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Is It Time To End Fractional Reserve Banking?

Is It Time To End Fractional Reserve Banking?

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The moment you realize that the financial system has an inherent fragility at its heart — that people can simply lose confidence in the system, withdraw their deposits en mass, and because banks only keep a fraction of their deposits on hand cause a liquidity crisis where the bank runs out of money — is undoubtedly a scary one. And even though the global financial system experienced over half a century of relative stability from the 1930s and 2008, where the existence of lenders of last resort like the Federal Reserve and the Bank of England acted as a stanch against large scale liquidity crises, the re-emergence of bank runs (or at least shadow bank runs) and liquidity crises in the wake of the sub-prime housing crisis reawakened many to the fragility of fractional reserve banking.

This is true to such an extent that we have seen multiple proposals for an end to fractional reserve banking by implementing full reserve banking from a diverse group of thinkers — Positive Money, the International Monetary Fund, Laurence KotlikoffJohn Cochrane and Martin Wolf. My colleague Frances Coppola gave a good, concise rundown of the detail of some of these proposals in 2012. And of course, there also exists a wing of Austrian economics that wants to squash fractional reserve banking simply through demanding an end to lender of last resort functions, so that bank runs doom banks who have acted “irresponsibly” by overextending their lending beyond their reserves face bank runs. The idea is that fractional reserve banking could not survive in a “true free market” system without government backing.

Yet I think exactly the opposite is true. Fractional reserve banking is ineradicable, and trying to do so is very risky. The Austro-goldbug case is easier to dismiss. Empirically, we know that the classical gold standard did not prevent fractional reserve banking. Far from it.There was both fractional banking and bank runs and panics during the 19th century and into the early 20th, up to the creation of the Fed in 1913 which was intended to act as a lender of last resort, as J.P. Morgan did following the 1907 panic. (And, I should add, has prevented bank panics and liquidity crises when it has acted as a committed lender of last resort and provider of liquidity insurance).

The full reserve banking case is more difficult to dismiss out of hand because unlike the gold standard it has never really been tried. Yet there does appear to be some serious logical holes in the arguments for it. Because banks would not be able to generate income via lending (because they would have to keep deposits on hand) customers would not be able to get much (or any) interest for their money, and access to the payments system would be something that would have to be charged for (or run by the government as a public utility). Positive Money, for example argues that bank users would have to pay fee would likely be around £5 ($8) per month. Ben Dyson of Positive Money argues: “Consider this a fee for a useful service, which would be more than outweighed by the other benefits you’ll get from the switch to a system where banks do not create the nation’s money as debt.”

This would effectively mean that depositors would be experiencing in effect negative nominal interest rates. People would be paying banks for the pleasure of holding their money. Obviously, this would encourage them to go elsewhere if customers want to gain a return on their money. One positive from this might be that it would channel money away from sitting as idle savings deposits and toward productive activity in the economy — reaching for yield into vehicles like mutual funds, money market funds, and exchange traded funds, cryptocurrencies which aren't insured and have no access to a lender of last resort. And it would also open the possibility of black market banking deposits — unregulated groups offering higher interest rates. As Frances Coppola argues here, we are all “banks”, because we can all extend lines of credit so anyone who wants to can really become a black market competitor in these markets. The barriers to entry are legal ones, not practical or technological ones, especially now that billions have access to computers.

Some would say that a return is only justifiable for those who take risk, so these changes would be a positive. On the other hand, the return on a bank deposit is more compensation for inflation than anything else. And the negative, of course, is that all of this money pouring out of the conventional banking system would no longer be insured by a lender of last resort, exacerbating the danger of bank runs and liquidity crises.

And as I wrote in The Week, this really is opening up an old problem that has largely been solved, rather than addressing the actual problem we faced in 2008: “The really strange thing about these kinds of proposals, as Paul Krugman argues, is that they act like conventional bank runs were a problem in 2008. They weren't. Bank runs have largely been prevented since the Great Depression by the existence of a lender of last resort and deposit insurance. In fact, the crisis of 2008 involved very few runs on conventional deposits but a massive run on shadow bankingThe shadow banking sector was a huge new sector of things that acted like banks that, crucially, were not regulated as banks, and had no access to a lender of last resort.”

The solution to crises in shadow banking, I would argue, is to regulate shadow banking (and anything that acts like a bank) like you would conventional banking, by providing liquidity insurance and a lender of resort function.

Indeed, other crises during the pre-2008 period also emanated out of parts of the financial sector that were acting as banks without being regulated as them, for example the UK experienced a wholesale run on unlicensed mortgage lenders in 1974.

And the bigger problem may well be that a money supply determined by committee is unresponsive to the broader financial and economic conditions in the economy. Under the current system, banks can increase the money supply to demand for money in a decentralized manner. Having the money supply determined by a committee (as the full reservists advocate) opens us to economic planning problems. Committees may badly misjudge the demand for money, leading to mistakes that cause excessive inflation and deflation.

Of course, I admit I am sympathetic to some of the anti-fractional reserve rhetoric, if not their solutions. Yes, the fact that the vast majority of money is created by private banks means that they have a central role in allocating society’s productive capital, centralizing power around them. The power to create money bestows the capacity to buy talent, resources, and even political favours. This is a strong motivation to want to reduce the power of the financial sector by reducing its power to allocate productive capital. But a money supply determined by committee is also vulnerable to the dangers of political capture and cronyism. 

On the other hand, there is already a tried and true conventional solution to this concentration problem which has actually worked in the past (for instance, during the post-WWII economic boom) that can work in the context of a conventional fractional banking system: redistribution, infrastructure creation and Keynesian measures to reduce and keep unemployment low. We do not need to try risky and unproven remedies like full reserve banking to fight inequality, and to keep the financial sector in check and prevent bank runs.

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