Fractional reserve banking is our banking system.
It’s a system where only a fraction of bank deposits are backed by cash.
It’s the system behind the 2008 financial crash.
And it’s this same system that allows us to borrow money to buy homes, build businesses, and that keeps the world moving.
It’s like Dr Jekyll and Mr Hyde looking after your money at the same time. Which isn’t very reassuring.
In fact, the whole thing makes many people angry, and understandably so.
One such angry person is the economist Murray Rothbard, who doesn’t hold back what he thinks about fractional reserve banking.
He describes it as:
“a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.”The Mystery of Banking, Murray N. Rothbard
In other words, he complains bankers get rich at the expense of the rest of us.
The Ponzi Scheme
A Ponzi scheme is an investment scam that promises a huge rate of return for relatively little risk, which is Rothbard’s opinion of our banking system.
The system works like like this.
We ask the bank for money, say a loan of some kind, and pay a nice bit of interest for the privilege. A banker presses a button on a computer and…voila! The bank creates commercial money.
However, the bank doesn’t have the physical assets – the cash – to back up the loan it’s just made.
This is Rothbard’s world. The bank is the money warehouse. The commercial money transaction created by the computer is the ‘fake warehouse receipt’. This commercial money circulates globally throughout the banking system but it can’t be backed by cash the bank didn’t have in the first place.
And it’s not only Rothbard who thinks there’s a problem.
After the financial crash when the taxpayer bailed out the banks, former Bank of England Governor, Mervyn King, had something to say about banks owing people money. In his book, The End of Alchemy, he paraphrases Churchill:
“…never in the field of financial endeavour had so much been owed by so few to so many – and with so little radical reform”.The End of Alchemy, Mervyn King
In other words, banks made loans they couldn’t pay. And not a lot has changed since. Banks may still be making loans they can’t pay.
So, if Rothbard is right, and fractional reserve banking is one big Ponzi scheme, why don’t we stop them doing this?
Why don’t we force them to hold 100% cash, known in the jargon as ‘reserves’, against the deposits we make?
This idea is known as 100% reserve banking, or full reserve banking, and it’s been suggested before, as part of The Chicago Plan, in 1933. Funnily enough, this suggestion came after the Great Depression when banks were in the spotlight once before!
Full Reserve Banking
When many people I know think about banking, it’s full reserve banking that springs to mind. This system of banking is like having a big vault in which to put your money.
You put your money in and the bank locks it away and keeps it safe. Whenever you need it, you go into the bank and withdraw it. You never have to worry about not being able to get at it when you need it because the bank doesn’t lend it out.
Now, by putting your money into the bank, you take it out of general circulation. So, the money in general circulation drops, and the bank’s demand deposits increase, leaving the money supply completely unchanged. Under this system, the bank can’t take any risks with your money.
So, there’s no reason for the bank to run out of your money. This means if lots of people decide to take their money out at once, known as a run on the bank, you still don’t have to worry about your money not being there for you.
Making the bank hold 100% reserves, would prevent a run on the bank. It also stops the bank from making those loans, those fake warehouse receipts. And it stops bankers from making risky investments with other peoples money and selling them as low risk. (Remember the sub-prime mortgages scandal…?)
It also stops us from getting our small business loans, our mortgages, or buying other assets like real estate or stocks because these investments are some of the risky transactions the bank engages in!
Fractional reserve banking is the very system that takes on the risk involved in financing new investment, whatever that investment may be. It’s what keeps our economy moving.
Fractional reserve banking
Our fractional reserve banking system relies on people not all taking their money out at the same time. It’s a constant juggle between managing withdrawals and cash deposits.
Once a deposit has been made into a bank account, rather than the money just sitting there doing nothing, it’s put to work helping to find homes, businesses, and funding any other expenditure (such as bankers ‘searching for yield’ with risky ventures).
For example, if you put £100 into your bank account, the bank may lend out £50 as part of someone’s small business loan and put it into their bank account. However, the bank still owes you £100.
