Fractional Reserve Banking: History & Risks

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The monetary system underlying economies in the West, and throughout much of the rest of the world as well, relies on what is known as fractional reserve banking. Understanding how this system works, its effects and tendencies, is important not only from an academic but also an investing perspective. This is because fractional reserve banking systems behave in ways that are marked by certain patterns that, while not necessarily easy to predict in the short run, can definitely be distinguished in the longer term.

What are these tendencies? One of the most marked effects of these systems is the occurrence of boom/bust economic cycles driven by rapid expansion of financial activity in various investment securities (otherwise known as a boom), and the subsequent rapid deflation of the value of these securities (otherwise known as a bust). Certainly, cyclical business cycles could be expected to occur even in the absence of fractional reserve banking, but this system, by its very nature, has the effect of expanding the scope of such cycles, both on the upside and downside. We’ll explore why this is so further down – for now, we turn to a brief description of how fractional reserve banking started and began to spread.

Beginnings Of Fractional Reserve Banking

The fractional reserve banking system originated from the practices of medieval goldsmiths, who used their facilities for safeguarding the gold coins and other items they produced to offer what might be called primitive banking services. Some of their customers, perhaps wary of keeping large amounts of precious metals at their homes, were willing to pay the goldsmith a fee to store their precious metals securely. Provision of this service ultimately led to the development of the earliest form of banking – a goldsmith’s, and later banker’s, letter assuring that a customer had a certain amount of gold or gold coins on deposit. It was much easier, and safer, to travel with such an assurance than to carry the actual precious metal.

This is only part of the story, of course, as goldsmiths/bankers early on realized that, as a general rule, their customers, considered as a whole, only demanded access to a certain portion of their holdings at any one time. This presented an opportunity for further profit, as an enterprising goldsmith/banker could with confidence lend out a portion of the gold held on deposit at interest. As long as the portion lent in such a manner was relatively small, the chances that the banker would be caught short were minimal.

Human nature being what it is, it should come as no surprise that not all early bankers were able to restrain themselves from lending an aggressive portion of the customer gold they held. If an economic downturn or panic then ensued, a banker taking this approach could be caught short, resulting in bankruptcy or worse for the banker and, if occurring on a large enough scale, exacerbating the downturn or panic, just as it could help turn an expansion into a mania on the upside.

The key to understanding this effect is the concept of leverage. Fractional reserve lending allows for the creation of markers, or tokens, of value in excess of actual stored value. This enables the prices of these tokens and the things purchased with them to rise to much higher levels than would be the case in a 100 percent reserve system. On the downside, the fact that too many tokens are chasing too little stored value leads to panic that can result in crashes, as individuals desperately seek to convert their tokens of value into actual stores of value such as precious metals or real estate.

Fractional Reserve Banking and Fiat Currency

It should be noted that, whatever its flaws, fractional reserve banking is held in check, to one degree or another, by a gold or silver monetary standard. If tokens of value such as currency notes or banker’s assurances can be converted into a store of value such as gold or silver, whenever the price of these tokens or assets purchased with them rises to a level that greatly exceeds their value, an increasing number of market participants are likely to sell the tokens or assets and convert the proceeds into items they believe will maintain their value like precious metals.

As modern monetary systems cut the link between currency and precious metals by renouncing convertibility between the two mediums, as Franklin Roosevelt (FDR) did to the link between the dollar and gold for individuals in the 1930s and Nixon did in 1971 for countries, the tendency of the fractional reserve system to foment booms and busts became even more pronounced. Now, when individuals sell assets they perceive to be overvalued, their penchant to flee to the safety of cash can be counterbalanced by the ability of governments to expand the creation of currency or cash with essentially no limit other than what the market will bear. In extreme cases such as the German hyperinflation of the 1920s and the Zimbabwean inflation of recent years, the level of currency creation involved rose to almost unimaginable levels. In such situations, investors face danger both from overpriced assets and the threat of currency debasement.

Investor Takeaways

As an investor, understanding the most notable features of our monetary system is essential to making informed decisions. The key takeaway from this discussion of fractional reserve banking from an investor’s perspective is that, when such a system is employed, it can lead to marked divergences between price and value, both to the upside and downside. This is especially the case when it is combined with fiat currency, which can add impetus to the price inflation stemming from fractional reserve banking by the process of currency debasement, much like fanning the flames helps a fire to spread.

With modern monetary systems having severed the link between precious metals and currency, the traditional boom/bust cycle of fractional reserve banking systems is altered in form, if not in substance, from the days of the gold standard. In fiat currency systems, the mania phase can still propel asset prices to what appear to be, from a value perspective, outrageous heights – however, in the panic, or bust, phase in some cases governments may choose to print tremendous amounts of currency to help support asset prices and stave off the bust, giving the illusion of erasing the effects of the crisis. This happened in the wake of the 2007/2008 financial crisis. In reality, this approach only debases the value of the currency as a whole, thereby disguising the decline in value caused by the crash by shifting the losses from asset owners to the users of the currency as a whole.