Fractional Reserve Banking, High Leverage, Low Liquidity, and Incompetent Regulators
What Could Possibly Go Wrong with the U.S. Banking System?
By Brian J. Donovan
Fractional reserve banking is a banking system that allows banks to create loans from a portion of the deposits they hold, with only a fraction of those deposits being required to be kept available for withdrawal. This system enables banks to expand lending and stimulate economic growth by freeing up capital. Fractional reserve banking is widely used in modern economies around the world.
When a customer creates an account at a bank, the customer agrees to allow the bank to use a portion of their deposits as loans to other customers while paying the customer a miniscule interest rate on their money, as specified in the contract. This does not restrict the customer's access to their deposited funds, but if they want to withdraw more than the portion of the deposit that the bank is required to keep on hand, the bank may need to access funds from elsewhere to fulfill the request.
The Federal Reserve is responsible for setting interest rates, which are determined by economic conditions and how they can best achieve the Federal Reserve’s dual mandate of maximum employment and price stability. When a bank requires capital to fund loans, withdrawals, pay debts, or meet other obligations, it can borrow from other banks and pay interest. If necessary, the Federal Reserve maintains the discount window service to lend money to banks at a higher interest rate than that which is charged between banks. This motivates banks to seek funding from each other instead of relying on the Federal Reserve.
The federal funds rate is the target interest rate established by the Federal Open Market Committee (FOMC). This rate represents the rate at which commercial banks lend and borrow their excess reserves to one another overnight. The FOMC, which is the Federal Reserve System’s policymaking body, meets eight times annually to set the target federal funds rate as part of its monetary policy, which aims to promote economic growth.
The deposit multiplier is the maximum amount of money that a bank can create for each unit of money it holds in reserves. This multiplier is calculated based on the percentage of the amount deposited that can be loaned out, as determined by the reserve requirement established by the Federal Reserve.
The deposit multiplier, also referred to as the deposit expansion multiplier or simple deposit multiplier, is closely linked to the portion of a bank’s deposits that can be lent out to borrowers after taking into account their required reserves. This lending activity helps to increase the overall money supply in the economy and support economic growth.
Central banks, like the Federal Reserve in the United States, set a minimum reserve requirement that banks must maintain. This reserve requirement is a percentage of a bank’s total deposits that must be held in reserve in either vault cash or deposits at the central bank. These reserve requirements are also known as required reserves, and banks must keep enough reserves to ensure they have sufficient cash on hand to meet customer withdrawal requests. Although reserve minimums are set by the Federal Reserve, banks may set higher ones for themselves. The Federal Reserve pays banks a small interest rate on their reserves, which can be held at the bank or at a local Federal Reserve bank.
To calculate the deposit multiplier, you take the inverse of the required reserve percentage. For example, if the reserve requirement is 10%, the deposit multiplier would be 10 (1 divided by 0.10). This means that for every $1 held in reserves, a bank can create $10 in deposits. The deposit multiplier is a key factor in determining the amount of money that banks can create and lend out to borrowers, which in turn affects the overall money supply and economic activity.
The money multiplier reflects the overall increase in the money supply that results from the deposit multiplier and the subsequent lending by banks. However, the money multiplier is often less than the deposit multiplier due to factors such as excess reserves, consumers holding onto their money in savings accounts, or consumers choosing to convert their deposits to cash. These factors can limit the amount of new money injected into the economy through bank lending.
In sum, fractional reserve banking allows banks to create new money by loaning out a portion of the funds deposited with them. For example, if a bank has $100 in deposits and a reserve requirement of 10%, it must hold $10 in reserve and can loan out the remaining $90. If the borrower deposits the $90 in another bank, that bank must hold $9 in reserve and can loan out $81. This process continues, with banks loaning out a portion of the money deposited with them and the money supply expanding.
Although fractional reserve banking allows for the creation of credit and the expansion of the money supply, which can help to support economic growth, it also creates the risk of bank runs if too many customers try to withdraw their funds at the same time. The central bank can use its reserve requirement as a tool to control the money supply and influence economic activity.
Fractional reserve banking has a long history dating back to the days of goldsmiths and their issuance of promissory notes. The National Bank Act of 1863 in the United States required banks to hold reserves to protect depositor funds. The Federal Reserve Act of 1913 established the Federal Reserve System and required banks to keep reserve balances with the Federal Reserve Banks. Reserve requirements were initially set at 13%, 10%, and 7% in 1917, and have fluctuated over time, ranging from as high as 17.5% in the 1950s and 1960s to between 8% and 10% in more recent decades.
The Federal Reserve reduced the reserve requirements for all banks to zero percent (0%) on March 26, 2020. Allegedly, this was done in response to the COVID-19 pandemic and the resulting economic downturn, in an effort to increase liquidity in the financial system and support lending.
