Fractional Reserve Banking

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    As a banker, I’ve been doing a lot of reading on the Austrian approach towards banking. Most of what I have read has been generally negative towards the system of fractional reserve banking.

    However, I’m not sure that fractional reserve banking in inherently bad economics. Here’s my thoughts; perhaps some of you who are smarter than myself can give me some additional perspectives to consider.

    In an unhampered economy, if a customer deposits money in a bank, they do so because they would see that decision as personally beneficial. Perhaps they were motivated by the interest rates the banks offered, the convenience of a checking account with a debit card, or the security of knowing that their funds would be kept safe. Most likely, they chose to deposit their money for a combination of these reasons.

    Bank then in turn loan that money back out to others. The bank would choose to do this because they saw this as beneficial, because of the interest they would be able to collect on those funds. However, as they loan this money out, they also assume the risk of not being able to collect on those funds. The more credit the bank issues, the greater the risk and the greater the potential gain. In an unhampered economy, the bank would be free to decide how much money they were willing to issue as credit. If the bank saw the benefits of fractional reserve banking to outweigh the risks of this practice, they should be free to do so.

    Rather than having government regulate the banks, the depositors would regulate the banks. If the bank over issued credit, depositors would be less willing to deposit funds into the bank.

    Therefore, it seems to me that in an unhampered economy, fractional reserve banking is not inherently bad. It only becomes bad when the government decides to step in and bail out the banks who have over issued their credit, thus removing the moral hazard.

    Am I understanding right?


    Well I’m certainly no “expert” in Austrian economics, but I have studied it for awhile and think I have a reasonable grasp on the concepts. I would say the mode of operation you have outlined is correct, there is nothing wrong with depositors freely depositing funds for reasons they find beneficial and for banks to lend said funds out for reasons beneficial to them and their depositors. The problem with fractional reserve lending is not the “fractionality” per se but rather the fact that the funds lent out are not then also restricted from withdrawal by the depositors… which ultimately causes all the lending to become an inflationary bubble. For example, under the current system if I deposit $100 into the bank, the bank can then lend out $90 of that… however I can also come and withdraw all $100 as well… so now you have two actors in the economy spending $100 and $90… the $90 being created out of thin air.

    A non-inflationary lending scenario would be one whereby I agree to deposit the $100 for x period and I understand I may not withdraw those funds. Period. Which is basically what we have with CD’s (time deposits)… that would be an example of “proper” non-inflationary lending. The bank earns interest and the depositor earns interest as well, the only tradeoff is they can’t use the funds. In a sense, the depositor is lending the funds and using the bank as broker to handle all the messy details and for the service of handling the messy details the bank gets to take a cut of the interest rate paid to the depositor (the actual lender of funds).

    There are different ways this could be structured, say I want to deposit $10,000 but only commit half of it to such lending, that way I could have some of my money pay me income to cover the costs of having the bank store the other $5000 for me so I can use it as I need to whenever I need to.

    Without any lending being done then depositors would pay the bank for the services provided (store-housing, check clearing, etc). It’s all up to the individual to decide whether they want to pay for the service or get it for “free” by committing some set amount of funds to be tied up for some set period of time.


    The problem economically with fractional reserve banking is similar to the problem of fiat money. Neither the production of fiduciary media, i.e. fractionally backed money substitutes, nor the production of fiat money can be regulated by profit. Without profit and loss as a guide, production will be inefficient. A bank can issue fiduciary media out of thin air by making a loan to a customer and writing the funds into his checking account. The bank is not intermediating credit from a saver by doing this but creating it with the issue of fiduciary media. It is always profitable to issue more fiduciary media. The interest a bank earns on the loan is always greater than the nominal cost of writing funds into a checking account.
    In like fashion, a central bank prints fiat paper money. It is always profitable to print more. Without special privileges in law, like legal tender laws, fiat money would not arise on the market. Fiat money would not develop a wide clientele as a medium of exchange in free competition with commodity money.
    In like fashion, fiduciary media is supported by legal privilege. Money certificates came into existence as warehouse receipts for money. The “bank” did not own the gold money placed by the customer in its vault for safe keeping. In order to legally loan the funds warehoused by a customer, the state had to supplant bailment contracts with “deposit” contracts. But, legislation cannot bring about conditions contrary to economic reality. It merely creates inconsistencies in private property claims. Fractional reserves mean that more than one party holds mutually exclusive claims to the same money.
    In a “deposit” contract, the customer transfers ownership of money to the bank who then issues a claim to pay the customer money in the future. Such contracts are suitable for intermediating credit. Without special privileges in law, deposits would not develop a wide clientele as a medium of exchange in free competition with money certificates.
    Take a look at Murray Rothbard’s What Has Government Done to Our Money?