So, the borrower has £50 and you’re owed £100 by the bank. A grand total of £150. But, only £100 is real cash because the bank has created £50 commercially!
Under fractional reserve banking, only a fraction of the bank’s deposits, or reserves, are backed by cash and available for withdrawal at any one time.
Or, paraphrasing Rothbard, the bank issues warehouse receipts and they circulate as the equivalent to the cash they supposedly represent. So, with this in mind, fractional reserve banking looks like a Ponzi scheme.
So, what happens when people do want to take their money out of the bank at at the same time?
The downsides – a bank run
It’s completely possible that a bank may not have the cash reserves to pay everyone back and it results in a run on the bank.
Remember that scene from the film Mary Poppins when Michael demands his money back from the bank, he doesn’t get it, and the bank closes for the day as chaos reigns?!
Well… that’s similar to what happened in the 2008 Financial Crash, only the crash was on a much larger scale.
During the crisis, banks’ reserves were not enough to absorb losses on some of the speculative ‘investments’ being taken. This made a bank run more likely as people and institutions wanted their money back, just in case of a bank run!
But the banks couldn’t pay it all because they couldn’t get their hands on the cash quickly enough, it’s called a liquidity crisis.
And again, this is what Rothbard means by “fake warehouse receipts”.
The banks, operating as ‘money warehouses’ create loan money not backed by real cash deposits.
If this happened to your business, you’d go bust and the creditors would come calling.
But with banks, the Central Bank (the Bank of England or the Federal Reserve in the US) acts as a lender of last resort and bails them out when told to by the Government. To do this, it allows the creation of money and the printing of cash.
However, the Central Bank bailing out badly-managed banks is seen as unfair by many people – a moral hazard. The banks take the risks and the taxpayer provides them with cash when they lose.
Do banks just print money?
However, it’s not only the Central Bank that prints money.
Private banks do too when they create those loans. Some economists disagree with this because loans have to be repaid at some point. But, this assumes that they are, and that’s not always the case.
Can you imagine being in charge of a bank during the financial crisis?
On the one hand, you have to reduce your debt because you’ve lent out too much, but on the other hand, more money is needed as people and institutions withdraw their funds.
And, to provide this money, you have to create it by increasing your debt. The creation of money and the creation of debt are linked!
I think this highlights an interesting point: banks create money but they don’t create wealth.
And this is a really important concept because if you take out a loan, you have more money. You have more cash available to exchange for whatever goods or services you need.
You still owe this money to the bank. You’re not richer for it. And you need to pay the bank for letting you borrow it. So in many ways, you’re actually poorer as you now owe more money than you did.
But, if you use this money to invest to make even more money, you create your own wealth – the difference between what you’ve borrowed and what you gain.
Money has no intrinsic value of its own. It’s purely a way for an exchange to happen. Moreover, banks creating money merely speed up this process.
This in itself is fine. And ‘printing money’ by itself does not necessarily make a Ponzi scheme.
It could be that as the risk of not being paid back increases, at some point, the process becomes a Ponzi scheme. If the bank makes a loan and is fairly confident it will get its money back, plus interest, surely it’s a no-brainer it should make the loan?
But, when the risk of not being paid back increases, the bank demands higher returns – more money – to make that loan. And this is when problems begin to occur.
The financial instability hypothesis
The economist Hyman Minsky had a theory about this. He called it the financial instability hypothesis.
Minsky argued that lending goes through three stages – Hedge, Speculative and Ponzi.
Right after a crash, such as that in 2008, banks are really careful to whom or to what they lend. They make sure as best they can that a borrower can repay both the loan itself, known as ‘the principal’, and the interest due on it.
However, as the good times roll, banks become more confident and they may start to make loans where a borrower can only afford to pay back the interest. The bank speculates it’s likely that whatever the borrower has bought with the loan will go up in value, and the borrower will be able to pay back the principal. Eventually, we get to the point where banks loan to people or companies who can’t afford to even pay the bank back the interest, let alone the principal.
