Doubt on fractional reserve banking

[Prashanth_Perumal]

Scene 1: Suppose, under fractional banking with a 20% reserve requirement, bank A gets $100 as deposit. Does this mean bank A can directly (at one go, independently) make $500 worth of loans?

Scene 2: Wikipedia’s article on fractional banking (http://en.wikipedia.org/wiki/Fractional-reserve_banking#Example_of_deposit_multiplication) sees the the money creation process in fractional banking to be more of a complex process involving a series of banks withholding 20% of the real hard money they get as deposits in each cycle, and the process eventually leading to the creation of $500 of new money.

Which of the above two scenes is correct? Or are both correct?

[LogisticEarth]

Scenerio 2 is closest to what happens. When a bank gets that $100, they keep 10% of it in reserve, and loan out $90, while still giving the original account holder $100 on demand deposit. So $90 has been “created”. Then someone takes that $90, puts it in thier bank account, then THAT bank takes $9 of that amount, keeps it in reserve, and loans out $81. Rinse and repeat, and you get a whole lot more currency circulating.

[JH2011]

In scene 1, where exactly does the bank get the other $420 to make loans?

If they get a $100 deposit and reserve requirements are 20%, then that bank can loan out $80.

If you want to read a discussion about the issues with fraud regarding the details of fractional reserve banking, this was discussed in great detail in this thread:

https://forum.freecapitalists.org/t/the-myth-of-fractional-reserve-banking-as-fraud/16927

The issue is not whether or not money gets “created” through fractional reserve banking (it does, period, because fractional reserve banking is a form of lending/sharing). The issue is that historically, and today, banks are able to engage in fractional reserve banking because there are governmental backstops that make the consumer OK with this (FDIC, Federal Reserve), and NOT because the banks are upfront with consumers making it clear to them that if they deposit $100, the bank will loan out $90, making it possible for a run on the bank, and the consumer not getting his money back.

[Prashanth_Perumal]

LogisticEarth, I actually went through the videos of Khan academy on fractional banking, and two videos in the series on fractional banking resemble scenario 1 and 2 respectively.

This video represents scenario 1: http://www.youtube.com/watch?v=On3c86V5A_E&feature=channel

And this represents scenario 2: http://www.youtube.com/watch?v=F7r7l1VG-Tw&feature=channel

I am really confused which one is correct.

The problem that I find with scenario 2 (the gradual process of expansion of money supply) is that I don’t see how it actually expands credit given to investment. It’s just hard money that is being loaned out as it enters each bank (in the gradual process), not the newly created money (in the form of virtual money in a checking deposit account). Each time the hard money moves into a new bank (or comes to the same bank in the next cycle), I see that a checking account is opened (thus creating money) in the name of depositors (the workers employed by business projects), and they can withdraw and use it for consumption purposes anytime. But, in this case, the new money doesn’t really get directed into investments to cause a boom (as is the main complaint against fractional banking). Scenario 1 seems to explain the artificial boom better. Or am I missing something?

[Prashanth_Perumal]

JH2011, in scene 1, the bank creates new money of $420 just by opening checking accounts for new loans (worth $420) that are provided to the borrowers.

[JH2011]

Ok, I think I understand what you are saying. The bank just artificially opens a checking account and tells a customer that it now has $X of money in it?

But how could you say the bank is following a 20% reserve requirement in scenario1 if they get $100 in deposits and make $500 in loans?

[billott1]

Scenario 2 is what happens. But the result for the bank is the same as if it did one, the bank if operating in a steady state of always lending 80% of deposits and keep 20% in reserve will have 1/20% x the deposits in loans or amt loaned = 5 x amt deposited.

[JH2011]

Bogart, understood. In scenario 1 the bank will eventually lend out $500 if it keeps lending 80% of deposits.

But my misunderstanding comes when Prashanth says can “bank A directly (at one go, independently) make $500 worth of loans?”

They would need to make many loans in order to lend out $500.

[Prashanth_Perumal]

JH2011, the reserve requirement being 20%, the bank is stipulated to hold 20% of the total value of loans made. Since, $100 would be 20% of $500, the bank can make $500 worth of loans.

