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posted on 20 January 2019

The Myth Of Fractional Reserve Banking

by Steve Keen, Steve Keen's Debtwatch

What is fractional reserve lending?

It is a textbook myth. Non-mainstream economists have been trying to debunk it for over 50 years, without success, until the Global Financial Crisis in 2008 led Central Banks to think much more seriously than they had about the nature of banking.

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Several have now come out and stated that this model is false. FromMoney creation in the modern economy" Bank of England Quarterly Bulletin 2014 Q1:

Money creation in practice differs from some popular misconceptions - banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.

Instead, as the Bundesbank put it inHow money is created", 25.04.2017:

banks can create book money just by making an accounting entry: according to the Bundesbank's economists, "this refutes a popular misconception that banks act simply as intermediaries at the time of lending - ie that banks can only grant credit using funds placed with them previously as deposits by other customers". By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit (and thus create money).

The Bundesbank’s explanation of what banks do is really simple to illustrate using the accountant’s tool of double-entry bookkeeping. Loans and Reserves are Assets for a bank; Deposits are a Liability; and the gap between the two is the bank’s Equity (or Capital). When a bank makes a loan, it increases its Assets (Loans) and its Liabilities (Deposits) by precisely the same amount. Similarly, repaying a loan reduces the bank’s Assets by precisely as much as it reduces its Liabilities. Interest payments by the borrower reduce the bank’s Liabilities and increase its Equity, as shown below:

Figure 1: Actual banking from the bank’s point of view

There’s more to it than just this (see John Carney’s excellent blog post “Basics of Banking: Loans Create a Lot More Than Deposits"), but that’s the basic idea, and it’s easy to illustrate (the tables in this answer were produced using the Open Source System Dynamics program I designed called Minsky[1]).

What about the “Fractional Reserve Lending" model, that banks “lend from Reserves?", after a Deposit gives them some excess reserves? That’s shown in the next table. but it’s obviously an incomplete picture: it doesn’t show how the borrower actually gets the lent money. Instead, Reserves fall and Loans rise by the same amount: but how does the borrower actually get the money in return for becoming a debtor of the bank?

Figure 2: Fractional Reserve Banking from the bank’s point of view

The only way we can complete this, and show the debtor actually getting some money in return for going into debt, is if the loan is taken out in cash (or some other negotiable instrument, like a bank cheque). In other words, the model of Fractional Reserve Banking only works to create money if all loans are taken out as cash. This is shown in Figure 3, which shows Fractional Reserve Banking from the borrower’s point of view:

So do banks hand out loans as cash? Not in the last half century or more: the typical loan these days is as shown in Figure 1: the bank credits your deposit account (your Asset and its Liability), and records you as owing the loan to it (your Liability and its Asset). If Fractional Reserve Banking was ever realistic, it was in the 19th century.

There are many more shortcomings and fallacies in the Fractional Reserve Banking model, but I’ll leave it at this for now.


Footnotes

[1] Minsky


Appeared on Quora 19 January 2019.

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