Is fractional reserve banking dangerous?

Critics say that our current system allows private banks to create money and this causes financial instability. Are they right? Matthew Partridge reports.

What is all the fuss about?

The current banking system (called fractional reserve banking) is based on the idea that people are very unlikely to demand all their deposits back at once.

One example of this in practice is someone depositing £100 in a bank. Assuming that the bank has a reserve ratio of 25% (though in reality it would be much lower), it lends out £75 to an industrial firm. This £75 is deposited in the firm's bank account. The bank then uses this £75 deposit to make a further loan of £56.25 and so on, until the bank has made loans of £300, backed by £100 worth of reserves.

But now there's a growing movement among policy makers and academics to abolish the ability of banks to lend money this way, because it is dangerous and amounts to printing money. The movement isn't supported solely by radical think tanks, such as the New Economics Foundation, but also by International Monetary Fund staff.

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What's the problem with the current system?

The fact that reserves are a fraction of total liabilities means that problems can arise when a large number of depositors suddenly ask for their money back and banks are unable to get their hands on enough cash to meet demand.

This is either because of a liquidity crisis (assets can't be converted into cash quickly enough), a solvency problem (assets aren't worth enough), or a combination of the two. If that happens banks face going out of business unless the central bank helps them with cash.

Banks in Britain and Europe have typical reserve ratios as low as 3%, so even a small loss of confidence can threaten their survival. While central bank intervention as 'lender of last resort' can solve the problem, it also creates moral hazard (because it shields banks from the consequences of unwise loans).

Are private banksprinting money?

A few economists still argue that loans have a neutral effect on the money supply, because they have to be repaid. However, most agree that because loans involve the creation of new bank deposits, banks are in effect printing money. This means that monetary policy is in private hands.

Martin Wolf points out in the FT that in the UK, money in bank accounts represents 97% of the money supply. Because the money supply is important in determining the level of demand in an economy, there's a danger that bank lending could end up accentuating the business cycle, pushing up demand in a boom and acting as a further drag in a depression.

In the last crisis, central bankers found themselves torn between trying to get banks to reduce their debt (to make them more stable) and lend more (to boost the money supply).

So what should we do?

Wolf thinks the best solution "would be to give the state a monopoly on money creation". He notes that the economist Irving Fisher came up with a proposal (called the Chicago Plan) in the 1930s that would have forced banks to back up all deposits with an equivalent amount in special government issued credits. This would have essentially banned fractional reserve banking.

Wolf envisages that banks' role would either be holding people's money (for which they would charge a fee) or running investment accounts. Under his system, money would only be created by the central bank "as needed to promote non-inflationary growth".

According to a 2013 paper by the IMF's Jaromir Benes and Michael Kumhof, this would improve financial stability (by eliminating the possibility of bank runs), stabilise the money supply and limit the growth of private debt.

The new money created could be used to pay down government debt (or increase public spending). Overall, they estimate that this plan could boost growth by 10%.

Can this be done?

The main problem is how to make the transition between the two systems. If abolishing fractional reserve banking would force banks to increase their reserves, or reduce the number of loans, this would lead to many businesses having to repay their debts. It would also shrink the money supply, risking deflation.

Wolf thinks that implementing these policies will take a long time and that the power of the big banks has grown since the crash. He thus calls for "raising capital requirements and ensuring maximum transparency of balance sheets".

Another idea is for the government or the Bank of England to limit the amount of money that banks can lend to certain sectors. This is starting to happen with stricter lending criteria imposed as part of the Mortgage Market Review. Japan's officials give "recommendations" on bank loans (with mixed results).

Has it always been this way?

The ratio of cash to total assets was 100% before the development of fractional banking. In the 1950s banks were holding around a third of their overall assets in liquid instruments (including cash and government bonds). The liquidity ratio was cut to 12.5% in 1971, then virtually abolished a decade later. By the time of the credit crunch in 2007 banks in both Britain and the United States were holding less than 1% of their assets in cash.

While economist Tim Congdon argues in his book Central Banking in a Free Society that this improves economic efficiency, others feel that it encourages reckless behaviour. Since the crash, there have been moves, on both a national and global level, to get financial institutions to build up their liquidity reserves.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri