In monetary economics the concept of banking is fundamental. There are different thoughts among economists as to how should be a banking system of a country. A popular concept in monetary economics is Fractional Reserve Banking (FRB), where banks are allowed to lend a share of a depositor’s money to a borrower. It might be difficult for a lender to find a borrower and banks in this system play the role of mediator between the saver and lender. The saver/depositor’s money in his bank account is lent to others.
It is generally evident that depositors do not typically withdraw all their money at once. They may withdraw a small portion for daily use, while the remaining funds remain idle. Fractional Reserve Banking (FRB) helps utilize this idle money, maintaining a higher velocity of money and contributing to economic growth
Moreover, when individuals borrow money, they typically deposit it into a bank account. Subsequently, a portion of this deposited money is lent to others by the bank, and those borrowers further deposit their borrowed funds. This process continues, with the bank effectively creating more money based on the initial deposit. This phenomenon is commonly referred to as the Money Multiplier. A simple equation to portray
M = mH
Where H is High Powered Money supplied by the central bank (also called M0), M is money created in the FRB system (also called M1), and m is the money multiplier. FRB is a well-known and accepted concept in economics and is fundamental in the mainstream too. But, there have been debates against this system too by a certain number of economists.
An alternative to Fractional Reserve Banking is 100% reserve banking (also called Full reserve banking) where the depositors’ money is only lent to others with their permission. Banks won’t concentrate on their role as mediators but would be there to keep depositors’ money secured. A depositor has his money secured and they can withdraw all the amount at once too. So, here the m value from the equation would be 1 meaning that there is no difference between M0 and M1 in this system. This system assures to avoid banks creating more money which is feared to cause inflation and artificially lower the interest rate in the economy.
The argument that would be highlighted here will be with respect to the free market capitalist system. This is because the two sides of debaters which are considered here both support the free market but have disagreement on this concept. Prominent Austrian economists like F.A. Hayek, Murray Rothbard, and Robert Murphy are against FRB because they believe this system can cause business cycles (derived from Austrian Business Cycle Theory by Hayek) and Rothbard also claimed this system to be a fraud that is supported by other scholars from Austrian School of Thought like Hans Herman Hoppe and Walter Block who say that this system breaks private property rights.
Many also believe that depositors aren’t aware of what is being done with their money and that the whole process of FRB happens behind their backs or they are not well informed about it. We will look into these issues next section onwards.
The arguments against FRB are rather allegations and they are strong ones too. But, it isn’t fair to call this system a fraud because a bank pays interest to its depositors, the interest rates means that the banks are borrowing money from the depositors and paying interest rate for it. It’s like person Y borrowing from X and then Y lends the same to Z at higher interest rates taking the difference of lending and borrowing interest rate as his revenue. Now, for some this might be right or not or immoral but for someone supporting free market capitalism and voluntary exchange, this shouldn’t at all be a problem. Y which is the bank here is taking the responsibility to pay the money that was borrowed. Banks take responsibility for depositor’s money and if they don’t then again in a free society people are free to take decisions and not deposit in such banks.
Apart from that when we talk about a capitalist society then everyone looks for their well-being and in that consumers are most fundamentally included too. The consumers are one to direct the market system and they will choose the option that benefits them more. FRB system will give depositors interest for just depositing their money but 100 percent reserve banking will charge them for depositing their money, in a free market and in a competitive environment which one will a person prefer? The one that provides them returns! This is seen in the case study of Britain where Scotland without a Central Bank had Free banking and FRB and there are other examples too on which the system was chosen by the market. Interestingly, 100 percent reserve banking has only prevailed by coercion of the government. So, monetary history and a simple understanding of the consumer role in the market don’t support the argument against FRB.
FRB is a source for banks to earn revenue and it isn’t just banks who benefit but those who deposit earn interest too while those who want to borrow can get money readily at a cheaper rate. On the other hand, in Full Reserve Banking, the money wouldn’t be lent to anyone else without the permission of the depositor but depositors won’t have any interest but rather would have to pay the bank for keeping their money safe. Banks in this case would only lend from their capital and hence to establish a bank there would be a need for huge capital. This not only affects the ease of borrowing but affects competition as the ease of doing business in the banking sector would be lesser. This shows the limitations that 100% reserve system carry for them to prevail in a competitive environment, the possibility of this system to survive in the free banking sector is only possible with government’s imposition.
When talking about FRB, Bank runs cannot be ignored. Bank runs are a situation when many clients start withdrawing their money from the bank and the bank is out of the money to give back depositor’s money. The reason why there are excessive withdrawals is because there is a fear of insolvency of the bank. This argument is a major one against FRB. It can’t be denied that a bank might fail and it can’t also be denied that uncertainty is an important chapter taught in microeconomics. One can’t mix the field of business studies (management, marketing, finance, etc..) with the science of economics. In a competitive market, it is bound that people will take risks and not all risk-takers will succeed and it is true that many firms will fail because of poor management. Falling of a firm because of poor management is rather a positive sign of the system.
