“In his court deposition, Cesare Brigante, former custodian of the petty cash funds at Roberto Pasta Spaghetti factory, noted that the € 2,000 were not, as he put it, 'really missing', but merely on a 'temporary leave of absence'. He pointed out that after several months of observation of the balances of the petty cash fund in his role as custodian, his 'entrepreneurial spirit was woken' by the fact that on average, a residual of € 2,500 seemed to remain unused at all times. He therefore decided to 'do something for the local economy by providing credit to it', in this case a 6 month loan of € 2,000 to his cousin, Toni Vitellone, at an annualized interest rate of 25%.  The petty cash fund held, proof-wise, the respective IOU signed by Signore Vitellone. In short, so Brigante, since an asset worth € 2,000 was evidently included in the petty cash fund, what obtained was not fraud, but merely a 'duration mismatch'.


Inexplicably to Brigante, the judge found him guilty of fraudulent misappropriation of funds anyway.” (a story we just made up).

Long time readers of this blog will already know where this is going. We wrote an extensive treatment on the topic of fractional reserves banking last year (parts 1, 2 and 3), organized roughly along the lines of, and heavily indebted to, J. Huerta de Soto's excellent work 'Money, Bank Credit and Economic Cycles'.

What prompts this revisiting of the topic is a recent article at the Daily Capitalist – 'Fractional Reserve Banking: The Real Story', that in turn was apparently prompted by our offhand paraphrasing of Rothbard's remark that 'fractionally reserved banks are essentially insolvent at all times' (see also the quote at the end of this article). Mish has already written a rebuttal, but we wanted to add our own two cents, so to speak, without (promise) expanding the money supply one bit.

The author of the above referenced article, Mr. Keith Weiner at the Daily Capitalist, holds that there is in principle nothing unsound about, or wrong with fractional reserve banking, except for the well-known 'duration mismatch' problem that besets banks due to their predilection of 'borrowing short and lending long'.

We hold by contrast – although there are many areas where we agree with Mr. Weiner – that there is much more to this than merely the 'duration mismatch' issue.

There are first of all important legal and ethical problems that need to be considered and furthermore the issue of the boom-bust cycle, which at its root is not only an economic issue, but also an ethical one, since the boom-bust cycle impoverishes society at large and thus ultimately violates everybody's property rights. This cycle in turn is set in motion by banks expanding the credit and money supply by creating new 'unbacked' deposit money beyond the pool of real savings and lending it to businesses.

Having read our little story presented above, would you be inclined to agree with Cesare Brigante or the judge who found him guilty? It is probably no question that most people would side with the judge's view.

The surprisingly widespread confusion about fractional reserves banking generally stems from a failure to differentiate between irregular deposit contracts and loan, or mutuum contracts, both legally and economically.

Looking at the historical development of banking, there were essentially two different functions that banks fulfilled:

One was the 'warehousing' of money for their customers, which generally included such services as the processing of payments on their customers behalf.

An irregular deposit (we have adopted this term from de Soto; 'irregular' is meant to denote deposits of perfectly fungible goods, of which money is one; de Soto in turn notes to the provenance of the term that 'Pasquale Coppa-Zuccari astutely points out, the expression depositum irregolare did not appear until it was first used by Jason de Maino, a fifteenth century annotator of earlier works, whose writings were published in Venice in the year 1513'), is supposed to be available at any time on demand. In no way was it ever meant to be a 'loan to the bank' which the bank could then use to provide credit to other borrowers. Such a deposit account was to provide income to the bank in the form of charges it levied against it for the warehousing and payment processing functions. It was not there for the bank to invest in its own business ventures, since it simply did not belong to the bank, just as the petty cash fund of the Spaghetti factory did not belong to Signore Brigante.

The other function of banks, that of acting as financiers and financial intermediaries, developed historically from merchant banking. Well-capitalized merchants began to provide credit to other merchants for trade purposes and the like; as a rule, they invested their own saved funds in this credit provision business. Some of these merchant banks became pure loan banks, and eventually began to also act as intermediaries between third party savers and borrowers, earning a spread.

If one hands over one savings to a loan bank against interest for a fixed term, a mutuum contract is established, which is completely different from an irregular deposit contract. It is indeed a 'loan to the bank', whereby the owner of the savings relinquishes use of his money for a fixed term in return for interest. Obviously, such money is not meant to be 'available on demand', but only after the agreed upon term has expired – it represents an exchange of present goods for future goods.

There is nothing objectionable about this type of business, as there will at no time be an inflation of the money supply or an inability to pay depositors – the bank merely acts as the knowledgeable intermediary channeling savings to their best use and earning a spread for this service.

