Fractional-reserve banking

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Fractional-reserve banking refers to a financial system where the bank uses a fraction of its deposits to finance borrowers.^[1]

Image:Fractional reserve lending at 20percent.gif

The expansion of $1,000 of actual money. $4,000 of virtual money is created through fractional reserve lending at a 20 percent rate.

[edit] History

At one time, people deposited gold coins and silver coins at goldsmiths for safe keeping, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.

As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.

[edit] Purpose

There are three main functions that fractional reserve banking provides:

A safe place for people to store their savings
An institution through which people can fund and receive loans
A system that regulates the expansion and contraction of the money supply. When a loan is supplied, new money is created. The newly created money is called bank money. As a loan is paid back, the bank money disappears from existence. A fractional reserve banking system usually regulates how many new loans can be created.

The United States Federal Reserve cites the purpose of fractional reserve banking as follows:

'The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. 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. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for 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.'^[2]

[edit] How a bank can lend more than it has

Reserves (silver, gold, and U.S. Bonds in past banking eras and U.S Bonds or Credit in the present banking era) are a special form of money which can be held by the commercial banks either in their vaults or on deposit at the central bank. They are generally described as a "high-powered" form of money and are needed to perform fractional reserve banking. When a bank is in possession of bank reserves this means that it is able to lend more currency to others than it has on deposit.^{[citation needed]}

If a bank has $100 in reserves, with a 20% reserve ratio, the bank would be able to make a maximum loan of $80. When the bank loans the $80, the asset side of the bank's balance sheet would show $36 in required reserves, $64 in excess reserves, and $80 in loans. The liability side would match the sum of $180 with $100 in initial deposit and $80 in new deposit. This demonstrates an increase of $80 in the money supply. If the process of deposit creation continues indefinitely, the banking system has the potential to create $400 of new lending capacity.

The balance sheet of the bank before its loaning activities will show:

Assets	Liabilities
Cash reserves $100	Deposit receipt $100

The bank is at the limit of the stipulated reserve ratio and we can see this by the following fraction:

<math>\frac{\text{Reserves}}{\text{Total Receipts}}=</math><math>\frac{100}{100+400} \, .</math>

For the bank to lend more money (while still staying within the reserve limits) it will need to wait until some of the loans have been paid back by the customers.

[edit] A bank can lend the money immediately

From The Federal Reserve Bank of New York (Reserve Requirements and Money Creation):

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).

Again this process shows that the reserve portions approaches a limit of Zero while the issued bank created credit dollars approaches a limit of $900 dollars. Thus begetting a sum total of credit dollars approaching $1,000 dollars.

The overarching principal of fractional reserve banking rests on the collective agreement within the banking community that it is impossible to distinguish between currency issued by different banks under the umbrella of Federal Reserve Note System. Therefore all Credit-Money issued in this way is generally fungible which means that the any bank is unable to determine if new money taken in on deposit has come from any other bank including its own bank branches or even the same branch. It is for this reason that there is nothing to prevent the customer from depositing the $90 immediately back into the same bank or any bank and the next borrow to borrow $81 and so on until we approach the $900 dollar limit.^{[citation needed]}

In reality it is not necessary for the group of customers to go through all of these steps and they can borrow the full amount (up to $900) immediately. In this instance the $100 of seed currency whether it be a silver certificate as in past banking eras or $100 of bank created credit in the present banking era, does immediately become $100 dollars of reserve currency and must be held in Vault ATM or Till Cash at the bank (or) Vault Cash/Electronic Book Entry/and or in U.S. Treasuries all held on account with that banks local Federal Reserve Bank.^{[citation needed]}

[edit] Avoiding Confusion with Capital Ratio etc.

It is important not to confuse a bank's reserve ratio with its capital ratio, or other financial ratios. It is also important to note that the term 'reserves' in the reserve ratio generally does not include all liquid assets.^{[citation needed]}

[edit] Liquidity Management For a Fractional Reserve Bank

To avoid defaulting on its obligations, the bank must maintain a reserve ratio greater than zero. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target by:

Selling or redeeming other assets,
Restricting investment in new loans,
Borrowing funds (whether repayable on demand or at a fixed maturity), or
issuing additional capital.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

Demand deposits with other banks
High quality marketable debt securities
Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2-3 months' etc. These residual contractual maturities may be adjusted to to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.