There are alternative monetary systems such as 100% reserve banking, Islamic banking, and others that operate differently from fractional reserve banking. These systems have their own advantages and disadvantages and are used in various countries and contexts. The choice of monetary system is a matter of policy and depends on various factors such as economic and social goals, legal frameworks, cultural and religious values, among others. However, fractional reserve banking remains the most widely used system in modern economies, due to its ability to efficiently create credit and support economic growth.
As for the debate around fractional-reserve banking, it is true that there are differing opinions on the topic. While some argue that fractional-reserve banking allows banks to create money out of thin air by loaning out more than they hold in reserves, others point out that this is not the case. Rather, they argue that fractional-reserve banking allows banks to leverage the deposits they hold in order to make loans and investments that stimulate economic growth [and maximize profit for the banks].
While fractional-reserve banking has been the dominant form of banking in the U.S. and around the world for many years, it still poses significant risks to the economy.
Bank Runs
Bank runs are a significant risk of fractional-reserve banking, and they can quickly escalate into a systemic crisis. In a bank run, depositors lose confidence in the bank’s ability to honor their withdrawals, leading to a rush to withdraw funds, potentially causing a liquidity crisis that can lead to the bank’s failure. The bank may not have enough cash on hand to meet all the withdrawals, leading to a default on its obligations and a further loss of confidence in the banking system. This can cause a chain reaction of bank runs, leading to a collapse of the entire banking system and a wider financial crisis. The government may step in to try to stop the panic and restore confidence, but this may require significant intervention and bailouts, potentially at great cost to taxpayers.
The widespread use of electronic banking and the increasing reliance on credit and debit cards means that many people have little need for cash on a day-to-day basis. This means that a bank run could potentially be even more devastating because the bank may not have enough physical cash on hand to meet the demands of panicked depositors.
The rise of financial technology (fintech) companies and online banks has created more competition in the banking industry. This means that traditional banks could be more vulnerable to a bank run as customers have more options for where to deposit their money.
All of these factors highlight the importance of maintaining stability in the banking system and ensuring that banks have adequate reserves to meet depositors’ demands. The FDIC, which currently provides insurance for deposits up to $250,000 in the event of a bank collapse, and other regulatory measures help to mitigate the risk of bank runs, but the possibility of a run still exists and should not be underestimated.
Inflation and Economic Instability
Another risk of fractional-reserve banking is the potential for inflation and economic instability. When banks create new money through loans and investments, they increase the money supply in the economy, which can lead to inflation if not properly managed. Additionally, the practice of fractional-reserve banking can create a debt-based economy where the growth of the economy depends on an ever-increasing amount of debt. This can lead to economic bubbles and eventual collapses.
As noted above, effective March 26, 2020, the Board of Governors of the Federal Reserve System reduced reserve requirement ratios on all net transaction accounts to zero percent, eliminating reserve requirements for all depository institutions. The annual indexation of the reserve requirement exemption amount and the low reserve tranche for 2023 is required by statute but will not affect depository institutions’ reserve requirements, which will remain zero.
The 2008 Meltdown of the Financial Services Industry
The 2008 meltdown of the financial services industry cost tens of millions of people their savings, their jobs, and their homes.
The inequality of wealth in the U.S. is now greater than in any other developed country. For the first time in history, average Americans have less education and are less prosperous than their parents.
It’s a Wall Street government. President Obama chose Timothy Geithner as Treasury Secretary. Obama picked Gary Gensler (former Goldman Sachs’ executive who had helped ban the regulation of derivatives) to heard the CFTC. Obama’s Chief Economic Advisor was Larry Summers.
In short, the 2008 meltdown of the financial services industry was due to a total lack of transparency, a total lack of accountability, the undue influence of highly compensated “Thought Leaders,” and a small group of very cooperative players who were driven by ego and insatiable greed which resulted in the explosion in the unregulated market of CDOs on the frontend and CDSs on the backend.
Meltdowns occur when regulators don’t regulate.
Conclusion
The pseudonymous creator of Bitcoin, Satoshi Nakamoto, called out fractional reserve banking, which no longer requires banks to hold even a small percentage of their deposit liabilities in liquid assets as a reserve, while being at liberty to lend the remainder to borrowers, as a core reason why he, she or they created the leading cryptocurrency.
Nakamoto stated, “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.” - Phil Champagne, The Book Of Satoshi: The Collected Writings of Bitcoin Creator Satoshi Nakamoto, Published: June 14, 2014 by E53 Publishing LLC
Nakamoto explained, that Bitcoin was “completely decentralized, with no central server or trusted parties because everything is based on crypto proof instead of trust….With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.”
The 2008 financial crisis and the recent collapse of Silicon Valley Bank, Silvergate, and Signature Bank clearly demonstrate that it is up to individuals to better understand risk management and consider alternative forms of banking, such as decentralized cryptocurrencies like Bitcoin, that do not rely on fractional reserve banking or centralized institutions.