Fractional reserve banking

Fractional reserve banking. This term is loaded with quicksand, primarily and unfortunately due to the great Murray Rothbard, who famously deemed it fraudulent. Though this author is a big fan of Rothbard in general, he (and many others) object to this issue in particular. The truth is revealed if one looks at the banking system’s data, understands bank balance sheets, and reads the fine print in their bank deposit agreements. This issue, if it materially is one, has been litigated on throughout history, and always resulted in only one verdict—deposit claims ‘not fully backed’ by basic money are not fraudulent.

All of this is further explored on this site, but simply be aware, this topic unfortunately slides into frequent virtue-signaled debates not based on economic, accounting, nor legal fact.

Yet, it is not all disagreement when it comes to classical liberal principles and banking. Let’s actually first take an a priori look at what free market, liberty-minded market actors all agree on when it comes to banking and entrepreneurship (which is a great thing!):

Legal tender is a monopolistic privilege (in modern times granted to central banks), and it makes the banking system less competitive.
Bad money drives out good. The absence of choice in money drives out the presence of ‘good money,’ and keeps ‘bad money’ in circulation. This is known as Gresham’s law. It is extremely important to note here, this (often confused) definition simply requires the government to bless the bad money, by law.
Banking charters, or banking licenses, further reduce competition and quality by monopolistic decree, while simultaneously driving up costs and interest, of any market’s banking system.
Deposit insurance, funded by the government, further distorts the ‘safety’ of the banking sector. Insurance—the definition of which is protection against unforeseen catastrophes—simply cannot work if the system’s potential claimants are coerced into a non-homogenous group by a government-mandated insurance provider.
Central planning board. It is impossible for a centralized planning board to understand and productively plan any business; a free-market price system is simply required. This is the reason the Soviet Union failed, and it will be, sooner or later, why the Chinese Communist Party’s ‘hybrid’ system will fail. So why then, would one ever trust a centralized planning board in the banking market? How could a central banker on a small board meeting once or twice per month possibly understand the correct makeup of vault cash, reserves, deposits, bonds, and loans that ‘should’ exist in any individual city under its orbit, let alone an entire nation, or the world?
Business cycle. Central banking injects money into the economy by fiat; that is, by the above-mentioned planning board. This fiat (by decree) injection of money into the economy’s supply without underlying and corresponding demand from the market creates and exacerbates distortion in prices, profits, and expectations, and it leads to what is most commonly known as ‘the business cycle.’
Implicit bailout protection. Should be self-explanatory. It’s important to note that the worst banking crises in history are orchestrated by government lending institutions, with financial instruments guaranteed by the government. This was true with Palmstruch’s Stockholms Banco (which evolved into the Riksbank), Law’s Banque Royale, or even the Federal Reserve’s bailout of Fannie, Freddie, and Ginnie MBS debt owners—trillions of dollars of which still reside on the Fed’s balance sheet to this day. These crashes were all caused by unnecessary risk, all caused by the ‘implicit protection’ that government would save the day if catastrophe occurs. And that is precisely what always happens. Banks themselves certainly aren’t absolved from this either, because their charters and legal protection are all wrapped up in the same package as these aforementioned government lending institutions. No one on Main Street ever agrees or wants bailouts by the government, yet those on Wall Street typically get it.

As we can see, when it comes to banking, there is so much to agree on regarding principled, free market entrepreneurship. One need not wade into the quicksand that is involved in the loaded term ‘fractional reserve banking.’ The author always prompts the full reservist / objector to FRB with the question—when can we simply drop the mysterious ‘fractional reserve’ part and simply call it banking already?

It’s a theme of this research that ‘Bitcoin makes everything easy.’ So it is here. For though the author views it as unlikely, the author would wholeheartedly embrace a modern Bitcoin-banking system if it developed where all demand deposit claims (this is the x-factor for full reservists) are explicitly, unequivocally, and fully understood by all market actors to be ‘fully backed’ by bitcoin held by the custodians. In other words, a bailment. For this particular product to ever make economic sense in practice, of course, the depositor would simply have to pay a fee—in one way or another—for the big doors, fancy computers, security, and custodianship of the bitcoin held by its fiduciaries.