In his examples at the Daily Capitalist, Mr. Weiner presents us with examples of bank balance sheets where demand deposit, savings and bank assets (loans) are presented by their different durations. It is perfectly correct to present bank balance sheets in this manner, but his article fails to deal with the objections presented above. At one point in his article, Mr. Weiner shows a bank balance sheet that looks like this:


Assets                                    Liabilities

Cash 100 oz                           Demand deposit accounts 100 oz

1-year loan portfolio 15 oz     1-year deposit account 15 oz

5-year loan portfolio 75 oz     5-year deposit account 75 oz


He rightly concludes that


“There is [still] no problem. The maturities of the bank’s assets match its liabilities.  This bank is perfectly solvent. (In the real world, the bank would set aside loan loss reserves out of its own capital to cover the credit risk, and of course it would charge interest at a much higher rate than the default rate.)”


Well, what can one say? There is no problem because this – such as it is presented above – is not the balance sheet of a fractionally reserved bank! Au contraire, this bank is 100% reserved. It holds the tantundem of 100 oz. of gold  in cash assets that cover its demand deposits 100%.

This is the balance sheet of a bank that is at the same time involved in he warehousing of money (the demand deposits) and loan banking. It looks like an entirely legitimate operation.

Note however that he arrives at this balance sheet by leaping from 'demand deposits' to 'savings deposits' to introduce the 'duration mismatch problem',  in the process at first increasing the the total money supply via the activities of this putative monopolistic bank by 90% – and later simply taking this operation  back – by changing over to term deposits. When his story begins, he shows us the following balance sheet example (we include his comments/explanations below). Says Mr. Weiner:


“First, someone deposits some gold coin into a bank.


Assets                                   Liabilities

Cash 100 oz                          Depositor account 100 oz


So far, so good. Next, the bank makes a loan of more

than zero but less than the total deposited.


Assets Liabilities

Cash 10 oz                            Depositor account 100 oz

Loan Portfolio 90 oz

It’s still solvent, and “total money supply” has not grown yet.


Well, actually, no. This bank isn't 'solvent' any longer, even though the money supply has yet to increase. Assuming that the deposit was an irregular monetary deposit, or sight deposit available on demand (since Mr. Weiner uses the terminology 'someone deposits 100 ounces of gold at the bank' we were inclined to assume this to be the case), then in effect, this bank is an analogous situation to the fraudster Cesare Brigante in our little story at the beginning. It has misappropriated the funds of the depositor to lend them out. If the depositor were to walk into the bank one day after the above loan has been made and demanded his deposit back, he would find the bank insolvent. It has only 10 of his 100 gold ounces left and thus can not pay him back.

Mr. Weiner continues:


“But now let’s say that the borrower pays the 90 oz to a contractor

to build a new house and the contractor deposits the money in the same bank.


Assets                                         Liabilities

Cash 100 oz                                Depositor accounts 190 oz

Loan Portfolio 90 oz


So what just happened here? First, the size of the balance sheet increased as

did the total “money supply” in the system (we will come back to this below).

But the balance sheet shows assets to match the liabilities; there is no

evidence of insolvency yet.  The bank may or may not be insolvent.”


In spite of just having demonstrated what fractional reserves banking essentially consists of,  Mr. Weiner still thinks everything is alright. Alas, it isn't. There are still only 100 gold ounces in specie in toto in the bank's vaults, but deposit liabilities of 190 gold ounces. At this point, the bank remains effectively insolvent. If both depositors came on the same day to demand their deposits back, the bank would be unable to pay them. It is however at this very point that Mr. Weiner lets us know that depositor number one – who deposited 100 gold ounces originally, did not solely make an irregular money deposit. Instead, he did several things. He deposited only 10 ounces in a demand deposit, 15 ounces in a one year savings account, and 75 ounces in a 5 year savings account.

This is how he arrives at the balance sheet we showed first, which is decidedly not the balance sheet of a fractionally reserved bank, and from which no money supply increase can be inferred. Why he hops so seamlessly from A) the fractionally reserved bank that has just increased the money supply by 90% to B) a bank that is de facto 100% reserved, he doesn't explain, but  the problem that is at the center of his entire explication, is the inability to differentiate a priori between the warehousing of money and legitimate loan banking, i.e. the irregular deposit contract, and the mutuum , or loan contract.

Note here that while in the balance sheets he shows initially, before we are apprised of the fact that 90 of the 100 gold ounces of the original depositor were actually lent to the bank in two separate mutuum contracts, we had to assume from the wording ('someone deposits, etc.') that the bank was lending out a fraction of a sight deposit. After the various follow-on transactions this resulted in the 90 gold ounces it had lent out to be redeposited by a third party, and  it had therefore increased the money supply by 90%, while not actually possessing enough specie to cover its demand deposits (which are by virtue of their designated 'availability on demand' perfect money substitutes). By apprising us of the fact that the bank was in effect not engaged in fractional reserves banking, we fail to see how the example serves to take the wind out of the sails of critics of fractional reserves banking.

