More thoughts on fractional reserve banking

I haven’t written about this, or economics generally, in a while. Left my graduate program 18 months ago, and have been too busy with a new house, new kids, and my business to do much reading on economics.

But a post in this Facebook group got me going. So here’s a string of thoughts I’ve had on fractional reserve banking over the past year.


The only difference between a deposits box, or a “full-reserve” account, and a bank account in a FRB is in degree of risk they assume.

If I give my cash to a fractional reserve bank, they assume some risk by guaranteeing me withdrawal-on-demand because, of course, they are lending out my cash to others and don’t actually have everyone’s cash on hand at all times.

If I give my cash to a full reserve bank, they assume some risks by guaranteeing withdrawal-on-demand because, of course, they can’t actually guarantee that — they have no idea what the future holds.

(Neither, of course, does the fractional reserve bank know what the future holds.)

Fractional reserve banks are just businesses, managing risk. Depositors are customers who take a gamble with the banks’ guarantee. Of course, a fractional reserve bank may (though not necessarily) be more likely to “default” on withdrawal demands, but a full-reserve bank can’t 100% guarantee full redemption, either.

What if, for example, they are robbed? Were they wrong to ever guarantee full redemption, knowing theft was a possibility? What if they even made decisions that increased the known likelihood of their vault’s being robbed, even if only slightly? Does this make their guarantee fraudulent (or more fraudulent)?

Critics call fractional reserve banking fraudulent because it’s “a claim by multiple parties to each use a present resource differently.” That description of fractional reserve banking is accurate, but there’s no fraud. For how is that different than any health insurance plan, whereby members claim the benefits of their plan and solicit/secure services on account of the plan’s guarantee to pay a provider after services rendered, while members (and providers) know full-well that the insurer cannot technically cover everyone’s possible claims at any possible time?

Another perspective (of the same argument): How is the risk assumed by a fractional reserve bank different, except only in degree, than that assumed by a full-reserve bank who moves their vault to a less-secure location (to, say, cut down on costs)? Or than that assumed by a full-reserve bank who moves their vault to a known fault line, where an earthquake is far more likely to cause damage to physical deposits (cash, buillon)?

Neither form of bank can absolutely guarantee withdrawal-on-demand any more than any business can guarantee that, if you pay, they’ll send your product.

It’s just a matter of degrees of risk. That’s how I think about full vs. fractional banking after many years of considering the issue. Please correct me if any of my analogies are not appropriate.

I grant that in a full-reserve system does not entail, like in a fractional reserve system, “a claim by multiple parties to each use a present resource differently.” But a full-reserve system is, in the context of making payments against full-reserve deposit accounts, no more a “guarantee” than drawing on funds at a bank that willingly and knowingly does not have sufficient funds on hand to honor every withdrawal request. Vendors are still taking the risk that your bank, against which your checking card is pulling, will actually transfer funds. And you are still assuming, when writing a check and expecting that to be sufficient enough for a vendor to let you walk out the door with product, that a full-reserve bank will honor their guarantees. There’s still a third-party involved here, such that the “claims” being laid are not on the funds (critics’ “present resource”) whatsoever, but against the guarantees made by a given bank (of any type).

A personal anecdote that also helps illustrate my point: One of my clients has more open POs (in terms of dollar amount) than my company could possibly honor, should they demand all their services be rendered at the same time (this is very unlikely, knowing their model and their history with us). Yet we’ve guaranteed, technically, that we will honor any requests for services at any time. They, in turn, guarantee their vendors certain timelines, and accept payment from those vendors in advance of us actually performing the contracted service. This has a similar “inflationary” effect on the economy as that inherent in a fractional reserve system.

Should I not be making this guarantee to my client? Is it fraudulent for me to do so? I think not. And I think fractional reserve banks are making the exact same “guarantee.”

Posted by Nick Freiling

Founder/Director of PeopleFish. I write on technology, market research and economics. Bylines at Startup Grind, FEE, the American Enterprise Institute and the Mises Institute.

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