Yet, if this demand deposit market ever did evolve in this way, in a future Bitcoin-banking world, it would indeed be the first banking system in history to do so. As Bitcoin itself is a system of firsts in so many departments, one can never rule this out. The author admittedly views this as unlikely; and furthermore, quite moot, as anyone today can simply ‘fully reserve’ bitcoin on their own personal balance sheet extremely easy and with very little cost by controlling their own keys—something even less costly than opening up a bank account today. Indeed, opening up a bank account today is so layered with KYC, AML, and other cumbersome government regulations, that it makes the likelihood of such a bailment account product very small. But we should be clear—even if no banking regulations existed—the likelihood of such a bitcoin-based, fully-reserved demand deposit product seems small; there were many free banking periods throughout history, and this analogous product was not found.

Note that we haven’t even mentioned the Lightning Network; another, wonderful and truly unique payment innovation from Bitcoin. If this works at scale, it is an additional reason that such a fully-backed, custodial demand deposit account is not required for payments in the financial system.

Remember, the moment you deposit base money notes or coins into a bank, or base money bitcoin into a cryptocurrency exchange, you no longer own that basic money. Fact. If we look at this fact through the lens of Bitcoin-speak, this is undeniably clear and well understood by all: not your keys, not your coins.

Yet of course, at this moment you absolutely do own something, but it is a differently thing entirely: it is a claim. You now have fiduciary media, with the ability to write checks (LOL) or make payments online, both examples being carried out by your fiduciary, by your bank, on your behalf. And correspondingly, the bank now records this deposit / claim in your name as its liability, and they now own the basic money notes or bitcoin (yes, they own it!) and that is recorded as a matching asset on their balance sheet. The basic money (the coins, the notes, the gold, the bitcoins) simply cannot exist in two places at one time, no matter how much one might like to deem it or dream it so. The bank is now a debtor to you, and you are now a creditor to the bank. This is the relationship.

Again, the above IOU account description (historically called a ‘mutuum’) has nothing to do, not legally, not morally, not economically, with the type of account called a bailment. That is the stuff of safety deposit boxes. That is typically referred to as a ‘commodatum.’ For more on this, see the Basic Money, Claims & Bailments section.

If one somehow refuses to believe the above or considers it inherently fraudulent, simply ask yourself this question. A business (any business, be it a bank or otherwise), goes bankrupt. How do you (potentially) get your ‘funds’ back? The answer is simple—you need to file, as they say, a claim, as a creditor, and it works its way through the jurisdiction’s legal system. Though we spoke of implicit bailouts above, there is no ‘free market’ precedent here that you will receive back 100% of what you deposited (invested!). You may get your claim redeemed in full, or in part. Or, you may get nothing at all. Caveat emptor.

(Fractional reserve) banking: The process

Again, when you entered into this debtor / creditor relationship upon making a deposit into a bank (or cryptocurrency exchange), you have literally, economically, and legally swapped one asset, for another. You have exchanged basic money (banknotes / bitcoins) for a banker’s claim (checks / online banking), in the assets column of your own personal balance sheet. Ownership has changed. You had one type of asset, and now you have another type of asset.

Let’s walk through it, from the beginning. We are going to consider an example in the ‘free market;’ that is, let’s ignore any central bank intervention or central government oversight on the banking sector.

This is the Accounting Identity, a business-tracking process that was invented during the Renaissance. It’s a beautiful, beautiful thing:

\begin{aligned} Assets &= Liabilities + Equity \end{aligned}

All assets are always tabulated on the ‘left-hand side’ of the ledger. Always. You can think of the asset-side of the balance sheet as the typical, real-world stuff we need to run our daily lives and businesses.

Located on the ‘right-hand side’ of the ledger is everything which has to do with the ‘financing’ of your real-world assets. These are comprised of two key elements: first, liabilities or debt; and second, owners’ equity. Liabilities encompass any loans you draw to purchase something or invest into something.

The second item on the ‘right-hand side’ of the ledger is Equity. This is also sometimes called ‘Capital.’ It is not ‘money’ but more ‘wealth.’ If you invested your own, sweat-equity into a business, built a brand, and retained profitable value over the years, then that is ‘Capital.’ That is the business term for how you acquired, and worked toward compiling your assets.