Mr. Weiner then shows various examples of 'duration mismatch' between savings deposits and the concomitant loan assets that are likely to get banks into trouble. We generally agree with what he writes there – 'duration mismatch' is liable to get banks into hot water. A pertinent example was provided in 2008, when SIV's ('special investment vehicles') set up by banks to hold long duration mortgage assets financed by short term commercial paper issuance found the CP market closed to them. Where he – in our opinion – makes several erroneous assertions again, is when he presents his conclusions:


“So what have we concluded? First, fractional reserve lending is about lending less than the bank takes in via deposits. The only party capable of creating money out of thin air is a central bank (which should be abolished).”


It is not true that in our modern system, the central bank is the 'only party capable of creating money out of thin air'. Rather, the central bank accommodates such 'money from thin air' creation by the commercial banks by setting 'reserve requirements' and 'supplying reserves' (from thin air, to be sure) to support these operations. The only privilege that is the sole province of the central bank nowadays is bank note issuance, this is to say the issuance of money proper. The private commercial banks are perfectly capable of creating deposit money, i.e., perfect money substitutes, from thin air all by themselves. We certainly agree with Mr. Weiner though that the central bank should be abolished and that by inference, the current banking cartel should be replaced by a free banking system (note also that the current 'QE' operations are distinct from how credit and money is expanded normally during a boom).

It is likewise not true that a private banking system without a central bank can not also increase the money supply by what is essentially a fraudulent operation. In fact, it has happened over and over again in history! The difference to today's situation is only that once the artificial expansion of money substitutes came to an end and worried depositors tried to claim their specie, the money supply would fairly quickly shrink back to its original size, i.e. to the amount of specie backing the money substitutes in what was a cleansing, but usually vicious deflation and economic bust. Mr. Weiner makes it sound as though private banks were entirely unable to issue more money substitutes than they hold in specie, but this is most definitely not so.

Deposit bankers soon realized (and we have reports of such banker behavior dating back to antiquity) that in the normal course of business, only a fraction of depositors would turn up to exchange their deposit slips (later, 'bank notes') for specie. They concluded – falsely – that they could apply the 'law of large numbers' that underlies actuarial accounting of insurance operations to demand deposits. They soon found out that deposit money served as a perfect money substitute, since people would accept checks drawn on deposits instead of money proper, which checks would usually be redeposited, allowing the deposit money to remain 'within the system'. Later they also noticed that their bank notes – essentially warehouse slips – began to circulate as money. These observations enabled them to increase credit by means of increasing the amount of deposit money and/or of bank notes in circulation beyond the amount of specie covering them.

We have previously shown that such a system of private banks, when it uses a reserve fraction of 10% can indeed increase the money supply ten-fold when it is 'fully loaned up' – the only condition is that all, or most banks, begin to expand credit and money simultaneously (a monopolistic bank would have no problem whatsoever to increase the money supply ten-fold, since by definition it would hold all extant deposits and would never be in danger of getting a check presented by a competing bank – these clearance operations between banks are, as Rothbard notes in 'Mystery of Banking' and elsewhere, the main factor inducing an element of caution in the expansion of money and credit by a banking system not backstopped by a central bank. The only restriction on a  monopolistic bank's money creation capabilities would be in the form of currency circulating outside the bank. If depositors were to withdraw deposit money in favor of currency, a 'reverse multiplier' effect would set in, provided the bank continued to hew to a 10% reserve requirement).

In practice, private banking systems of the past have rarely increased the money supply ten-fold during a boom, but just to illustrate the point with an extreme historical example: the famous Medici bank, which originally had been a merchant bank cum pure loan bank during the 14th century, started deposit banking operations in the 15th century. When it went bankrupt in the late 15th century, its depositors found out that it was indeed only 10% reserved. The bank's depositors lost the bulk of their money and had to wait for years for whatever small compensation they could squeeze from the insolvent institution's assets. What had happened? A boom followed by a bust of course, a boom the Medici bank had helped to finance by means of fractional reserve banking. When the bust came, bank runs ensued and (once again) depositors found out that the perfect money substitutes they held were less perfect than thought. Of 163 banks that operated in Venice in the late Medieval period, documentary evidence exists that proves that a minimum of 93 went under (mentioned by Raymond Bogaert, in Banques et banquiers dans les cités grecques, note 513, p.392.). As JH de Soto mentions to this point:


“This same fate of failures affected all banks in Seville in the 15th century. Hence, the systematic failure of fractional-reserve private banks not supported by a central bank (or equivalent) is a fact of history.”


Mr. Weiner continues:

"Second, fractional reserves do not necessarily cause any problems to the bank. If a depositor wants to liquidate a time deposit before maturity, the bank will seek the best bid in the market—and hand the loss off to the depositor.”

