Fractional reserve banking

Economics Economics Questions
1

Hello,

I am a layperson only recently exposed to the Austrian school of economics. I’m fascinated by it and I’m buying what you’re selling. I do have a question:

I’ve read a few books by Murray Rothbard and he’s critical of the fractional reserve banking system. What I do not understand: without fractional resreve banking, how can money be loaned and how could a bank possibly pay me interest? I certainly understand the risk of fractional reserve banking, especially when rerserve requirement is very low but I don’t understand what the alternative is.

Thanks.

Don

2

They will answer:

You can only lend out as much money as you have. So if a bank has X amount of $'s in deposits, it can only lend out X $'s.

So if it pays 3% in interest on deposits, and makes 5% on loans, it would in theory make profit.

Ixtellor

3

I think I am going to sticky this thread, because this must’ve been asked at least a hundred times by now (not the OP’s fault), so that it’s readily available for future participants to see.

4

Thanks for your answer.

But - how do you loan the first dollar? i.e., if, as a bank, all my deposits must be backed, isn’t 100% of my money not loanable?

5

This is an easy answer:

There are a bunch of ways to get money without making fractional reserve loans on deposits that users can claim immediately:

  1. Most Common: Issue equity. That is you sell ownership in a bank, normally done through stock holders but can be done through a mutual system. In either case the investors are not contractually obligated to be paid the money back. Understand that if the bank makes more than the interest rates then the investors get more money paid back. There are many more insurance companies that use the mutual system and it has advantages.

  2. Contract deposits now for money later. A certificate of deposit is an example. The agreement for higher interest rates means the depositor has limit access to their deposit unlike a checking account or passbook savings. This method includes selling long term bonds.

6

Banks today perform two seperate functions.

  1. Warehouse money
  2. Make loans

These two activities are not neccesarily linked. What fractional reserve banks do is the monetary equivalent is renting out furniture left in a U-Store it.

7

In all likelyhood there would arise, in a stateless society, two different kinds of institutions.

The first would be a true financial intermediary, who would facilitate the loaning of money. There profits would be the result of arbitrage. For example, person A comes to the bank offering them money for 5% per annum, they would then lend this money at a rate higher than that and (e.g. 6% per annum) and then pocket the difference as a profit.

The second would be more like a warehousing business with whom individuals would conduct a monetary irregular deposit contract. The bank would charge a sum of money in order to guard the gold (or whatever other commodity) and this is how they would make money.

8

You have to get a depositor (or an investor) to allow you to do so. That’s what a CD is for example. Remember you only need to maintain 100% backing for demand deposits.

The definitive work on this subject from an Austrin perspective is De Soto’s book Money, Bank Credit, and Economic Cycles. It’s available online in pdf format here.

9

I cannot see how fractional reserves would not arise. Too much benefit for potential banks and borrowers.

10

Benefit? Like the business cycle?

11

Becoming insolvent is very beneficial.

12

You know, banks would not have done it if it was not beneficial to them. And borrowers like more lending.

13

It was only beneficial because they had help, from the state.

14

I think you would see banks from time to time engage in fractional reserve banking. Although we might see deposits move to a more secure bank, it is in the interest for the bank to try to balance fractional reserves and the rate of withdraws - they fail, but they would still try.

15

They were not helped by the state. Only quite lately.

16

Yes, they were.

17

Like how exactly?

18

Legal privileges, how else? Read Money, Bank Credit and Economic Cycles if you want the specifics, I’m not feeding them to you.

19

Dmuldoon: I think this will answer your question if it hasn’t been answered already.

I deposit money into a checking account at a bank (money in the Austrian sense). This is a demand deposit, which means that the funds must be immediately available at any given time. These funds would not be loanable. The deposit would most likely require a fee to be paid as this particular transaction in itself could not generate any revenue for the bank. Real loanable funds would come from the investors and owners of the bank itself or through other financial instruments made available to customers. A CD would not be a useful financial tool in a world of 100% reserves. The reason is simple. If a bank were to loan out funds from a CD and the loan were not repaid in time, then the bank could not pay back the CD at its maturity. One might make the following argument:

“If the default rate of lent funds is 1%, then a bank may keep available 1% of total lent funds for the purpose of covering bad loans. The funds to cover bad loans could come from the savings of investors and owners. This keeps the 100% reserve requirement in case of default.”

This would leave the bank open to fraud charges should more loans go bad than they have in reserves to cover bad loans. If the purchaser of a CD was not made aware that their funds would be lent out and consequently at risk then fraud is committed. If the bank only has 1% of total lent funds in reserves, and 2% of the loans go bad then the bank is on a fractional reserve and guilty of fraud because of the fact that the bank at that point could not possibly pay back its demand depositors.

Here is how a successful bank would operate:

e.g. As an investor and owner of stock in a bank, I have made my savings available to the bank for different uses. One of those uses might be as loans to consumers and business people. These funds are at risk of being lost if lent out, but typically in this case the risk has been spread across all investors and owners of the bank.

e.g. A bank may create a financial instrument so that its customers can participate in the lending market to make returns on their savings or to offset the cost of their demand deposit accounts. A bank may create fund pools which its customers can contribute to. If 10 customers contribute $100 each, then the pool now has $1,000 to be lent out according to guidelines the customer has been made aware of. The great thing about pooling of funds is that all investors in the pool share and spread risk so that any one particular investor only takes a small loss upon a single default.

