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Encyclopedia > Fractional reserve banking
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In economics, particularly in financial economics, fractional-reserve banking is the near-universal practice of banks of retaining only a fraction of their deposits and notes as reserves to satisfy demands for withdrawals, investing the remainder at interest to obtain income that can be used to pay interest to depositors and provide profits for the banks' owners. U.S. Economic Calendar Economics at the Open Directory Project Economics textbooks on Wikibooks The Economists Economics A-Z Institutions and organizations Bureau of Labor Statistics - from the American Labor Department Center for Economic and Policy Research (USA) National Bureau of Economic Research (USA) - Economics material from the organization... Financial economics is the branch of economics concerned with the workings of financial markets, such as the stock market, and the financing of companies. ... The essential function of a bank is to provide services related to the storing of deposits and the extending of credit. ...


The key financial ratio used to analyse fractional-reserve banks is the reserve ratio, which is the ratio of reserves to demand deposits and notes. Term deposits such as certificates of deposit are ignored when calculating this ratio because the bank only needs reserves to pay the term deposit at its maturity, and not during its term. The 'reserves' part of the reserve ratio, can be most narrowly defined as legal tender, i.e. assets that can be directly paid out as withdrawals, and do not have to be exchanged or sold. However, banks and financial analysts use other liquidity ratios and methods to measure and monitor liquidity in order to capture other cash outflows and sources of liquidity (such as early redemptions of term deposits, and lines of credit with other banks, respectively) A certificate of deposit or CD is, in the United States, a time deposit, a familiar financial product, commonly offered to consumers by banks, thrift institutions, and credit unions. ...


The 'reserve ratio' should not be confused with the 'capital ratio', which is the ratio of the bank's capital to its assets. The capital of a bank includes the net worth of the bank (assets less liabilities), and subordinated debt, which ranks behind the claims of general depositors and other unsecured creditors, and thereby provides similar protection from loss. The capital ratio is adjusted by risk-weighting the assets of the bank, and the result is called the risk-adjusted capital ratio.

Contents


Fractional-Reserve Banking and Central Banking

Central Banks are government owned and/or sponsored banks that issue notes and typically receive special priviliges in the form of exemption from restrictions or taxes on note issue, or whose notes are made legal tender by government fiat (hence the term fiat currency -- the notes are current (legal tender) by government fiat (artificial law). Legal tender or forced tender is payment that cannot be refused in settlement of a debt by virtue of law. ... Fiat money or fiat currency, usually paper money, is a type of currency whose only value is that a government made a fiat (i. ...


Central banks also 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 reserves of specie from within a country and from abroad into the central bank treasury, or stemming their outflow, is to offer higher interest rates on deposits (central banks take deposits as well as issue notes).


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 or specie (gold coin). This occurred before the adoption of irredeemable fiat money in most developed countries in 1971 with the collapse of the gold bullion exchange standard Bretton Woods Agreement, when the US Federal Government defaulted on its redemption obligations. 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. Mainstream economists do not generally make this analogy. Jump to: navigation, search This article is about libertarianism, a liberal individualist philosophy favoring private property (the most common meaning of the term today in most English-speaking countries). ... 1922 U.S. gold certificate The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold and currency issuers guarantee, under specified rules, to redeem notes in that amount of gold. ... Fiat money or fiat currency, is money such as paper money, that is current or legal tender as satisfaction for money debts by government fiat, that is by artificial law. ... Jump to: navigation, search 1971 is a common year starting on Friday (click for link to calendar). ... The Bretton Woods system of international economic management established the rules for commercial and financial relations among the major industrial states. ...


Historical background

At one time, people deposited their precious metal coins at goldsmiths, receiving in turn a note for their deposit. As these notes began to be used directly in trading, participants no longer needed to redeem their notes to perform the trade. Thus an early form of paper money was born. Main article deposit (bank) A deposit is a specific sum of money taken and held on account, by a bank as a service provided for its clients. ... A fruit stand at a market. ... A £20 Ulster Bank banknote. ...


As the notes were used directly for trade, the goldsmiths realized that people would never redeem all their notes at the same time. Thus goldsmiths saw the opportunity to issue new bank notes and lend them at interest—a process that altered their role from passive guardians of coin to interest-earning (and interest-paying) banks. Here fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to redeem their note, they would try to redeem the note. This was called a run on the bank and many early banks either went broke or refused to pay up.


The process with which commercial banks practise fractional-reserve banking is explained at deposit creation multiplier. The opposite of fractional reserve banking is full reserve banking, but this is not used in practice. There are several ways that a government, in coordination with the countries commercial banks, can increase or decrease the money supply of a country. ... Full-reserve banking is a theoretically conceivable banking practice in which all currency circulating in a financial system would be backed up by an asset that is generally considered to be a stable store of value, such as gold. ...


Criticism of Fractional-Reserve Banking

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 allegedly thereby, its exchange rate. Fractional reserve banking started with reserve of gold and silver, but still continues in current fiat-money based banking, where money is no longer backed by precious metals and therefore has no inherent value.


Risk

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 then would be liquidated and the creditors of the bank would suffer a loss if the proceeds from the bank's assets were insufficient. A Bank run is a panic response which occurs when a large number of people in a short time take their savings out of a bank, which they fear is financially unsound and about to collapse. ...


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.


Responses to the problem of financial risk described above include:

  1. Opponents of fractional reserve banking who insist that notes and demand deposits are 100% reserved, and
  2. 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) and
  3. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors and creditors would result in effective risk management.