Again, time deposits are not even part of the money supply, and have nothing to do with fractional reserves banking. They are credit transactions, broadly speaking, since they are mutuum, or loan contracts. This is to say, they represent an exchange of present for future goods. The saver relinquishes his  use of the money to the bank for the agreed term. However, we would note that Rothbard argues that a case can be made for including time deposits in the money supply at a discount , since they are in practice generally available on demand at a penalty discount (see Rothbard, 'Austrian Definitions of the  Supply of Money' – pdf, for details). Mr. Weiner then says:


“Third, one cannot simply add up the various kinds and durations of banking deposits to come up with a simple (scalar) total. A demand deposit is money; a time deposit will mature into money next year or in 2041 but is not money today. Thus banks can expand credit in the system (which is not necessarily bad) but not money.”


The first half of this paragraph is entirely correct. It makes no sense to e.g. add up demand deposits and CDs and time deposits and claim that this total represents the money supply. One would end up double counting, which incidentally, the official 'broad' money supply measures such as M2 and M3 are indeed doing.

The second sentence is just plain wrong.  We invite you to review the process by which banks can indeed create 'money from thin air' – even gold banks without a central bank. They do it by lending out a fraction of their sight deposits, which then become new demand deposits elsewhere, which can again be used for the same pyramiding operation, ad infinitum. What Mr. Weiner fails to realize is that all deposit money that is theoretically available on demand is a perfect money substitute and thus forms part of the money supply. To illustrate this, if we come back to the assumption that in his initial example, an irregular deposit of 100 ounces of gold is used to lend out 90 ounces of gold, and that this money is then spent and redeposited by a third party, then both money and credit have expanded, since the original depositor has in no way relinquished his claim to the 100 ounces. We have discussed the difference between money and credit and how exactly they nevertheless 'hang together' in a fractionally reserved banking system in the aptly named 'Money and Credit – There is a Difference'.

Mr. Weiner continues:


“Fourth, borrowing short to lend long, aka duration mismatch, inevitably implodes. This is not a matter of odds or probability. Like a geological fault line, one can try to assess probability of a destructive event in any given year, but sooner or later catastrophe is certain. When a business knowingly engages in an activity that is guaranteed to cause it to dishonor its obligations, that is acting in bad faith. Such a business has no intention of honoring its obligations over the long term, only in the short term when it is expedient.”


We don't disagree, but there is more to fractional reserves banking than merely the 'duration mismatch issue', see above and the links we have provided to further reading matter on the subject.

Mr. Weiner's final comment leaves us slightly flabbergasted:


“Finally, fractional reserve banking is one of those issues where there is a deep misunderstanding in Austrian circles. This is compounded by the dearth of information about duration mismatch (I am only aware of Professor Antal Fekete writing about it, and of course some of his students such as myself) and the proliferation of misinformation about it. I strongly encourage anyone interested in this topic (which should be all students of the Austrian School) to read the works of Fekete which go deeper than I could in this one essay.”


We would argue that the exact opposite is true – in Austrian circles we find the deepest, most profound understanding of the issue of fractional reserves banking. We would recommend to readers to acquaint themselves with Ludwig von Mises' 1912 work 'The Theory of Money and Credit' for starters. This work improved immeasurably on the works of the 'banking' and 'currency' schools of the 19th century, showing where exactly they erred. One of the most important insights Mises provided was to show that deposit money, insofar as it takes the form of irregular deposits available on demand, forms part of the money supply and must be added to what Mises referred to as the stock of 'money proper' (i.e., gold coin or currency). Austrians even construct their own money supply measures (such as Money AMS, Money TMS, Money Prime, and 'real' versions thereof), in recognition of the fact that the 'official' money measures are less than ideal. For details on this see 'True “Austrian” Money Supply Definitions, Sources, Notes and References' by Michael Pollaro, who provides regular updates on the 'Austrian' money supply data that can be accessed (in pdf form) via the box to the left. For details on 'M Prime', see Mish's relevant article (M Prime is a close variant of Frank Shostak's money AMS, or what Michael Pollaro terms 'narrow Austrian money supply TMS-1').

As to Dr. Fekete's monetary theories,  they happen to leave a lot to be desired. We have previously mentioned that we respect Dr. Fekete as an original thinker worthy of engagement, but we are also aware that he holds some very 'un-Austrian' views, even though referencing Austrian economists in his writings (such as the idea that the law of marginal utility does not apply to gold) and was/is a vocal supporter of the 'Real Bills Doctrine', which is in the end just another inflationary scheme. For a critique of the Real Bills Doctrine, see Blumen ('Real Bills and Phony Wealth') and Corrigan ('Unreal Bills Doctrine', pdf).