Bogart, over here: http://www.lewrockwell.com/rothbard/frb.html

Doesn’t Rothbard seem to support scenario 1, as the real process of fractional banking? And as I already said, scenario 2 can’t possibly cause an investment boom since the money that is created is not really directed into investment projects. It is in the checking deposit account of depositors who didn’t possibly have any idea of investing it (judging from the fact they wanted the bank to act as a safe-keeper). I’m not sure.

[scineram]

If you recieved $100 in deposits you can only lend out that without reserve requirements. If the reserve ratio is 20% you can lend out $80.

[Prashanth_Perumal]

scineram, here is Rothbard:

“Let’s see how the fractional reserve process works, in the absence of a central bank. I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I “lend out” $10,000 to someone, either for consumer spending or to invest in his business. How can I “lend out” far more than I have? Ahh, that’s the magic of the “fraction” in the fractional reserve. I simply open up a checking account of $10,000 which I am happy to lend to Mr. Jones. Why does Jones borrow from me? Well, for one thing, I can charge a lower rate of interest than savers would. I don’t have to save up the money myself, but simply can counterfeit it out of thin air. (In the nineteenth century, I would have been able to issue bank notes, but the Federal Reserve now monopolizes note issues.) Since demand deposits at the Rothbard Bank function as equivalent to cash, the nation’s money supply has just, by magic, increased by $10,000. The inflationary, counterfeiting process is under way.”

Scenario 1, no?

[scineram]

What does he mean lending a checking account? The paragraph makes no sense to me.

[nirgrahamUK]

He means rather than making a loan to someone by handing them a wad of cash over the counter for £10,000; give them a cheque book and debit card for a checking account whose balance is £10,000

[J.R.M]

Prashanth,

I believe in the example you quoted, Rothbard was making a simplistic statement about how fractional reserve banking works. In his “Mystery of Banking” he explains in more detail how it actually works in practice, and indeed, it is scenario 2 that takes place.

See, if Rothbard bank has $100 in demand deposits, they will lend out 100% - reserve requirement (10%) = 90% of the demand deposits. so they make a loan to a business for $90. that business then uses that $90 to pay employess or buy goods. that money eventually makes it back into demand deposits at any number of banks. so whatever bank receives the $90 will lend out 90% of that ($81) and so on. as this process continues ($73, $66, $60, $54…), more and more of the demand deposits get lent out (while still claiming they are available on demand to the depositor). In the long run, you end up with $900 of new “money” having been created, based on the initial $100 deposit.

This is how eventually, the inverse of the reserve requirement is the amount of new money that is created.

[DD5]

@J.R.M.

This is how eventually, the inverse of the reserve requirement is the amount of new money that is created.

This is simply the common practice under central banking. It is both efficient for interbank clearings and it just happens to make the effective outcome of money creation less conspicuous in the accounting balance sheets. But there is nothing in principle that prevents banks from issuing $900 worth of new loans on account of a $100 deposit.

[J.R.M]

@DD5

This is simply the common practice under central banking. It is both efficient for interbank clearings and it just happens to make the effective outcome of money creation less conspicuous in the accounting balance sheets. But there is nothing in principle that prevents banks from issuing $900 worth of new loans on account of a $100 deposit.

true, they could, but there are inherent risks in doing this. From Mystery of Banking:

To see the answer, we have to examine the detailed bank-to- bank process of credit expansion under central banking. To make it simple, suppose we assume that the Fed buys a bond for $1,000 from Jones & Co., and Jones & Co. deposits the bond in Bank A, Citibank. The first step that occurs we have already seen (Figure 10.9) but will be shown again in Figure 11.1. Demand deposits, and therefore the money supply, increase by $1,000, held by Jones & Co., and Citibank’s reserves also go up by $1,000.

At this point, Citibank cannot simply increase demand deposits by another $4,000 and lend them out. For while it could do so and remain with a required minimum reserve/deposit ratio of 20 percent, it could not keep that vital status for long. Let us make the reasonable assumption that the $4,000 is loaned to R.H. Macy & Co., and that Macy’s will spend its new deposits on someone who is a client of another, competing bank. And if Citibank should be lucky enough to have Macy’s spend the $4,000 on another of its clients, then that client, or another one soon thereafter, will spend the money on a nonclient. Suppose that Macy’s spends $4,000 on furniture from the Smith Furniture Co. But the Smith Furniture Co. is the client of another bank, ChemBank, and it deposits Macy’s Citibank check into its Chem- Bank account. ChemBank then calls on Citibank to redeem its $4,000. But Citibank hasn’t got the $4,000, and this call for redemption will make Citibank technically bankrupt. Its reserves are only $1,000, and it therefore will not be able to pay the $4,000 demanded by the competing bank.