Stated another way, and always, without fail, your liabilities plus your capital will equal your total assets. Note that we are saying nothing about how to calculate such things. The conservative, old-school way to do this would be to calculate all these things up using the lower of cost, or market value. This is not always true today, however.

Also note that the units themselves don’t matter, as long as you are consistent. We can tabulate a balance sheet using US dollars, UK pound sterling, Japanese yen, ounces of gold, bitcoins, or Granny Smith apples. But beware that monetary units, as always, follow Wittgenstein’s Ruler; you can only compare assets and liabilities to one monetary unit, and you must be consistent. Furthermore, that monetary unit will always change in the market, every day, relatieve to the value of a different monetary unit.

And speaking of daily changes, that is in fact how often a balance sheet does. Unlike the profit and loss statement, balance sheets are always snapshots; they are tabulated at a certain period in time.

Standard balance sheet: Bank perspective

Now since we’re focused on banking here, and not just general, operating businesses, let’s look at a bank balance sheet. Banks are unique in that they are in the business of making loans. So their balance sheet, on a normal day, looks somewhat different than ours, than the rest of the economy:

\begin{gather*} BaseMoney(A) + LoansIssued (A) \\ = \\ DepositsIssued(L) + RetainedProfits(E) \end{gather*}

Notice how with banks, their assets comprise loans that they issued, which would be liabilities to you and me. If we had a mortgage, for example, this is a liability on our own balance sheet, yet this is an asset for the bank. Banks are ‘due’ that money from their debtors. And in banking, on the opposite side of the ledger, the funds for those very loans issued consist of two things: first, deposits from customers; and second, capital from investors. So depositors (also people like you and me) who have put money into a bank–regardless if it is for ‘safe-keeping,’ or to ‘make payments,’ or for ‘convenience,’ are actually creditors to the bank. We are an integral part of banking. This is a factual matter. As written above, it has been litigated throughout history, without fail upholding this principle.

It means that when we make a deposit into our bank account, we have lent the bank our money, and the bank ‘owes us’ that money back. In the case of our deposit, we are the creditor, and the bank is the debtor. The timeline for when we get that money back is subject to the deposit agreement, and it typically looks like this:

Sight or demand deposit: We can collect, draw on, or make payments with our money whenever we want (banks typically do not pay interest on this type of account);
Savings deposit: We may have a few restrictions on how often and how much of our money we can withdraw per month (banks typically pay higher interest on this type of account);
Time deposit: We have definite timelines on when we can withdraw our money, such as after six or twelve months (banks typically pay higher interest on this type of account).

Personal balance sheet: Holding cash

Regardless of the type of the account, all of them are identical as far as banking and the balance sheet are concerned–economically, legally, morally, and accounting-wise.

Now, let’s keep moving. Let’s look back at your own personal balance sheet, and let’s analyze how it would look if you held bearer money, be it physical cash (banknotes or coins), ounces of gold, or digital bitcoins. This is how your own personal balance sheet would look:

\begin{gather*} BaseMoney(A) = Capital(E) \end{gather*}

This should make sense to you based on what we’ve discussed. You physically hold the basic money, and it is on your person (in your wallet, under your mattress, whatever). And on the other side of the ledger, we can use the financial term for what this basic money represents to you in the marketplace–it is your own personal capital.

Personal balance sheet: Having a bank account

Now let’s get the bank involved. For whatever reason, as mentioned, this could be for payment purposes, convenience, or safe-keeping, you have decided to deposit your basic money into the bank. You have legally, morally, economically, and from an accounting perspective swapped assets on your own personal balance sheet:

\begin{gather*} DepositClaim(A) = Capital(E) \end{gather*}

Notice how your capital has not changed. This causes great confusion for those that deem fractional reserve banking as some ‘fraudulent’ invention. Contrary to their view, you still have the same amount of capital, but your asset ownership has changed. You now have made a deposit into the bank. You now have a claim on the bank. You are now a creditor, to the bank. Simple as that. This is defined in your deposit agreement.