We would remind here that the expansion of credit and deposit money via fractional reserve banking has the following major effects:

1. it lowers the purchasing power of existing money, and thus robs all money holders and savers surreptitiously of wealth;

2. it redistributes wealth to the 'early receivers' of newly created money from the 'later receivers', or those who do not receive it at all (people receiving fixed income for instance, such as pensioners) due to the fact that the decline of money's purchasing power only happens slowly as the new money percolates through the system;

3. it sets in motion exchanges of 'nothing' (money from thin air) for 'something' (real resources) without the early receivers contributing to the pool of real funding;

4. it distorts the structure of relative prices by dint of entering the economy at specific points and not 'everywhere at once' and is thus the primary cause of the business cycle. As such it is injurious to everybody in society.

Although it was held throughout antiquity until the early medieval period that the irregular monetary deposit contract required that 100% of the tantundem (an equal amount of money as that deposited, although not necessarily the very same coins, only perfectly identical ones) be held available by  deposit banks at all times, in Anglo-Saxon law the legal differentiation between deposit and loan contracts has unfortunately been abolished in the early 19th century already. Due to Anglo-Saxon law relying heavily on precedent cases, the privilege of fractional reserve banking has subsequently been perpetuated. As a result, it is both fraudulent and legal, i.e. a fraud that has been statutorily enshrined. It is no less harmful for that, rather more so, and it provides an early example of the lobbying powers of bankers (the same lobbying powers that have been on  such effective display at the time the Fed was founded and during and following the 2008 crisis). Rothbard wrote on this point, in 'The Case Against the Fed':


“Unfortunately, since bailment law was undeveloped in the nineteenth century, the bankers' counsel were able to swing the judicial decisions their way. The landmark decisions came in Britain in the first half of the nineteenth century, and these decisions were then taken over by the American courts. In the first important case, Carr v. Carr, in 1811, the British judge, Sir William Grant, ruled that since the money paid into a bank deposit had been paid generally, and not earmarked in a sealed bag (i.e., as a "specific deposit") that the transaction had become a loan rather than a bailment. Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued correctly that "a banker is rather a bailee of his customer's fund than his debtor, … because the money in … [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up." But the same Judge Grant again insisted that "money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount." In the final culminating case, Foley v. Hill and Others, decided by the House of Lords in 1848, Lord Cottenham, repeating the reasoning of the previous cases, put it lucidly if astonishingly:

The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with as he pleases; he is guilty of no breach of trust in employing it; he i s not answerable to the principal if he puts it into jeopardy, i f he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.[3]

The argument of Lord Cottenham and of all other apologists for fractional-reserve banking, that the banker only contracts for the amount of money, but not to keep the money on hand, ignores the fact that if all the depositors knew what was going on and exercised their claims at once, the banker could not possibly honor his commitments. In other words, honoring the contracts, and maintaining the entire system of fractional-reserve banking, requires a structure of smoke-and-mirrors, of duping the depositors into thinking that "their" money is safe, and would be honored should they wish to redeem their claims. The entire system of fractional-reserve banking, therefore, is built on deceit, a deceit connived at by the legal system.

A crucial question to be asked is this: why did grain warehouse law, where the conditions – of depositing fungible goods – are exactly the same, and grain is a general deposit and not an earmarked bundle – develop in precisely the opposite direction? Why did the courts finally recognize that deposits of even a fungible good, in the case of grain, are emphatically a bailment, not a debt? Could it be that the bankers conducted a more effective lobbying operation than did the grain men?

Indeed, the American courts, while adhering to the debt-not-bailment doctrine, have introduced puzzling anomalies which indicate their confusion and hedging on this critical point. Thus, the authoritative law reporter Michie states that, in American law, a "bank deposit is more than an ordinary debt, and the depositor's relation to the bank is not identical to that of an ordinary creditor." Michie cites a Pennsylvania case, People's Bank v. Legrand, which affirmed that "a bank deposit is different from an ordinary debt in this, that from its very nature it is constantly subject to the check of the depositor, and is always payable on demand." Also, despite the law's insistence, following Lord Cottenham, that a bank "becomes the absolute owner of money deposited with it," yet a bank still "cannot speculate with its depositors' [?] money."[4]

Why aren't banks treated like grain elevators? That the answer is the result of politics rather than considerations of justice or property rights is suggested by the distinguished legal historian Arthur Nussbaum, when he asserts that adopting the "contrary view" (that a bank deposit is a bailment not a debt) would "lay an unbearable burden upon banking business." No doubt bank profits from the issue of fraudulent warehouse receipts would indeed come to an end as do any fraudulent profits when fraud is cracked down on. But grain elevators and other warehouses, after all, are able to remain in business successfully; why not genuine safe places for money?[5]

To highlight the essential nature of fractional-reserve banking, let us move for a moment away from banks that issue counterfeit warehouse receipts to cash. Let us assume, rather, that these deposit banks instead actually print dollar bills made up to look like the genuine article, replete with forged signatures by the Treasurer of the United States. The banks, let us say, print these bills and lend them out at interest. If they are denounced for what everyone would agree is forgery and counterfeiting, why couldn't these banks reply as follows: "Well, look, we do have genuine, non-counterfeit cash reserves of, say, 10 percent in our vaults. As long as people are willing to trust us, and accept these bills as equivalent to genuine cash, what's wrong with that? We are only engaged in a market transaction, no more nor less so than any other type of fractional-reserve banking." And what indeed is wrong about this statement that cannot be applied to any case of fractional-reserve banking?”


