is not required to keep a 100 percent reserve on hand. (Technically, the fraction could range anywhere from 1 to 99 percent, but the amount required is generally determined by the Federal Reserve.) To make money, banks usually loan out the amount that they aren’t required to keep as a reserve.
While that seems straightforward, the effect is rather surprising (and often controversial): because the bank is allowed to loan the portion that isn’t required to be held in reserve, commercial banks create new money.
To make it easier to understand this point, watch this one-minute video:
If you only leave with one takeaway from this post it should be this: the fractional reserve system makes it possible for commercial banks to increase the money supply in the economy by creating money. (This will be important to know for future posts in this series.)
Other Stuff You Might Want to Know:
• How much money can banks add to the money supply using fractional reserve banking? We can get a rough, though mostly accurate, estimation using the formula called the “money multiplier.” This formula says that the money multiplier, m, is the inverse of the reserve requirement, R or m = 1/R.
For example, if the reserve ratio is 20 percent (i.e., the Federal reserve requires banks to hold 20 percent of all deposits in reserve, or 20 cents on every dollar), the reserve ratio, R, would be 1/5 or .20. So when we plug that into our equation we get: m = 1/.20 = 5. So if a bank gets a $1,000 deposit and the reserve rate is 20 percent the money they loan will add a maximum of $5,000 into the money supply.
• The primary alternative to fractional reserve banking is full-reserve banking (also known as 100 percent reserve banking). This is the requirement that banks must keep 100 percent of demand deposits in cash. Since they wouldn’t be able loan out money kept in demand deposits, banks would likely charge customers a higher fee to store such deposits. This system was favored by many free market economists, such as Milton Friedman and Murray Rothbard. (Some Austrian economists even claim that, “In a free-market system, the practice of fractional-reserve banking would be illegal by its very nature.”)
• Fractional reserve banking predates government control/oversight of the banking system. Some economic historians claim that federal reserve systems were implemented by nation-states precisely to provide some control over the money supply. This is also why some economists still support full-reserve banking. Irving Fischer, who Milton Friedman called the “greatest economist of the 20th century”, wrote in 1935 that, “100 per cent banking […] would give the Federal Reserve absolute control over the money supply.”
• Some Christians argue that the fractional reserve system violates biblical principles. For example, the theonomist Gary North says, “The Bible is clear on three legal principles . . . (2) multiple indebtedness, which is the basis of fractional reserve banking, must not be allowed (Exodus 22:26).” North lays out his argument for this claim in his free book, Honest Money. Personally, I do not find North’s argument either coherent or compelling. I think he’s engaging in creative eisegesis to contend that Scripture agrees with his own economic policy preference. As John W. Robbins says,
[Exodus 22:26] is the only passage in the Bible that North has found that he says condemns fractional reserve banking. Unfortunately, the passage has little to do with banking, and nothing to do with fractional reserves. North himself admits that “the context of this verse is the general prohibition of interest taken from a poor fellow believer…. This is not a business loan” (80). Therefore, on North’s own premises, the Biblical blueprint for money and banking does not include any condemnation of fractional reserve banking.