The examples others used for interest rates I’m sure were only meant to be arbitrary, but private loans made by individuals today through savings would command interest rates of around 8% (friends rate) to 16% under most normal circumstances. If lenders of private savings could not get these returns, then why would they not put their money into less risky investments which can generate greater returns? The Federal Reserve has distorted the consumer’s expectation for interest rates because they are not held to be accountable for profits and losses.

One last example of the distortion of returns in the market:

An income producing property with a 10% capitalization rate (a generous rate in most of today’s markets) is purchased for $1 million. The purchaser puts $200k down on the property. The lender puts $800k into the deal. With a 10% cap rate, the pretax net operating income before loan payments are made is $100,000. Loan payments on a $800k loan with a 6% interest rate and 30 year amortization comes to about $57k per year. The remaining income of $43k goes to the owner. The owner is getting a cash return of 21.5% pretax while the bank is getting a 6% return on their money pretax. The bank’s income is not net to the bank since they also have to account for overhead of staff and buildings. The property owner’s income already takes into account the expense at market rate for a property manager (typically 5% of the effective gross income). This is a gross distortion of risk sharing and respective returns and is one explaination for why so much speculation has occured over the past several years in the real estate markets. How can you blaim entrepreneurs for being misled? The only way these returns make sense for a bank is because they are able to practice fractional reserve banking. This would not occur when real savings are lent out.

Lastly, a HUD loan for an income producing property like an apartment complex can offer a 40 year amortization which makes the loan payment even lower than in my example. Most private notes I have seen are on much shorter payment schedules.

20

I think this will answer your question if it hasn’t been answered already. Hopefully someone will get some use out of the information at least.

I deposit money into a checking account at a bank (money in the Austrian sense). This is a demand deposit, which means that the funds must be immediately available at any given time. These funds would not be loanable. The deposit would most likely require a fee to be paid as this particular transaction in itself could not generate any revenue for the bank. Real loanable funds would come from the investors and owners of the bank itself or through other financial instruments made available to customers. A CD would not be a useful financial tool in a world of 100% reserves. The reason is simple. If a bank were to loan out funds from a CD and the loan were not repaid in time, then the bank could not pay back the CD at its maturity. One might make the following argument:

“If the default rate of lent funds is 1%, then a bank may keep available 1% of total lent funds for the purpose of covering bad loans. The funds to cover bad loans could come from the savings of investors and owners. This keeps the 100% reserve requirement in case of default.”

This would leave the bank open to fraud charges should more loans go bad than they have in reserves to cover bad loans. If the purchaser of a CD was not made aware that their funds would be lent out and consequently at risk then fraud is committed. If the bank only has 1% of total lent funds in reserves, and 2% of the loans go bad then the bank is on a fractional reserve and guilty of fraud because of the fact that the bank at that point could not possibly pay back its demand depositors.

Here is how a successful bank would operate:

e.g. As an investor and owner of stock in a bank, I have made my savings available to the bank for different uses. One of those uses might be as loans to consumers and business people. These funds are at risk of being lost if lent out, but typically in this case the risk has been spread across all investors and owners of the bank.

e.g. A bank may create a financial instrument so that its customers can participate in the lending market to make returns on their savings or to offset the cost of their demand deposit accounts. A bank may create fund pools which its customers can contribute to. If 10 customers contribute $100 each, then the pool now has $1,000 to be lent out according to guidelines the customer has been made aware of. The great thing about pooling of funds is that all investors in the pool share and spread risk so that any one particular investor only takes a small loss upon a single default.

The examples others used for interest rates I’m sure were only meant to be arbitrary, but private loans made by individuals today through savings would command interest rates of around 8% (friends rate) to 16% under most normal circumstances. If lenders of private savings could not get these returns, then why would they not put their money into less risky investments which can generate greater returns? The Federal Reserve has distorted the consumer’s expectation for interest rates because they are not held to be accountable for profits and losses.

One last example of the distortion of returns in the market:

An income producing property with a 10% capitalization rate (a generous rate in most of today’s markets) is purchased for $1 million. The purchaser puts $200k down on the property. The lender puts $800k into the deal. With a 10% cap rate, the pretax net operating income before loan payments are made is $100,000. Loan payments on a $800k loan with a 6% interest rate and 30 year amortization comes to about $57k per year. The remaining income of $43k goes to the owner. The owner is getting a cash return of 21.5% pretax while the bank is getting a 6% return on their money pretax. The bank’s income is not net to the bank since they also have to account for overhead of staff and buildings. The property owner’s income already takes into account the expense at market rate for a property manager (typically 5% of the effective gross income). This is a gross distortion of risk sharing and respective returns and is one explaination for why so much speculation has occured over the past several years in the real estate markets. How can you blaim entrepreneurs for being misled? The only way these returns make sense for a bank is because they are able to practice fractional reserve banking. This would not occur when real savings are lent out.

Lastly, a HUD loan for an income producing property like an apartment complex can offer a 40 year amortization which makes the loan payment even lower than in my example. Most private notes I have seen are on much shorter payment schedules.