5. Limits to Fractional Reserve Banking

Let us suppose that we have a system a “free banking” in which, unfortunately, fractional-reserve banking is not treated as fraud.  To what extent can banks use fractional-reserve banking?  What limits does the market naturally place on it?

 

Firstly, for any bank to even begin fractional-reserve banking, it must be reputable and trusted by individuals in society.  The bank must build up trust among the people that it will be able to redeem their bank notes and bank accounts at any time, on demand.

 

A second limit is the extent to which people use banks.  If individuals insisted on using gold (or government paper), the opportunity for fractional-reserve is severely reduced.

 

These limits are minor considerations, which mean precious little once banks and banking have become established.

 

A much more powerful market restraint is the dreaded bank run.  This occurs when clients of the bank – depositors and/or note-holders – lose confidence in the bank, and begin to fear that the bank does not have the money to redeem all its bank notes and deposit slips.  The clients begin to rush to the bank to demand their money and, in the case of a fractional-reserve bank, there is of course not enough money to redeem all outstanding notes and deposits.  Furthermore a run on one bank can lead to runs on other banks, and a widespread loss of confidence can quickly bring down the entire system and the game, for the bankers, is up.

 

Fear of a bank run will cause banks to be more cautious and to not let the fraction of reserves they hold get too low.  With a very low reserve ratio, even a mild loss of confidence could cause a bank to collapse.  A mild loss of confidence, typically caused by a period of inflation due to bank credit expansion, will cause the banks to increase their reserves.  Hence, the money supply will tend to contract and there will be a recession and deflation of prices.  This cycle of bank credit expansion, causing inflation, leading to a loss of confidence and then a bank credit contraction, is known as the “business cycle”.

 

But even the fear of bank runs still allows fractional-reserve banking to be practiced to a considerable extent.  There is, however, an even more powerful, day-to-day constraint in the market.  This is the limited clientele of the bank.  Any single bank’s fractional-reserve practices are limited to the extent that their bank notes are used as a medium of exchange.

 

We saw previously the example of a bank (let us call it the Wright Bank), that had 500oz of gold in its vault, and had pyramided 5000oz of bank notes on top of it, giving it a huge profit from loans to entrepreneurs and borrowers.  But the process does not stop there.  Suppose Smith has borrowed 1000oz of Wright bank notes for a business project.  He does not hold on to the bank notes, but spends them, causing a ripple of inflation from the point at which he injected the new money into the economy.  Suppose with his 1000oz of bank notes, he paid them to Jones.  Now, what is Jones going to do with the money?  If he is himself a client of the Wright bank, then he now simply has 1000oz extra on deposit at the Wright Bank.  So long as confidence is retained, all is well.

 

But what if Jones is not a client of the Wright Bank?  What if he prefers using gold or is a client of a different bank?  Then he will go to the Wright Bank and demand redemption.  Or, he will deposit his Wright bank note in his own bank, the Brown Bank, and that bank would demand redemption from the Wright Bank.  This is not because he does not trust the bank, or because he has lost confidence in it, but simply because he prefers not to use the Wright Bank’s services.  In any case, it is clear that it is sudden death for the Wright Bank.  It cannot redeem the 1000oz of bank notes, because it only has 500oz of gold in the vault.  It is immediately bankrupt and out of business.

 

Why would the Brown Bank want to redeem the Wright bank note?  Why should it do anything else?  The banks are competitors, not allies.  The Brown Bank would not want to issue the Wright bank note to its customers, and it does not want notes in its vaults: it wants gold, ready to redeem to customers on demand.  Furthermore, if the Brown Bank is a fractional reserve bank as well, gold can be added to its reserves and it can pyramid bank credit on top of it.  There is no reason for banks not to demand redemption for each other’s notes.

 

Thus as soon as one bank’s note is deposited in another bank, it will be redeemed.  It is therefore clear that a bank with a large clientele will have more opportunity for fractional reserve banking, because it will take longer before his bank notes reach somebody who is not a client of that bank.

 

Consider the extremes.  In the absurd case of every bank having exactly one client, no fractional reserve banking is possible, because as soon as the one client spends his loan in the form of an un-backed bank note, that bank note would be redeemed immediately by the bank of the person who accepted it. 

 

On the other hand, if every person in a whole country used the same bank, this limit would be removed entirely, and the single bank could inflate the currency as it saw fit, subject only to the other market limits, like the inevitable loss of confidence necessitating a contraction and, in the worst case, a bank run.  But even with one bank for a whole nation, there is still the risk of redemptions from overseas.  This is especially likely if the bank expands to any great extent, because it will cause prices to rise at home and hence foreign goods will tend to be imported, causing the bank notes to quickly go overseas.

 

One way to avoid this problem entirely, of course, is for all the banks to simply agree not to redeem each other’s bank notes, so that they can practice fractional reserve banking together, and all get away with it for as long as they could before the inevitable loss of confidence causing a recession.  In other words, they could form a cartel agreement.

 

As with any cartel on a free market, a banking cartel would be inherently unstable and unable to survive very long, due to both internal and external factors causing the cartel to break down.  The external factor is competition from new banks, and sound banks not interested in forming a cartel.  As these competitors would instantly ask for redemption from whichever cartel bank it receives a note from, gold would flow from the cartel banks to the sound banks, which would cause a contraction of the cartel banks.  The non-cartel banks could cause a deliberate loss of confidence in the inflated banks, just by advertising their own non-inflationary practice and pointing out the unsoundness of the cartel banks.  The cartel would soon break down and the member banks would be forced to either become sound or go out of business.  Only with government grants of privileges excluding competition would such a cartel be protected from external pressures.

 

There would also be internal pressures.  Why, for example, would a sounder bank continue in the cartel, effectively enabling less sound cartel members to gain greater profits and a bigger market share?  They may get around this by agreeing to all abide by a fixed reserve ratio, say 10%, but during inflationary booms there will be a temptation for all the banks to expand faster and break the agreement, and during recessions, many banks, fearing for their own survival, will contract faster.

 

So, in a “free banking” system, there are limits to the extent to which banks can practice fractional reserve banking.  These are:

• Loss of confidence – credit expansion will cause inflation which will lead to a loss of confidence, necessitating a contraction (the ‘business cycle’), and, in the worst case, a bank run, and a collapse of the whole system.
• Competition from other banks – sound competing banks will prevent practicing fractional reserve to any significant extent.  A government grant is required in order to allow a successful cartel or monopoly to survive.  This is the only way to eliminate this threat, but there is still the problem of foreign banks demanding redemption.