In short, when Citibank’s demand deposits were owed to Macy’s, its own client, everything was fine. But now, not from loss of confidence or from a sudden demand for cash, but in the course of regular, everyday trade, Macy’s demand deposits have been transferred to ChemBank, and ChemBank is asking for reserves at the Fed for redemption. But Citibank doesn’t have any reserves to spare and is therefore insolvent.

One bank, therefore, cannot blithely heap 5:1 on top of new reserves. But if it cannot expand 500 percent on top of its reserves, what can it do? It can and does expand much more mod- erately and cautiously. In fact, to keep within its reserve require- ments now and in the foreseeable future, it expands not by 500 percent but by 1 minus the minimum reserve requirement. In this case, it expands by 80 percent rather than by 500 percent. We will see in the figures below how each bank’s expanding by 80 percent in a central banking system causes all banks, in the aggregate, in a short period of time, to expand by the money multiplier of 5:1. Each bank’s expansion of 80 percent leads to a system or aggre- gate expansion of 500 percent.

[Southern]

in scene 1, the bank creates new money of $420 just by opening checking accounts for new loans (worth $420) that are provided to the borrowers.

Banks do not create money by opening checking accounts. The money is created when a new loan is made. However a single bank can, theoretically, expand the money supply in the same way mulitple banks would. In order for this to happen the money that was lent out would only need to be redeposited bank into the original bank. The bank could then create a new loan (thus new money) based on that deposit.

	Liabilities				Assets
	DDA Cust 1	DDA Cust 2	DDA Cust 3		Loan Cust 2		Loan Cust 3		Cash on Hand
Begin	$0.00	$0.00	$0.00		$0.00		$0.00		$0.00
	$1,000.00								$1,000.00
End	$1,000.00	$0.00	$0.00		$0.00		$0.00		$1,000.00
Cust 1 deposits $1000 in hard currency at the bank. The bank raises Cust 1 checking balance to $1000 (liability) and raises cash on hand by $1000 (asset)
	Liabilities				Assets
	DDA Cust 1	DDA Cust 2	DDA Cust 3		Loan Cust 2		Loan Cust 3		Cash on Hand
Begin	$1,000.00	$0.00	$0.00		$0.00		$0.00		$1,000.00
		$900.00			$900.00
End	$1,000.00	$900.00	$0.00		$900.00		$0.00		$1,000.00
Cust 2 borrows $900 from the bank. The bank increases Cust 2 checking account by $900 (liability) and creates a loan account for $900 (asset). The banks deposits have grown by $900 so now they can lend an additional $810.
	Liabilities				Assets
	DDA Cust 1	DDA Cust 2	DDA Cust 3		Loan Cust 2		Loan Cust 3		Cash on Hand
Begin	$1,000.00	$900.00	$0.00		$900.00		$0.00		$1,000.00
			$810.00				$810.00
End	$1,000.00	$900.00	$810.00		$900.00		$810.00		$1,000.00
Cust 3 borrows $810 from the bank. The bank increases Cust 3 checking account by $810 (liability) and creates another loan account for $810 (asset). The banks deposits have grown by $810 so now they can lend $729.

[scineram]

The bank cannot open a checking account for $900 for Cust2 and lend him the same amount the same time.

[Stranger]

Banks have no limit on reserve requirements, so they can withhold 20% or 1% or 0%, but their ability to make loans is limited by the scarcity of their loan officers, who need to make sure that the loans are good and will be paid back (or at least serviced).

This is why finance employment goes up in a credit expansion.

[Southern]

The bank cannot open a checking account for $900 for Cust2 and lend him the same amount the same time.

I think you may be confused. I can see how i might have been unclear. The loan created first and the money is Then put into his account. That is exactly what happens everyday at banks. I lend you money and deposit it into your account.