Transforming cash to loans: Bank perspective

Now, let’s imagine you just deposited one million dollars into the bank. The bank, as it is in the business of banking, will turn right around and lend that money out, in order to earn interest and profit (and pay you some interest as well, depending on your account type). This is how the bank balance sheet now looks, and we will only show the assets and liabilities portion, as owner’s equity remains unchanged for the bank at this point:

\begin{gather*} BaseMoney(A) + LoansIssued(A) \\ = \\ DepositsIssued(L) \end{gather*}

Notice, now, that the basic money belongs to the bank. This is key. It is not yours anymore! You own a claim (a deposit account), and the bank owns the basic money. In a free market, it would depend on a variety of factors for the bank to consider how much of this basic money to then loan out, and how much to keep in reserve (to satisfy other demand depositors, in particular). This is simply the business of banking. Nothing criminal or problematic about it. It is precisely because of this leverage, of this financialization, of these capital markets, that we can see growth in the economy (which we are about to illustrate).

So let’s say the bank decides to loan out 700 thousand dollars to someone on ‘Main Street.’ They decide to keep 300 thousand dollars in reserve, based on local market conditions. Remember, our scenario involves a free market, where decisions are being made based on local economics. The banks understand and cater to clients’ historical needs, they have actuarial tables considering how often a typical depositor draws on demand accounts, they consider what the market can ‘bear,’ as well as a variety of other localized factors. Perhaps in this particular situation they are also loaning this much because you have deposited the majority of your basic money in the form of a savings-type account, from which you will have some restrictions on withdrawing. Again, bear in mind our situation here is a hypothetical, free market: free from central bank or government oversight.

Main street balance sheet: Business with loan

Moving on. Now ‘Main Street’ comes into the picture. Let’s say one of the bank’s business clients is an auto parts factory, and they want to expand by investing into more efficient equipment. The catch-all accounting category for such an investment is ‘Property, plant, and equipment,’ or PPE. Let’s assume, conveniently, that this also costs one million dollars. They can afford about 30% of this new equipment themselves, and they need to finance 70%. And yes, I am keeping the percentages the same as the deposit-side, for simplicity.

So the auto parts factory and the bank do a deal, establish a loan contract, and the factory immediately takes the loaned funds, together with its own funds, and purchases the PPE. This is now its ‘Main Street-facing’ balance sheet:

\begin{gather*} Property,Plant,Equipment(A) \\ = \\ BankLoan(L) + Capital(E) \end{gather*}

And from this point, it’s just business. From the perspective of the bank and its issued loan, hopefully the auto parts factory will be timely with its bank payments, fulfill its covenants, and most importantly, develop into and continue to grow as a profitable business in its own right. Had the capital markets not existed, it would have been that much more difficult for the auto parts factory to take this step. The bank can be there as a good financial partner, but in the end it will be up to the factory to succeed, grow, and repay its loan over time. Note how the bank’s due diligence at the beginning of loan issuance was also crucially important—the bank needs to be rigorous in understanding how much of a track record does the business have, have they been responsible and successful in the past, and so on.

And looking over to the bank’s deposit-side, its withdrawal-ready liquidity is a question of proper treasury and cash management. Does it have enough reserves to fulfill the needs of creditors on a rolling basis? Is there a good relationship between time deposit accounts and demand deposit accounts? How is it doing with new clients? The law of large numbers is also at play here, because (unlike in our example with a perfect 1:1 ratio between a bank depositor and bank borrower) the relationship between a bank’s creditors and debtors will always ebb and flow according to the market. Banks need to be prepared for this, and historically in free banking systems they have been.

As for those cash withdrawals, there are observable, historical trends here. This seasonality has actually remained consistent from times of agricultural economies, even until today. There is typically a jump in the demand for cash around harvesting in the late spring and planting in the fall, as well as for a brief period around Christmas. Banks prepare for this.

There is nothing fraudulent or business-cycle inducing in the above example. It’s just how the capital markets work, and we can see how (typically, in a free market) savings will equal investment. We don’t even have to concern ourselves with hypothetical interest rates, profits, or tax scenarios. All of that stuff is short-term and details. From the ultimate perspective of the balance sheet, this is just how it is.

