4. Fractional Reserve Banking

Suppose the goldsmith’s bank notes are in widespread use as money substitutes.  The goldsmith now makes an astute observation: only a very few depositors come to claim their gold at any time, most of it stays in the safe permanently.  So the goldsmith has a great idea: he will create some “fake” warehouse receipts, exact replicas of the certificates representing claims to gold that he gave to the initial depositors, and spend them on a new luxury item for himself, a yacht.  He prints up the fake certificates, and buys a yacht with them.  They are accepted like normal money.  The seller of the yacht passes the money on to others, and none of them realize that there is no gold actually backing these certificates. 

 

The goldsmith buys his yacht, and no one can see the scam he has just pulled off.  He has actually created money for himself.

 

As soon as he creates a fake warehouse receipt, a fake certificate, he is engaging in fractional-reserve banking, because the reserves he has in stock – the actual gold in his safe – is now less than (a “fraction” of) the claims to gold that are owned by individuals in the society.  Now, if everyone holding a certificate came to the goldsmith at once, there would not be enough gold to go round.  The last people to the bank would not get the gold that was rightfully theirs.  It is clear that the goldsmith has in effect stolen the gold from these people. 

 

Now, the money supply has been increased, because the fake certificates are circulating like real money, even though there is no gold to back them up.  They are “fiat”, or “un-backed” notes.  Analytically there is no difference between whether the goldsmith issued fake certificates, or spent the depositors gold directly.  The point is that not 100% of the certificates to gold can be redeemed, only a fraction of them.  The issuing of fake certificates was an act of fraud, because the gold never existed.  This is true whether the crime is discovered or not. 

 

As long as the goldsmith restrains himself and does not issue too many fake warehouse receipts, he may well get away with his clever scam.  He must not be too extravagant, because his depositors may suspect that he is spending their money, and they may en-masse lose trust in the goldsmith-bank and demand their gold in exchange for the bank notes – known as a “bank run”. 

 

How many “fake” bank notes could the goldsmith create?  It depends on how much of risk he wishes to take.  For example, if he had 100oz of gold in his safe and produced 9000oz-worth of fake receipts, he would have only a 1% reserve.  If one day several people wanted to redeem large bank notes, he may not have enough gold on hand and his lucrative crime would be exposed.  A 1% reserve may be too much of a risk. 

 

But so long as people maintain their trust in the goldsmith (that is, they have full faith that he will be able to supply them with gold in exchange for the bank note), and keep reserves above, say, 20%, to make sure there is always enough to cover demands for redemptions on a normal day, he should be OK, so long as he keeps the scam a secret.

 

But then the goldsmith has another idea: rather than spending fake bank notes on my own consumption, why not lend them out and receive an interest on them?  Thus, the goldsmith becomes both a deposit bank and a loan bank; the two concepts start to link together.

 

It would be perfectly legitimate for an institution to be both a deposit bank and a loan bank, so long as the two functions were kept separate.  That is, it must be clear that there are two types of deposits individuals can make with the bank:

1.        As demand-deposits, available on demand and for which the saver pays the bank interest – essentially money-warehousing.

2.        As timed-deposits, not available on demand and for which the banker pays the saver (investor) interest.

 

These two distinct functions have become combined into a single entity: a bank.  The profits available to a fractional-reserve practicing combined deposit and loan bank are enormous.

 

Let us illustrate the profits that are available.  Suppose first that the goldsmith, now combined banker, is not practicing fractional reserve banking.  He has 100oz of gold demand-deposited in his safe, which is represented by 100oz-worth of bank notes in the hands of the depositors and circulating as money substitutes.  He is collecting a 1% storage fee for the gold.  He also has 100oz of gold timed-deposits from investors, which he has loaned out to entrepreneurs.  He is charging 6% interest from the entrepreneurs and paying 2% interest to investors. 

 

The bank’s T-account will look like this:

                        Assets                                                  Liabilities

                        100oz IOU’s from entrepreneurs              100oz of timed-deposits with investors

                                                           

Note that since the deposit bank does not own the money it is storing, that gold does not appear on the T-account.  But since this bank is about to practice fractional reserve banking, it assumes ownership of that money, and enters it onto its T-account, so that it will look like this:

Assets                                                  Liabilities & Equity

                        100oz gold                                            100oz of bank notes

                        100oz IOU’s from entrepreneurs              100oz of timed-deposits with investors

 

The bank’s profit & loss sheet would look like this:

• 1% storage fee from the holders of 100 gold certificates (= 1oz income per year)
• 6% income from loans given to entrepreneurs (100oz-worth of loans) (= 6oz income per year
• -2% interest payment to investors (100oz-worth of investment) (= -2oz income per year)

 

The bank will be making a steady 5oz of gold in profits per year: 4oz from his loans-and-investment business and 1oz from his gold storage business.

 

We saw previously how charging a storage fee for gold, whether it an upfront fee or is paid “in arrears” alters the value of the notes and makes them less suitable as a money.  Since getting bank notes to circulate as money is essential to enabling fractional-reserve banking, this storage fee may well be waived.  The bank will offer gold storage for free!  It is not out of generosity, but to conceal a scam.