In 1991, following several bank runs in Maryland in 1985 and the spreading S&L crisis, Rothbard wrote a comment on the sudden banking crisis that is worth repeating and the source of our 'fractionally reserved banks are inherently insolvent' paraphrasing that inspired  Keith Weiner to write about the topic.  Rothbard in 'Bank Crisis':


“What is the reason for this crisis? We all know that the real estate collapse is bringing down the value of bank assets. But there is no "run" on real estate. Values simply fall, which is hardly the same thing as everyone failing and going insolvent. Even if bank loans are faulty and asset values come down, there is no need on that ground for all banks in a region to fail.

Put more pointedly, why does this domino process affect only banks, and not real estate, publishing, oil, or any other industry that may get into trouble? Why are what Samuelson and other economists call "good" banks so all-fired vulnerable, and then in what sense are they really "good"?

The answer is that the "bad" banks are vulnerable to the familiar charges: they made reckless loans, or they overinvested in Brazilian bonds, or their managers were crooks. In any case, their poor loans put their assets into shaky shape or made them actually insolvent. The "good" banks committed none of these sins; their loans were sensible. And yet, they too, can fall to a run almost as readily as the bad banks. Clearly, the "good" banks are in reality only slightly less unsound than the bad ones.

There therefore must be something about all banks–commercial, savings, S&L, and credit union–which make them inherently unsound. And that something is very simple although almost never mentioned: fractional-reserve banking. All these forms of banks issue deposits that are contractually redeemable at par upon the demand of the depositor. Only if all the deposits were backed 100% by cash at all times (or, what is the equivalent nowadays, by a demand deposit of the bank at the Fed which is redeemable in cash on demand) can the banks fulfill these contractual obligations.

Instead of this sound, noninflationary policy of 100% reserves, all of these banks are both allowed and encouraged by government policy to keep reserves that are only a fraction of their deposits, ranging from 10% for commercial banks to only a couple of percent for the other banking forms. This means that commercial banks inflate the money supply tenfold over their reserves a policy that results in our system of permanent inflation, periodic boom-bust cycles, and bank runs when the public begins to realize the inherent insolvency of the entire banking system.

That is why, unlike any other industry, the continued existence of the banking system rests so heavily on "public confidence," and why the Establishment feels it has to issue statements that it would have to admit privately were bald lies. It is also why economists and financial writers from all parts of the ideological spectrum rushed to say that the FDIC "had to" bail out all the depositors of the Bank of New England, not just those who were "insured" up to $100,000 per deposit account. The FDIC had to perform this bailout, everyone said, because "otherwise the financial system would collapse." That is, everyone would find out that the entire fractional-reserve system is held together by lies and smoke and mirrors, that is, by an Establishment con.”


(our emphasis)

Even though the existence of the Fed in its function of 'lender of last resort' with unlimited money creation capabilities and the FDIC which insures depositors from loss (with its equally theoretically 'unlimited' credit line from the treasury in case its own funds run out) have blunted bank runs by simply socializing bank losses via inflation on the part of the former and reliance on the tax payer on the part of the latter (to be fair, somewhat less than 1% of all deposits would be effectively 'insured' by the organization's own funds that it receives from banks in the form of a fee), nothing could be plainer than the fact that the banking system as it is constituted today is at its core unsound.

Today we are at a point where an unprecedented rescue operation was mounted to prop this unsound system up across the Western world – to avert the painful cycle of credit and money supply deflation that would no doubt have resulted otherwise, but this was done at a cost that will likely only become fully apparent at a later stage. The alleged attempt to 'reform' the system falls flat by completely ignoring the issue that is at the heart of its unsoundness. Instead of true reform, we have merely seen a piling of new regulations atop a veritable jungle of already existing regulations – none of which could avert the catastrophe (a catastrophe the establishment denied could ever occur until the last minute). As others have remarked, instead of 'too big to fail' institutions being eliminated, they have been made even bigger (Mervyn King is one of the few central bankers railing against this outcome, alas to no avail).