Money Creation

When banks issue notes and accept demand deposits, the bank's liabilities can be used as a means of payment to buy goods and services, for example by tendering bank notes and by writing cheques on demand deposit accounts. Bank liabilities therefore act as a substitute to legal tender, and allows banks to create the inverse of their reserve ratio in legal tender substitutes. For example, if the bank's reserve ratio is 10%, it can create 10 times its reserves of legal tender in notes and demand deposits that are used as money, and for this reason the inverse of the reserve ratio is called the money multiplier. ...


Those who hold to the quantity theory of money 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 reducing the exchange rate and causing inflation. In fact quantity theorists often call the issue of bank-money 'inflation' and consider a falling exchange rate merely a symptom of inflation.


Others, however, hold that the exchange rate of money is governed by factors other than the quantity of money. An alternative to the quantity theory considers the notes and demand deposits to be holding and representing the value of the non-reserve assets as well as the reserve assets. For example, if a bank issues notes and holds 10% of the funds as reserves and 90% as commercial loans (disregarding bank assets supported by owner equity and term debt), then the value of the currency is unaffected, since when counting all the assets it supports, there is no deficiency. Another complimentary theory is that the monetary standard of legal tender creates an anchor on the value of money, independently from the quantity of money. For example under a gold coin standard, since all notes and demand deposits may be redeemed in gold coin, and gold coin has its own price relative to other goods and services, notes and demand deposits payable in gold coin cannot affect the exchange rate of gold coin, and therefore of notes and deposits payable in gold coin.


Quantity theorists, understandably are typically either hostile to fractional reserve banking, or supportive of minimum reserve ratios, and other government controls on the quantity of money created by commercial banks.


Pro Gold-Coin-Standard Criticisms of Fractional-Reserve Banking

Many critics of irredeemable fiat money see fractional-reserve banking as a threat to the gold coin standard, through fractional reserve banking leading to exhuastion of reserves, prompting governments to make the notes of government-favoured 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. Fiat money or fiat currency, is money such as paper money, that is current or legal tender as satisfaction for money debts by government fiat, that is by artificial law. ...


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.


For more criticism, see the fiat money, seignorage, and Austrian School of Economics pages. Fiat money or fiat currency, is money such as paper money, that is current or legal tender as satisfaction for money debts by government fiat, that is by artificial law. ... Seigniorage, also spelled seignorage, is the net revenue derived from the issuing of currency. ... Jump to: navigation, search The Austrian School is a school of economic thought that rejects opposing economists reliance on methods used in natural science for the study of human action, and instead bases its formalism of economics on relationships through logic or introspection called praxeology. ...


Government Controls on Fractional-Reserve Banking

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, along side of the mono-metallic gold standard versus the bi-metallic gold or silver standard debate.


Government controls on banking 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:

  1. Minimum reserve ratios
  2. Minimum capital ratios
  3. Government bond deposit requirements for note issue
  4. 100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
  5. Sanction on bank defaults and protection from creditors for many months or even years, and
  6. 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.

However critics of banking regulation argue that:

  1. Minimum reserve ratios put reserves beyond reach in a time of need
  2. 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
  3. Government bond deposit schemes distort government bond prices, bank portfolios and finance methods, and create inflexibility
  4. 100% marginal reserve requirements can be met even if the bank has no reserves
  5. Protecting insolvent banks from their creditors creates moral hazard, and increases the losses bad banks make, and is inequitable, and
  6. Central bank support and government protection of creditors creates moral hazard and socialises credit risk.

See also

In economics, bimetallism is a monetary standard in which the value of the monetary unit can be expressed either with a certain amount of gold or with a certain amount of silver: the ratio between the two metals is fixed by law. ... Wikipedia does not have an article with this exact name. ... Credit money is money that is backed by a promise to pay made by someone other than the state. ... Fiat money or fiat currency, is money such as paper money, that is current or legal tender as satisfaction for money debts by government fiat, that is by artificial law. ... 1922 U.S. gold certificate The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold and currency issuers guarantee, under specified rules, to redeem notes in that amount of gold. ... The Money Masters is a documentary on the history of banking and monetary policy. ...

Related topics

This aims to be a complete list of the articles on economics. ... Jump to: navigation, search What follows is a list of over 250 Wikipedia articles on finance topics. ... Jump to: navigation, search See business ethics, political economy and Philosophy of business for an overview. ...

References

  • 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.
  • John F. Kennedy vs The Federal Reserve
  • More John F. Kennedy vs The Federal Reserve

External links

Libertarian viewpoint

These links discuss "fractional-reserve banking" using Libertarian terminology, from a Libertarian point of view. They are cited here because as of 2003 Libertarians are a group that has been vocal in attacking the practice. This article deals with the libertarianism as defined in America and several other nations. ... 2003 is a common year starting on Wednesday of the Gregorian calendar, and also: The International Year of Freshwater The European Disability Year Events January events January 1 Luíz Inácio Lula Da Silva becomes the 37th President of Brazil. ...

  • Fractional-reserve banking Murray N. Rothbard uses the term "fractional-reserve banking" in reference to both commercial and central bank practices. He characterizes the customary modern-day practices with terms such as counterfeit, swindle, and "creating money out of thin air," and asserts that "the general public, not inducted into the mysteries of banking, still persists in thinking that their money remains 'in the bank.'"
  • The Libertarian Case Against Fractional-Reserve Banking is a critical analysis of Rothbard's views by Gene Callahan, who finds them unconvincing, and asserts that banking practices are compatible with Libertarianism, or could be made so with only minor alterations. He discusses at length (but inconclusively) the question of what depositors actually believe, which he sees as relevant to the charge that fractional-reserve banking is fraudulent or deceptive.

 
 

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