[edit] Real Example of a Fractional Reserve Bank Balance Sheet and Financial Ratios

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:

Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007^{[citation needed]}
Assets	NZ$m	Liabilities	NZ$m
Cash	201	Demand Deposits	25482
Balance with Central Bank	2809	Term Deposits and other borrowings	35231
Other Liquid Assets	1797	Due to Other Financial Institutions	3170
Due from other Financial Institutions	3563	Derivative financial instruments	4924
Trading Securities	1887	Payables and other liabilities	1351
Derivative financial instruments	4771	Provisions	165
Available for sale assets	48	Bonds and Notes	14607
Net loans and advances	87878	Related Party Funding	2775
Shares in controlled entities	206	[subordinated] Loan Capital	2062
Current Tax Assets	112	Total Liabilities	99084
Other assets	1045	Share Capital	5943
Deferred Tax Assets	11	[revaluation] Reserves	83
Premises and Equipment	232	Retained profits	2667
Goodwill and other intangibles	3297	Total Equity	8703
Total Assets	107787	Total Liabilities plus Net Worth	107787

In this example the (legal tender) cash held by the bank is $201m and the demand liabilities of the bank are $25482m, for a (legal tender) cash reserve ratio of 0.79%.

[edit] Other Financial ratios

The key financial ratio used to analyse fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits and notes. However, other important financial ratios are also used to analyse the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

The (legal tender) cash reserve ratio is $201m/$25482m, i.e. 0.79%.
The central bank notes/balances reserve ratio is $3010m/$25482m, i.e. 11.81%.
The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
The equity capital ratio is $8703m/107787m, i.e. 8.07%.
The tangible equity ratio is ($8703m-$3227m)/10787m, i.e. 5.08%
The total capital ratio is ($8703m+$2062m)/$10787m, i.e. 9.98%.

Clearly, then, it is very important how the term 'reserves' is defined for calculating the reserve ratio, and different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

[edit] How the Example Bank Manages its Liquidity

The ANZ National Bank Limited explains its methods as:^{[citation needed]}

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.

The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.

Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007^{[citation needed]}
	Total carrying value	Less than 3 months	3-12 months	1-5 years	Beyond 5 years	No Specified Maturity
Assets
Liquid Assets	4807	4807
Due from other financial institutions	3563	2650	440	187	286
Derivative Financial Instruments	4711					4711
Assets available for sale	48	33	1	13		1
Net loans and advances	87878	9276	9906	24142	44905
Other Assets	4903	970	179			3754
Total Assets	107787	18394	10922	25013	45343	8115
Liabilities
Due to other financial institutions	3170	2356	405	32	377
Deposits and other borrowings	70030	53059	14726	2245
Derivative financial instruments	4932					4932
Other liabilities	1516	1315	96	32	60	13
Bonds and notes	14607	672	4341	9594
Related party funding	2275	2275
Loan capital	2062		100	1653	309
Total liabilities	99084	60177	19668	13556	746	4937
Net liquidity gap	8703	(41783)	(8746)	11457	44597	3178
Net liquidity gap - cumulative	8703	(41783)	(50529)	(39072)	5525	8703

[edit] Convertibility

Typically, privately-issued checking account dollars are convertible into paper dollars on demand. But paper dollars issued by the central bank are no longer convertible into silver (or gold, as the case may be). The Federal Reserve Note is thus physically inconvertible, although it remains financially convertible, in the sense that the central bank stands ready to use its bonds to buy paper dollars issued by the commercial banking system. For example, during the Christmas shopping season, when the demand for cash is high, the Federal Reserve will normally swap about 10 billion paper dollars for $10 billion in bonds from the commercial banking system.^{[citation needed]} After the shopping season ends, the Federal Reserve will swap $10 billion in bonds for 10 billion paper dollars from the commercial banking system, thus soaking up the now superfluous paper dollars.

[edit] Increased money supply and inflation

Main articles: Money supply and Inflation

Since fractional reserve banking involves the issue of money, the link to inflation has been the subject of debates. According to the quantity theory of money, the expansion of the money supply leads to "more money chasing the same amount of goods" and thus to inflation. Some monetarists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as a cause of inflation. In fact quantity theorists often call the issue of bank-money 'inflation' and consider a falling exchange rate merely a symptom of inflation.^{[citation needed]} Most schools of economics recognize the link between money supply and inflation; many economists, however, consider the issue of money through the banking system as a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Quantity theorists may either be hostile to fractional reserve banking or supportive of minimum reserve ratios and other government controls on the quantity of money created by commercial banks. The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.

[edit] Government regulation

Banking has been subject to generally a greater extent of government regulation and controls than other forms of business, and banking law has in many countries been the subject of extensive political debate.^{[citation needed]}

Government controls and bank regulations related to fractional-reserve banking have generally been to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

Minimum required reserve ratios (RRRs)
Minimum capital ratios
Government bond deposit requirements for note issue
100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
Sanction on bank defaults and protection from creditors for many months or even years, and
Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counter-act bank runs and to protect bank creditors.