In their hubris, central bankers continue to assert that if only they are given more power, nothing untoward will ever happen again (see for instance this special report, 'Revolution in Central Banking' at Reuters). In essence, the planners are telling us that they have belatedly realized that they need a 'better plan' – which naturally, requires that their bureaucracies be expanded and given greater authority. Just as Rothbard noted in his essay back in 1991, the term 'fractional reserves banking' remains unmentioned, as though it were a dirty word, a topic not worthy of discussion or reflection. And yet, it is the very problem that needs to be tackled.


Ludwig von Mises: he laid it all out in the 'Theory of Money and Credit' , published in 1912.

(Photo via: mises.ca)

Murray Rothbard: Mises' pupil and a major economic and social theorist as well as economic historian in his own right – and life-long enemy of the practice of fractional reserve banking.

(Photo via: libertyclick.com)

Jesus Huerta de Soto: “Central banks insist on dictating manu militari what should be the freest of market prices (the interest rate), and on managing the money supply. Austrian theorists showed that a central planning agency could not possibly gather all the information necessary to make its commands meaningful. This is the principle of the impossibility of socialism. Monetary authorities trigger and reinforce economic cycles instead of stopping them.” (from an interview he gave in  late 2009)

(Photo via tuloveras.com)



Lorenzo de Medici – one of the richest men in Europe in the second half of the 15th century, Politician and Banker. Under his leadership, the famous Medici Bank declined and eventually went bankrupt shortly after he handed the reins to his son Piero. In an ultimately doomed attempt to prop up the falling house of cards, Lorenzo inter alia raided the Florentine treasury (sound familiar?). Yes, the Florentine banks operated with gold money and without a central bank. And yet, the Medici bank was only 10% reserved at the end, and the entire Florentine banking system had blown up the supply of credit and deposit money to such an extent that many of the Medici Bank's competitors were found to be only 5% reserved against their demand deposits when the  crisis struck.

(Painting by: Angelo Bronzino)




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5 Responses to “Fractional Reserve Banking Revisited”

  • White eagle:

    Great article!
    I would point only to one thing that you already hinted to in comment on Lorenzo di Medici.He operated in situation with gold money and in absence of banking cartel(central bank) and still disaster happened as you pointed out.In addition,fractional reserve banking surely was not legal as it is now.Nor were there legal tender laws.So we have here libertarian wet dream:free private banking and free sound money,no central bank and no deposit insurance scheme.Yet there was credit boom and bust,fractionally reserve banking and attempt at public bailout of private interests.
    Ludwig von Mises is intellectual giant and M.Rothbard deserves great respect but there is one crucial problem here.It is a psychological nature of Homo sapiens at present stage of evolution.Greed,avarice,laziness,ignorance,sheer stupidity,recklessness…
    You can install perfect libertarian system populated with present day people and you would end up with disaster anyway!
    True solution is in the field of psychology,not regulation,laws and institutions.

  • The sad point Pater is the worse this situation gets, the more actions the governments of the world take to cover up the fraud. I don’t even believe in the term fractional reserve, as it is even more extreme than that. The term is actually deficient, as the reserves in the banking system are nothing but credits of other banks. The cash represented by the Fed balance sheet don’t even exist in the banking system, but have already been paid out by the banks and in hoards around the world. This doesn’t mean it is not available for deposit, but that it doesn’t exist on the balance sheet.

    The only way a true run on a bank would be successful is if the runs were universal, thus the money not redeposited somewhere. But, absent a guarantee, anything that had to be cleared through the system likely would be demanded by the receiving bank in cash. Reserves follow credit, not precede it. In fact, as long as there is not a second bank involved, the originating bank can merely shift money from one account to the other. I suspect that within 10 years, only interbank transactions will be allowed and the idea of pay to the order on demand will be lost. Such is the lure and power of a perpetual fraud.

    In truth, I don’t believe reserves exceed the capital of a bank. In order for there to be any legitimacy in banking at all, the banker has to have skin in the game. Otherwise, he is merely lending his own IOU’s. I have a document somewhere that was filed in Federal court which lists the court cases in the US that forbade a bank from lending its liabilities. The rulings mentioned on bailment border on absurdity, as the money on deposit at the bank is clearly a liability of the bank and not an asset. The great secret is the entire balance sheet is nothing but liabilities. The bank is liable for its asset in that if they don’t perform, the bank has to perform. They made themselves liable when the created the loan. They are liable for the loan, not the customer. The customer has merely pledged his credit or his collateral.

    The banks assets are only good to the extent the borrowers on these loans can acquire the liabilities of the banking system. There is no other species in circulation other than the coin of the United States or whatever other country is involved. If the Fed is creating new deposits by financing the treasury directly, then these are also bank liabilities. This runs a lot deeper than the nonsense that the problem with banks is a mismatch of maturity and runs directly to the solvency of assets on the balance sheet. These assets represent the banks liabilities and if the bank can’t be liable for the losses on the assets, then under any imaginable form of law, they aren’t a legitimate business, but a Ponzi scheme.

