When UKIP MP Douglas Carswell brought up fractional reserve banking on Question Time last Thursday, David Dimbleby appeared quite perplexed, although some in the crowd and on the panel seemed to understand and agree with Douglas’s point. So what is fractional reserve banking? And why should anyone be concerned about it?

Put simply: fractional reserve banking is the practice whereby banks only hold a fraction of the money they are liable for i.e. the money the bank’s customers have deposited in their accounts. When Mary, for example, deposits £1000 in her account, the bank will not simply keep the £1000 locked up in a vault for when she needs it; instead, the bank will only keep a small percentage (say 5%), and then lend out the other £950 to other customers. This practice is near universal; the vast majority of banks around the world hold fractional reserves. Despite what its name suggests, a bank should not be thought of simply as a money storage facility. A bank is a business which makes money by granting loans at interest. Those who deposit money in the bank are in fact investing in a lending business; the interest you earn on your account can be thought of as the return on your investment.

Perhaps the most controversial aspect of fractional reserve banking is that it allows the creation of new money out of thin air. For example: imagine Mary deposits her £1000 at the bank, and the bank keeps £50 whilst lending £950 to Bob. (The whole issue of interest will be ignored here for the sake of simplicity). Now imagine that Bob deposits his newly acquired £950 at the same bank. The bank keeps 5% in reserve (£47.50), whilst lending the other £902.50 to Tim. We started with only £1000 (deposited by Mary) and yet the bank has somehow managed to lend out £1825.50 (£950 to Bob + £902.50 to Tim). An extra £825.50 has been conjured out of thin air. Such is the magic of modern finance.

The Achilles heal of fractional reserve banking is the possibility of fear sparking off a “bank run”. Technically, a bank’s depositors are entitled to withdraw their money at any time they like (unless their account is a fixed ISA or something similar); in reality such is not possible, at least not for all depositors at the same point in time. If the bank is only holding a fraction of its deposits at any one point in time, then it can only reimburse a fraction of its depositors at any one point in time. If all the depositors came into the bank at the same time and asked for all their money back, the bank would not be able to pay them. When depositors lose confidence in the ability of a bank to reimburse them, they scramble to get as much of their money back as possible before it’s too late (remember the queues outside Northern Rock?). This sets off a chain reaction, with the loss of confidence spreading to the customers of other banks, until the whole financial sector is in crisis.

Over the years, governments have attempted to mitigate the risk of financial collapse in several ways: by forcing banks to keep their reserves at a certain level, by manipulating interest rates, by guaranteeing people’s deposits up to a certain amount, by establishing central banks to act as a “lender of last resort”, and (when all else fails) simply bailing out the banks when they go under. Whilst somewhat reassuring the public (and the bankers), these measures have also introduced a large degree of moral hazard into the banking sector. Banks are more likely to take risks when they know a bailout is guaranteed. Investors are more likely to take risks when they know their investment is guaranteed. When financial crises come, it will be the ordinary person who suffers, and the government’s friends who dodge the bullet—hence the vast public outrage that swept the world following the 2008 recession.

What is the solution? That depends on your worldview. Socialists might suggest doing away with money and banking altogether, or nationalising the banks, or creating some kind of mutual banking system as suggested by the French philosopher Proudhon. Many libertarians believe that fractional reserve banking should be classified as fraudulent, and that all banks should be forced to hold one hundred percent reserves. Others advocate a system called “free banking” where the banking system is entirely decentralised, the government does nothing to prop the banks up, and banks print their own private currencies which then compete against each-other in the marketplace; under such a system, it is argued, banks that inflated too much would see their own currency decrease in value in relation to those of other banks; customers would then have an incentive to invest in the other banks, and the inflationary bank would have an incentive to be less inflationary in order to win those customers back. All these proposals are quite radical, and unlikely to be accepted any time soon.

In his pamphlet ‘After Osbrown’, Douglas Carswell suggests some reforms that are more easily achievable: setting up a clear legal distinction between ‘lending accounts’ and ‘safekeeping accounts’, breaking up the large banks into smaller ones, making it easier for companies in other sectors to offer banking services, and running banks as partnerships in order to avoid disconnect between owners and management. These are all a good start, but they do not address the fundamental problem of moral hazard; bankers must be made to take responsibility for their own mistakes.

Monetary policy often takes a backseat to more immediate issues like the NHS, schools and welfare, since it seems so distant from ordinary life. In reality however, money affects everything. Financial crises devastate a country. Until serious banking reform is undertaken, such crises will happen again—and again—and again.

Print Friendly, PDF & Email