    Fractional Reserve Banking: Applying the “I can have my cake and eat it too” theory to money. Nothing dishonest there.


    I hope my little aside was not insulting. I enjoyed both the question and the answers.


    So far in this course I’ve learned that fractional reserve banking and fiduciary media are not considered part of the unhampered market economy.

    What about Free Banking where fractional reserves are allowed but are market regulated? Rothbard wrote that competition among banks would lead to a high reserve ratio, but banks might still take on some risk with their customer’s deposits. Are there cases, for example the Suffolk Bank, where fractional lending could exist peacefully in an unhampered market economy? From the wikipedia page on Suffolk Bank:

    In his History of Money and Banking in the United States, Murray Rothbard credits the Suffolk Bank with exercising “a stabilizing influence on the New England economy.”[5] John Jay Knox, a former Comptroller of the United States Treasury, stated that the success of the Suffolk Bank demonstrated that,

    “the fact is established that private enterprise could be entrusted with the work of redeeming the circulating notes of the banks, and it could thus be done as safely and much more economically than the same service can be performed by the Government.”[6]


    There are two issues involved. The first is the private property status of money substitutes. It’s clear how money certificates are consistent with private property. It’s not clear how fiduciary media are so. People hold (i.e., own) fiduciary media as part of a ready stock of medium of exchange and yet, simultaneously the un-backed portion is lent to other people to use as a medium of exchange. Rothbard thought fractional reserve banking, as it has been practiced, was fraudulent. Take a look at the following article to see the back and forth of the debate with free bankers.

    The second issue is what would happen on the market if all the legal privileges for fractional reserve banking were eliminated. Then demand deposits would be highly liquid assets and if banks wanted to stimulate customers to hold such balances by ensuring that the deposits serve as a medium of exchange, they would need to hold very high, if not 100%, reserves. Otherwise non-customers of the bank of issue would not accept the deposits as a medium of exchange. As you note, this view is taken by Rothbard. It was also the view of Mises and Salerno. Take a look at the following piece by Salerno.


    I would have no problem with Fractional Reserve Banking if it did not have the blessing of the state.

    If banks and central banks were not chartered and “allowed” to loan out money based on their reserves in excess of those reserves, they would have to compete in the free market with other investments and bailments.

    Clearly you would not bring your valuables to a storage unit on the agreement that the owner of the facility might loan out your stuff and subject to how well he is managing the unit, or how many friends he has in government you might get your stuff back.

    In a circumstance where fractional reserve banking is not backed by law, banks engaging in such practices would have to offer interest rates that would be far higher than a bank that safeguarded your cash for perhaps a fee with no interest.
    If a bank had decent management they could pull off lending out more money than their depositors give them.

    The moral hazard is the central bank or the FDIC will bail out a bank that makes too many mistakes with its depositors money. If these types of banks failed it would send a message to the investors to be more prudent and that there is market risk in lending to a bank who in turn lends out your money in excess of its total amount of deposits.

    But I would not out law such banks.

    Perversely, through state sanctioning of fractional reserve banking and the FDIC people are convinced that its safe to take next to no interest from banks that take your money and “promise” to pay it back as long as too many other depositors don’t want their money back too at the same time.

    For more on fractional reserve banking see
    Mises on Money by Gary North
    Austrian Economics a Primer by Dr. Eamonn Butler
    The Case Against the Fed By Murray Rothbard-calls fractional reserve banking insidious

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