Arnold Kling  

Fractional Reserve Banking from a Modern Finance Perspective

Watch Walter Block Defend Comm... Anti-Democratic Thought for th...

Walter Block, arguing against Bryan, says that fractional reserve banking is fraudulent. There is some chance that when you make your deposit you will not get your money back, and instead someone else will have taken title to it. Therefore, your rights were violated.

My point will be that there are many other modern financial contracts with the feature that there are contingencies where the contract cannot be fulfilled.

[UPDATE: a commenter points to a post by Eric Posner that makes my point more clearly.]

For example, I think that it is fair to say that my reading of AIG is that if there are enough defaults on bonds that they insured, they will not be able to meet all of their obligations under the credit default swaps that they sold. However, my reading is that at least one person, Gary Gorton, believes that AIG will not suffer so many losses on their default swaps, and if their counterparties would just be patient things would be fine. It sounds to me as though AIG put itself in a position similar to that of a fractional reserve bank. Under some conditions, it cannot fulfill its contracts. Because of that, a "run" took place at AIG.

Other modern financial contracts that cannot necessarily be fulfilled: any deep, out-of-the-money unhedged short option position--credit defaults swaps being just one example; any short sale, because the price can rise so fast that the short seller is busted before he can buy out his position.

Defined-benefit pension plans are probably fraudulent by the strict definition. Surely, there are contingencies where the pension plans will not be able to meet their obligations.

From an individual point of view, you get some protection from risk by diversification. Otherwise, in the modern theory of finance, there is room for a risk-free asset. What Block and others want to call fraud is the pretense that bank deposits are a risk-free asset. But people incur all sorts of other risks in the modern financial sector that they tend to ignore. They think that there are lot more risk-free assets out there than is the case.

My view of the world is that people's trust that assets are risk-free is a beautiful but dangerous thing. Right now, most of that trust is being placed in the securities of the U.S. government, which in turn is guaranteeing everything in sight, which by all logic should completely undermine that trust. I keep wondering what the new safe haven will be when people start to treat the U.S. like the banana republic it is becoming.

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COMMENTS (20 to date)
Devin Finbarr writes:

The fraud is not the fact that the assets have risk. The fraud is promising your customers one thing and then doing another. Sentinel's Prime Fund promised to keep its customer's money in overnight loans. Instead, it invested in 30-year bonds. When customers wanted their money back, the fund found it could not liquidate the long term holdings, and they had to suspend redemptions. This is clear cut fraud.

Mark writes:

There is one easy answer for Walter Block: If he doesn't want his bank perpetrating fraud on him, all he has to do is purchase a safe deposit box and use it to hold all the money he desires. The bank will not lend a cent of it.

Ajay writes:

I don't think Block's argument is that default risk is fraudulent, rather I would characterize it as a misguided attempt to attack FRB purely using a property rights argument. The fundamental problem with FRB is that it is inherently unstable and anytime there are even unrelated financial problems, we have to worry about the rickety infrastructure going under. The difference between FRB and the other instruments you list is the one you and Devin point out: that a lot more people think FRB is risk-free, while anybody buying credit-default swaps knows that they are far from risk-free. I suspect that more than 90% of depositors do not even know that a large proportion of demand deposits are loaned out, I certainly didn't till recently.

FRB is a centuries-old practice that most people cannot even bring themselves to question: Bryan appears unable and Arnold seems mixed, writing a post that seemed to weigh against it earlier but now seemingly arguing against its critics. I suspect that FRB wasn't as dangerous in the pre-industrial era when growth was much slower but became a major contributor of the bank panics of the industrial era, once growth started arriving in leaps and bounds and started giving bankers fits as they tried to keep up with higher growth with this antiquated system of credit. Today, we have the Federal Reserve, which tries to act as a kind of buffer to this rickety financial system but is limited in what it can accomplish and certainly hasn't killed off the phenomenon known as a bank run. I suspect that even Milton Friedman did not realize this, as he focused on how the Fed could have been a better buffer rather than how FRB is the root cause. I would say that the primary argument against abandoning FRB is that as an unstable financial system, it is prone to greatly exaggerating recessions, which are inevitable, leading to bureacrats in the '30s and today using these panics as an excuse for power grabs. If we replace FRB with a more stable financial system, not only do we have something much better, but we avoid the threats of socialists taking the reins because free markets keep using this antiquated and unstable system. The next problem is that even once you realize how bad FRB is, it is not an easy transition to something better. I suspect that when the transition comes it will be an unnecessarily painful one that will be pushed through by the private sector.

