What is Fractional Reserve Banking?

Here we look at the history, function, operation and some criticisms of fractional reserve banking. This is important as most every nation has a FRB system in place.

History

In the middle ages goldsmiths would take deposits of gold/silver coins and issue 'goldsmiths notes' to depositers. Over time these notes became a trusted medium of exchange. Soon goldsmiths realised not everyone would want their gold at the same time and began to issue more 'goldsmith notes' in loans than they had in actual gold. Thus were born the first banks which paid interest to creditors (depositers of gold/silver) and received interest from a greater pool of debtors (people the bank loaned money to).

Function

The US Federal Reserve summarises FRB:
Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money... For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to create "money".

Money Creation

Modern banks start with money from the nations central bank (M0). From here the amount of commercial bank money created through loans depends on the reserve requirements of the bank. From the NY Fed:
If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000).

Control of Money Supply (and inflation?)

We see that the money supply is either central bank money (M0) or commercial bank money (M1-M3). We also know that inflation is 'always and everywhere a monetary phenomenon'. So how can central banks control money supply?

• Central bank money. Central banks can directly adjust their supply of money as they control the physical (notes/coin) and electronic creation of money.
• Commercial bank money. Central banks control this through regulation by changing the reserve requirements on banks. For example, a 10% reserve requirement enables $100 to become $1000. A 20% reserve requirement reduces that figure to $500. Capital ratio requirements also limit the types of loans banks can make (more low risk loans, fewer high risk loans).
  

Criticisms of Fractional Reserve Banking

There are two general criticisms of FRB. The first is that changes in money supply rely on the commercial bank lending process. When contracting money supply, this can be achieve easily as bank foreclose or withdraw credit in response to higher central bank imposed interest rates or reserve requirements. However, when seeking to expand money supply, the bank must have a willing borrower to borrow the new funds into existence. When the economy enters a down turn, borrows may not be willing to do this. Thus lowering interest rates and/or reserve requirements in a slow economy can be like 'pushing on a string'.

The second criticism is that increasing money supply artificially through money creation effectively lowers the cost of money (interest rates) through a simple supply demand mechanism (more money than goods). Alternatively, reducing money supply can create money shortages (for loans etc) which pushes up interest rates. Low interest rates can lead to over investment in unproductive assets (such as US housing from 2002-2006). High interest rates can lead to under investment in assets needed for current and future productive capacity.

Business cycle recessions are seen by Austrian School economics (more later) as necessary to liquidate unprofitable investments made due to artificially low interest rates. Once liquidated, capital is freed up for new investment in productive assets to take place.