Other than that, bank failures can also occur with central bank’s top-down approach and regulations in the banking sector. This leaves out a decentralized and individualist option where every firm will be accountable to themselves and have the liberty to run their firm the way they like. If the banking sector is regulated by central bank, then everything is happening according to the decisions made by them. Central bank’s wrong decisions may lead to the failing of not just one but many banks. Everykind of central authority faces a knowledge problem in collective decision making and decisions by the central authority can be driven by their self-interests too, the probability that central authority can make mistakes is quite higher than one expects. Due to this, a decentralized and liberal system like Free banking is more suitable.
But, whatever may be suitable, it might not be fair to blame the system over something when the historical/empirical evidence of cases like Scotland, Canada, etc… doesn’t show traces of it while having an FRB Free banking system.
In order to understand briefly about the consumer preference, the data was collected in India via Questionnaire with random sampling method. Before any objections, this data doesn’t claim to check the credibility of any theory based on public opinion but rather tends to understand the choice of consumers through objective and explicit facts. Many claim that people are unaware of what is happening with their money or in a free market competitive environment people will prefer full reserve banking which is more secure. To identify these the data would be useful.
The sample size crosses 100. The average age of the sample population is 43. 80% of the participants are male. The participants are from different parts of India but the majority are either from Delhi or Uttar Pradesh. Almost all the participants have bank accounts. 90% of the sample population prefer to keep their money in the bank.
The question was asked whether the people know about Fractional Reserve Banking. 56% said they weren’t aware of it but the other 44% know about FRB. This question was of less importance to our conclusion because not everyone is trained in economics to have a grasp on the concept and almost all who have bank accounts know well that they can’t withdraw all of their deposits at once and also know how the banks earn revenue. So, the reason behind many saying “No” to knowing about FRB was because they didn’t know the term but they seemingly know about its features. But, it is one fact about the survey that many participants are well aware about FRB.
The second question and which also carries utmost importance was where the participant will choose their preference. Around 85% preferred “Interest on deposits from banks to depositors” over “No interest on deposits but 100% availability of your money in a bank account”. This shows that the consumers will be preferring the former option where they would earn interest on deposits. This is only possible in the FRB system. Therefore, banks will adopt Fractional Reserve Banking because not only they will benefit from it but the depositors and borrowers would too. If a bank doesn’t adopt it then they will face a larger opportunity cost in the competitive market. The only limitation here was that it wasn’t mentioned that in the second option, the depositor would have to pay for banks to secure their money too, and that would have made the second option more unfavorable.
The last question asked whether the people have any issues with their banks using FRB. Around 50% choose the option “Can’t say” as many aren’t well aware of it while around 46% also voted “No” while the rest tiny portion voted “Yes”. This shows Indians with bank accounts don’t seem to have a problem with FRB (at least those who are well aware of the term). Indian bank account holders quite well understand that banks should lend their money to others rather than keep it idle, that’s how banks earn revenue.
The write-up only deals with the debate between Fractional Reserve or Full Reserve Banking system in a free market. It possesses both qualitative and quantitative analysis. There can be strong economic arguments against Fractional Reserve Banking but to stop it there would be a need for government coercion. The data speaks louder and clearer that people prefer Interest earnings rather than 100% deposits being at the bank. This is the reason why a full reserve system never existed in the history of free market capitalism.
It is undeniable that the majority might be wrong as they aren’t trained in economics and are common people. But, the questions asked weren’t related to technical side of the debate and even if they are wrong then they will prefer a bank that will pay them interest over the one that will keep 100% reserve, in a market system the consequences of making a mistake are faced by the player but in this case, the people who have bank account have been in the fractional reserve banking system which has prevailed in the country for a long time. Also, the RBI sets the reserve ratio maintaining banks to keep a certain amount of money as a reserve or for withdrawers. But, this is the limit below which nobody can go but there are no restrictions for anyone to adopt a 100% reserve system and no banks have yet come forward with such a project. Why? Because the people aren’t interested in it, business decisions are based on consumer preferences and they see a benefit in keeping the money in banks and earning interests rather than just keeping it for security.
The argument that people aren’t well aware of what’s happening with their money is false in India. FRB might have some disadvantages but it cannot be ignored what benefits it brings to the economic growth and probably due to this it is widely accepted in economics. Even if there is a problem then economists like F.A. Hayek supported government regulations in the banking sector (before he invented the concept of private currencies) which seems a realistic solution but it’s baffling how those who identify as anarchists can advocate for 100% reserve banking within a voluntary exchange-based banking system.