    The system of credit doesn’t bother me as much as the fraud that is going on about the solvency of the banking system. That any regulated industry that is likely short of capital should be allowed to engage in partial liquidation of its capital positions disturbs me. The call these stock buybacks, but what they are in truth is a liquidation. Lets see what happens when the FDIC serves its purpose of guaranteeing deposits and not the other sources of financing in the banking system when a partial liquidation is undertaken? In a free market, I have to believe that the bond holders of the banks would get nervous. They maybe already have.

    The incapacity of the regulators to enforce haircuts in the system, as opposed to bailouts is astonishing to me. For all practical purposes, the 4 or 5 largest banks in the US should have failed. The shareholders should have absolutely no interest in these institutions and the officers of these institutions and their financial practices should have been investigated. The bondholders should have owned the banks in reorganization and in most cases, the deposits wouldn’t have been touched.

    I bring this last point up because the only way to have saved this ponzi system was to destroy its components in the short term. The haircuts are not optional and it is clear they are planning on taking the losses out of the side of the depositor and not the banker. The entire rule of law has been stood on its head in this instance, going back to the cases that Rothbard mentioned in his book, the mystery of banking. I need to read the remainder of that book, but then again I have read the modern story too many times.

    One more thing. The only truth in the money and banking courses taught in college is that commercial banks create money when they make loans. It absolutely astounds me that the focus of these courses is the nonsense about reserves and the fed doing this nonsense and that nonsense when the only truth that can be gleaned out of this course is that banks create deposits and thus money supply when they make loans. They all get back to what account the bank takes the money from when there isn’t any account. The guy that wrote that rebuttal mentioned above seems to totally miss that idea. Those that talk about fractional reserve miss the point as well. Banks don’t keep reserves, as it is a total nonsense to keep people talking about something. They borrow back what leaves the bank. There are no reserves.

    • Note here that in this article, I merely wanted to make clear the process of ex nihilo money as such and point out the conceptual error in Keith Weiner’s article. I’m well aware that the US banking system has not truly ‘reserved’ its deposit liabilities since at least 1995 when sweeps were introduced. This is how it was possible for the money supply to explode into the blue yonder while the level of ‘required reserves’ parked at the Fed remained more or less static until the 2008 crisis hit and the Fed’s monetization operations went into overdrive creating the current pile of ‘excess reserves’. Naturally, these are also an ex nihilo creation, only that in this case, the Fed was the active initiator thereof.
      The entire system is a gigantic Ponzi scheme, resp. a three card Monte purposely designed to obfuscate the truth in order to keep up the public’s vaunted ‘confidence’. It is indeed a confidence game, one that ultimately derives its legitimacy solely from the State’s apparatus of coercion and compulsion that has decreed that ‘legal tender’ shall be the only legitimate money. The pretense that true free market capitalism can be based on such a monetary system is preposterous. The monetary system such as it is constituted today has paved the way for a formerly free society’s slide into a quasi-tyranny. Yes, we can stll say what we want to say and we can ‘elect’ this or that figurehead to occupy the station of temporary dictator, but there is no longer any reasonable possibility of stemming the growth of the State or of calling into question its existence as such. If you do that, the establishment stands poised to immediately discredit you as a radical lunatic. I guess the US founding fathers would all be considered raving lunatics by the standards of today’s establishment and its hanger-on etatistes in the press, academe, business, bureaucracy, etc. The state-mandated monetary system and the banking cartel administering it and profiting from it is the crucial feature enabling the modern State and its inexorable growth. That’s why they literally stopped at nothing when it came to ‘saving the system’ and socializing its vast losses. Allegedly Hank Paulson even threatened the imposition of martial law to get reluctant Congressmen to agree to the bailouts. Since one of the Senators on the receiving end of this particular Paulson jeremiad told us about it, we can assume that it’s true.
      see: http://www.lewrockwell.com/blog/lewrw/archives/24103.html

  • For those who have been waiting for replies to comments, I have now belatedly caught up and posted replies to comments from the Christina Romer article onward.

  • I am going to come back and read this later, but it appear the guy actually thinks banks loan out our money when in fact they have to attract it to cover what they already loaned out. No one ever gets a debit slip from the bank telling them they can no longer have their money.

    The money supply of the world is now almost entirely made up of nothing but liabilities of the worlds banks. The whole system is nothing but a system of liabilities, the value of which exists only as liabilities. The real problem isn’t whether the banker can pay out all the money, because he can’t, but can he make good on the liabilities. I believe the position of a banker is to act as surety. Otherwise he is lending liabilities of his own that he is creating and nothing else. There aren’t assets in the system of banking outside of what the bank itself has up as surety. The entire system is liabilities, notes drawn on notes.

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