Enter the central bank

For those of us who long for a free market (no matter our views), this is where the stars align—in a bad way. This is where we can return to the 7-point list above that we all agree on. It’s impossible not to agree. This is where we can begin to see distortions in the economy. This is where you should take extra consideration, regarding the very crucial value of your savings and investments.

The central bank is a monopoly.

Therefore, its interactions in the free market cause things to be more expensive than they otherwise would be. With regard to our capital and money, it means that they fall in value relative to demand, ceteris paribus and had the central bank not existed.

If basic money is gold or silver, its supply will be born into an economy from mining and recycling; however, free market theory tells us that over the long run, real demand for this product would meet the new supply (otherwise miners wouldn’t do it). If new demand meets new supply, economically it must mean that prices don’t rise over the long run.

If basic money is bitcoin, even though there is a continuous issuance of coins until the 21 million limit is reached, we can actually say that Bitcoin is not inflationary, as everyone knows it will eventually be 21 million. Predictability is important here, and it’s different from gold or silver, or any asset in the world for that matter. Therefore, as population, productivity, and demand for money continues to increase over the long term, prices are expected to gradually fall—in terms of satoshis—as Bitcoin’s supply is fixed.

Creation of money: Central bank perspective

Fiat basic money (banknotes and coins) under central banking is different. As discussed here, it is typically inflationary and its supply arbitrary according to the monopolist.

Therefore, when we consider basic money, its supply, and any distortions in ‘banking,’ you need not look any further than the balance sheet of an economy’s central bank:

\begin{gather*} Gold(A) + GovernmentBonds(A) \\ = \\ BaseMoneyIssued(L) + RetainedProfits(E) \end{gather*}

This is the x-factor in the business cycle. In the free market, ‘Main Street’ examples above, the systemic quantity of basic money does not increase beyond the quantity demanded (at all). When a financial system is burdened with a central bank, however, the story changes.

The central bank has a monopoly over the tool we call currency, or basic cash. It means that they can and do issue more basic money, whenever they feel it is best. Different central banks have different ‘definitions’ for the why and the how of monetary policy (for employment, for stable prices, etc.), but we can see the real reason for such intervention, simply by looking at their balance sheet.

Central banks exist first and foremost for their government and its treasury. How do we know this? Because the government bond has become the perennial asset of the central bank in the modern fiat world. As central banks exist, and as they are monopolies, the prices of the assets they purchase (said government bonds) are higher than they otherwise would be. It means that if the central bank did not exist, government bonds would look less attractivein the free market. This is analogous to saying that the government couldn’t run as high a fiscal deficit under free market conditions. This is the x-factor. This is why the government bond has become the perennial asset of the central bank in the modern fiat world. The function of managing currency is a sideshow (with bad economic consequences) to the main event of buying government bonds. Need more currency? Print it up, sure; but you Mr. Central Banker must buy government bonds with it as you spend that money into the economy. That’s how it works. Show me a central bank balance sheet that does not look like this, and I will retract this summary. It is written very clearly on both sides of their balance sheet ledger. Look it up your central bank’s balance sheet, see what you find.

The second reason central banks exist, naturally, is for the banking system. They are known as the ‘lender of last resort’ for this reason. When banking problems arise due to too much basic money being created—a problem caused specifically by the central bank (and the sideshow result of the first reason for their existence)—the central bank is expected to step in and ‘stabilize,’ or bail out the banks. This happens continuously, in all societies dominated by a central bank.

In capitalistic societies, there aren’t too many other sectors which are afforded this privilege like the financial system. Depending on how socialist a society gets, you will see this privilege afforded more and more to the healthcare sector, educational sector, and so on. But the financial sector is always first.

It should be understood that a central bank exists firstly and always for its nation’s Treasury; but secondly, for its own banking system.

One more note on fractional reserve banking. Its presumably altruistic opposite, full reserve banking, has historically emerged not under free banking systems, yet under highly regulated, state banking systems, and yet this banking structure has always failed.

Bitcoin will do much for the clarity and functioning of banking (i.e. depositing and lending), and for the very nature of property rights. This clarity will grow faster in the absence of government regulation and censorship, and slower in the presence of such. 3 January 2009 was the start date, but there is no end date.

Fix the money, fix the world.