The bank is betting that what’s been bought with the loan will go up in value. This is Minsky’s Ponzi finance.
And it’s a great description of what happened in the financial crisis of 2008/9. The crash was a ‘Minsky moment’. Asset prices dropped, people and institutions couldn’t pay back their debts, and the whole house of cards came tumbling down.
By the way, Hyman Minsky died in 1996. His theory was based on his own observations of The Great Depression; and those observations were noted again by other economists in 2008.
I think the evidence that fractional reserve banking is a Ponzi scheme is quite strong. It must be because an economist predicted it!
And it appears many other economists agree because since the crash, regulators have tightened banking rules.
How banking’s improved since the 2008 Crash
Central banks and regulators have done a few things to try and make our fractional reserve banking system less risky.
- Told banks to increase the amount of their reserves, or drop the amount they loan out. Unfortunately, this also means people and businesses having to repay their debts more quickly than planned because banks have tightened up their lending criteria. This means personal loans or mortgages are harder to get, especially if you don’t have property to borrow against. And, the money supply slows down;
- Told banks to keep ‘more liquid’ assets on hand. This means banks need to hold enough cash, or assets that can be easily converted to cash, to see them through the difficult times;
- Directed banks balance short-term and long-term funding better than they did. Short-term funding can stop fairly quickly in a difficult patch, so banks are now less dependent on it than they were. This helps them ‘stay afloat’ and keep banking;
- Changed the regulator. In the UK, the banks were supervised by the Financial Services Authority (FSA). But, the FSA had too much to do and couldn’t do it all. So, after the crisis, it was split into two separate authorities;
- Told senior bank managers to sit a qualification, the Senior Managers and Certification Regime (CM&CR). Believe it or not, there were no qualifications to run a bank, which was why very few bankers could be held responsible for the problems. This is now changed; and
- Banks are now allowed to fail. Don’t shout! It’s a good thing this time because our deposits are now ‘ring-fenced’ meaning they’re protected from the failure. If a bank does fail, our deposits, savings, and payments will continue as usual. This is why we’ve all had lots of bumpf from the banks over the last couple of years telling us they’re changing the way banking works.
In theory, all these changes, and there are more, should help to reduce some of the risk in banking. It’s supposed to prevent the system from moving from hedging through to Ponzi finance, and stop another house of cards collapsing.
But Financial Times journalist, Martin Wolf, thinks we could go further.
How to improve the system even more
Wolf’s idea is to separate the retail banks that store peoples’ deposits, from the investment banks that make loans. This effectively makes safe banks and risky banks. Any bank loans from risky banks would be financed by people or institutions wanting to do so (equity) or by long-term debt.
This means the more risky banks wouldn’t be able to create money, breaking the link between creating money and creating credit. So, banks would lend money but they couldn’t make it. The downside of course is that it could mean the banking system would slow down because we couldn’t get ourselves into as much debt to fund investment as quickly. But less debt is probably no bad thing.
But Martin Wolf goes further than this. He’d also stop banks from printing money, leaving it to the Central Bank only. This effectively ends the fractional reserve banking system. That such a renowned economics journalist would propose such a thing, is pretty damning I think.
In conclusion, is fractional reserve banking one big Ponzi scheme?
Ponzi schemes are fraudulent investing scams where high returns are promised to investors for little risk. They usually end when the money stops.
I think this is a fairly good description of the riskier decisions involved in fractional reserve banking. So, I’m in agreement with Minsky here, although by definition, if something is legal it can’t be fraudulent.
So, is it technically a Ponzi scheme? Probably not. But Rothbard’s description of fake warehouse receipts is pretty spot on. And Mervyn King is right when he says that banks make loans they can’t pay.
However, fractional reserve banking also provides the means for investment that keeps our world turning.
But the risks still need to be better managed.
Is fractional reserve banking one big Ponzi scheme? What do you think? Let me know below.