[edit] Influence of central banks

Central banks operate as fractional-reserve banks, and the reserve ratio policies of the central bank influence specie flows and credit conditions, making the control of fractional-reserve banking a political issue, with financial and economic impacts. Also involved with reserve ratios is the interest rate, because the primary method of attracting cash reserves from within a country and from abroad into the central bank, or stemming their outflow, is to offer higher interest rates on deposits (central banks take deposits as well as issue banknotes).^{[citation needed]}

Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking in reference to fractional-reserve banking by central banks in particular, where the nation's central bank holds fractional reserves of gold bullion, specie (gold coin) or other reserves (such as foreign currency).^{[citation needed]} This occurred before the adoption of irredeemable fiat money in most developed countries in 1971 with the collapse of the Bretton Woods system, when the US government defaulted on its gold payment obligations under the agreement. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partly-reserved currencies as a form of fractional-reserve banking may create more confusion than it alleviates.^{[citation needed]} Mainstream economists do not generally make this analogy.

[edit] Criticisms

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Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the financial risk note holders and depositors bear, and the impact bank notes and demand deposits have on the stock of money, and potentially its value (that is, the effect on inflation and the exchange rate). The proposed alternative to fractional reserve banking is full-reserve banking.

[edit] Business Cycle

Main articles: Austrian School and Business_cycle#Austrian_School

Fractional Reserve Banking allows an increase in the supply of currency available to make loans to purchase investment capital, without increasing the quantity of investment capital or real savings. The quantity of loans will be higher than the actual supply of saved resources available for investment. Investors will assume that the quantity of loans available represents real savings. This misinformation leads investors to misallocate capital, borrowing and investing too much in long-term projects for which there is insufficient demand and real savings. As investors spend borrowed currency, segments of the economy will boom. Later investors will find the prices of their outputs falling and their costs rising, leading to the failure of new projects and a bust.

[edit] Risk

Main article: Full-reserve banking

Fractional-reserve banking allows for the possibility of a bank run in which the demand depositors and note holders collectively attempt to withdraw more money than the bank has in reserves, causing the bank to default. The bank would then be liquidated and the creditors of the bank would suffer a loss if the proceeds from the bank's assets were insufficient to pay its liabilities. Since liquidation may require selling assets quickly, and potentially in large enough quantities to affect the price of those assets, an otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Responses to the problem of financial risk described above include:

Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved;
Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used.

[edit] Incompatible with a gold standard

Main articles: Gold standard, Seigniorage, and Austrian School

Many critics of irredeemable fiat currency see fractional-reserve banking as incompatible with a return of the gold standard, despite the fact that most countries that used a gold standard in the twentieth century had commercial fractional reserve banking. These critics claim that fractional-reserve banking leading to exhaustion of reserves, prompting governments to make the notes of government-favored banks legal tender, even though the issuer is in default. If such defaulted bank notes are made legal tender by government fiat, as they trade at a discount to their face value in terms of gold coin, will be a cheaper way to discharge debts, driving out gold coin. In countries where commercial banks do not issue bank notes, this issue does not exist.

However, other critics of irredeemable fiat currency, from the free banking school, support fractional-reserve banking, and view the threat to the gold standard as originating from central banking and government controls on the formation and winding-up of banks and the business of banking.

[edit] Inadequate government regulation

Critics of current bank regulations argue that:

Minimum reserve ratios put reserves beyond reach in a time of need
Minimum capital ratios are poor regulators of financial risk, as they ignore other portfolio risk drivers such as scale and diversification and come at a heavy compliance cost
Government bond deposit schemes distort government bond prices, bank portfolios and finance methods, and create inflexibility
100% marginal reserve requirements can be met even if the bank has no reserves
Protecting insolvent banks from their creditors creates moral hazard, and increases the losses bad banks make, and is inequitable, and
Central bank support and government protection of creditors creates moral hazard and socializes credit risk.

[edit] See also

[edit] References

^ Freixas, Xavier; Jean-Charles Rochet (1997). Microeconomics of Banking. MIT Press, 20. ISBN 0262061937. Retrieved on 2008-1-3.
^ Page 57 of 'The FED today', a publication released by the united states federal reserve education website designed to educate people on the history and purpose of the united states federal reserve system. http://www.federalreserveeducation.org/fed101/fedtoday/FedTodayAll.pdf

Huerta de Soto, J. (2006), Money, Bank Credit and Economic Cycles, Ludwig von Mises Institute
Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191-202.
Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965-970.
Parliament of Tasmania, Monetary System, Report of Select Committee, With Minutes of Proceedings, 1935.
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