 

The bank now decides to commit fraud and use fractional-reserve banking, keeping only enough gold to cover 10% of outstanding bank notes.  The bank creates 900oz-worth of un-backed bank notes and loans them out to entrepreneurs.  This increases the money supply by 900oz.  The T-account now looks like this:

Assets                                                Liabilities & Equity

                        100oz gold                                          1000oz of bank notes (demand deposits)

                        1000oz IOU’s from entrepreneurs          100oz of timed-deposits with investors

 

The bank’s profit & loss sheet would look like this:

• 6% income from loans given to entrepreneurs (1000oz-worth of loans) (= 60oz income per year)
• -2% interest payment to investors (100oz-worth of investment) (= -2oz income per year)

 

The bank is now making a profit of 58oz! 

 

Additionally, instead of loaning out the investors’ gold itself to the entrepreneurs, the bank could simply issue bank notes, and keep the gold in storage.  This would not in itself be fraud, as the gold does really exist.  There would be no increase in the money supply here.  The T-account would look like this:

Assets                                                  Liabilities & Equity

                        200oz gold                                            1100oz of bank notes

                        1000oz IOU’s from entrepreneurs            100oz of timed-deposits with investors

 

The advantage of doing this, of course, is that the bank now has more gold reserves, so it can create another 900oz of bank notes un-backed by gold, to maintain a reserve ratio of 10%.  The money supply will increase by another 900oz.  The T-account will now look like this:

Assets                                                  Liabilities & Equity

                        200oz gold                                            2000oz of bank notes

                        1900oz IOU’s from entrepreneurs            100oz of timed-deposits with investors

 

The bank’s profit & loss sheet would look like this:

• 6% income from loans given to entrepreneurs (1900oz-worth of loans) (= 114oz income per year)
• -2% interest payment to investors (100oz-worth of investment) (= -2oz income per year)

 

The bank is now making a profit of 112oz!  This increase has come about via a further merging of the functions of deposit banking and loan banking.  The small storage fees the bank used to collect on deposits pales in comparison to the profits available by fractional-reserve lending.  It is clear that offering free deposit banking is a huge benefit – and only a minor loss of revenue – for a fractional reserve bank.  Furthermore, the bank will be hailed as charitable and altruistic, and many more people will want to take advantage of the free gold storage service the bank offers.

 

Enticed by the generous offer, individuals deposit 100oz more gold at the bank, which is swiftly turned into 1000oz of bank notes.  The T-account becomes:

Assets                                                  Liabilities & Equity

                        300oz gold                                            3000oz of bank notes

                        2800oz IOU’s from entrepreneurs            100oz of timed-deposits with investors

 

The bank’s profit & loss sheet would look like this:

• 6% income from loans given to entrepreneurs (2800oz-worth of loans) (= 168oz income per year)
• -2% interest payment to investors (100oz-worth of investment) (= -2oz income per year)

The bank is now making 164oz profit.  With fractional-reserve banking, it is extremely profitable for a bank to attract deposits.  It may even be profitable to pay people to store their gold in your vault!  Suppose the bank decides to pay depositors 2% interest, as well as investors, and that this attracts another 200oz of deposits.  The bank creates 1800oz of fake bank notes and the T-account becomes:

                        Assets                                                 Liabilities & Equity

                        500oz gold                                           5000oz of bank notes

                        4600oz IOU’s from entrepreneurs           100oz of timed-deposits with investors

 

The bank’s profit & loss sheet would look like this:

• 6% income from loans given to entrepreneurs (4600oz-worth of loans) (= 276oz income per year)
• -2% interest payment to investors (100oz-worth of investment) (= -2oz income per year)
• -2% interest payment to depositors (400oz-worth of deposits) (= -8oz income per year)

 

The bank is now making 266oz profit. 

 

The investors, meanwhile, see that there is no reason to invest their money in a time-deposit.  They can earn the same interest rate by depositing their money in an on-demand account.  There is now no need for time-deposits; the line between the two distinct functions of banking has finally disappeared.  (Note that banks may still accept time-deposits, perhaps even offering a higher rate for them, but analytically, there is no difference between them.  Both types of deposit are added to the reserves and new money is created on top of them)

 

It would appear at first glance that, even though it is evidently a scam, no one is worse off because of it.  So long as the money certificates continue to circulate as money, and the goldsmith-banker keeps his good name, redeeming certificates on demand, and always having high enough reserves to cover daily demands for gold, no one will be any the wiser.  But wealth cannot be generated out of nothing.  Someone must be losing out because of this scam.  But who exactly?

 

The scam increases the money supply.  Therefore, it decreases the purchasing power of money, raising prices.  Everyone will suffer from increased prices.  But it will not affect everyone evenly.  The redistributive effect is that wealth is transferred from the late receivers of the new money to the early receivers of the money.  The structure of production is distorted, depending on how the early receivers spend their money.  If, for example, the goldsmith-banker particularly enjoyed waterfalls, he may use the new money to build waterfalls throughout the town.  Thus, production will be shifted from satisfying consumers’ desires, to satisfying the goldsmith’s desires.  Waterfall-builders will also benefit.  In the long-term, all will suffer from decreased productivity.

 

A credit expansion is an increase in the number of loans.  Without fractional-reserve banking, credit expansions and contractions would not be an issue, because it does not increase the money supply.  We shall examine the full effect of the distortions in the economy caused by credit expansions under fractional reserve banking – in particular the business cycle – in a later chapter.