Sean writes:

Re: Mark

If a bank closes due to its inability to meet the demands of its depositors, there is little likelihood that the doors to the safe deposit vault will be opened for you anytime soon. There was a good bit of money made back in the days leading up to the S&L crisis by private, non-bank, safety deposit companies. I suspect we will see a few such businesses pop up soon.

Brian Shelley writes:

Is it possible that fractional reserve banking only survives in modern times because it is continually bailed out by the government? Is it a relic of a bygone era of asymmetric information. With ample data available, sometimes for free on the internet, why do so many financial activities still include a middle man? Why can't I invest in a Credit-score-between-650-and-700-with-10%-down-car-loan fund?

If Mr. Block is correct, shouldn't there be a market trend away from banking activity and towards direct investment?

Matt C. writes:

If I understand Professor Block, he is arguing what Rothbard argued. Rothbard argued that you put your money in a bank account for the strict purpose of safe keeping. If you want to earn money on that account, or interest, there are other vehicles like CDs, etc. This is the same for the banks, if they want to lend money they have other available sources for lending purposes.

Rothbard used the example of a warehouse receipt. You put your chair or dining room table in the warehouse and they give you a receipt. You show up to "withdraw" your chair or table and you find out it's been loaned out. Now clearly there is a difference between a chair and a fungible asset like currency. But you clearly have a right to your property if you have "stored" your money with an insitution.

Again if we go back to Rothbard he demonstrated that with the help of the governments banks have been able to not honor their contracts with their depositors. In the history of the US, state governments and also the Federal government have allowed banks to default or not pay out there obligations. This violates depositor's property rights, hence an act of fraud.

Jonathan W. writes:

There is an excellent dissection of the Block/Caplan argument at The Volokh Conspiracy by Eric Posner.

Carl The EconGuy writes:

Block's mistake is that he views property rights as a 0-1 variable -- it is, or it isn't. That's too simple. My wife and I are co-owners of a car. My right to the car is then conditional upon her claims. If we don't spell out the details of the conditional claim, then we have implicitly agreed to negotiate on the spot. "OK, hunny, you can drive to grandma's on Saturday if I can take it to the ballpark on Sunday." That's exactly what frb is all about. I deposit my money in a bank, for which I receive interest, on the condition that the bank can lend it and make a profit. The risk I assume is that my claim to withdraw the money cannot be honored instantaneously. My claim is still a valid claim, but it is conditional upon the bank remaining solvent. If fractional reserve banking is illegal, then all conditional contracts would be illegal. Block seems to have a mind-block on this one. There are not two owners to the same money in the bank. There are all separate owners of conditional claims on the bank, and that's the essence of the contract that establishes claims to the property rights involved.

MattYoung writes:

Two parties in any contract would exchange profitably if the result is an increase in predictability, fewer contingencies, after the exchange.

Hence, any profitable exchange would result in a reduction of liquidity and increase in long term capital, an increase, ultimately, in predictability of goods flow.

We become more fraudulent as we become efficient. But, fraud should eventually overwhelm.

Bill Woolsey writes:

I agree with Kling that there are any number of financial contracts that cannot be paid off under certain contingencies, but he doesn't have to get so exotic as credit default swaps.

Banks can create liquidity without issuing financial instruments that can be used as money or making any promises about paying off on demand.

Suppose that a bank offers 1 year CD's and makes one year loans. Clearly, there is no guarantee that the bank will be able to pay off the CD's. If it can't collect on enough loans, then it becomes insolvent and cannot fully pay off the depositors.

Suppose a bank only offers 6 month CDs and makes one year loans. Paying off the CDs after six months requires the bank borrow new money (issue new CDs) or else sell of the loans. Rolling over the CD's is one way to borrow "new" money.

If the loans look to be bad, it is possible that the bank will not be able to borrow new money (or maintain rollovers of funds) or sell the loans.

The bank might default after six month. It might also borrow more money and then default at the end of the year as before, because the loans turn out to be bad.

But there was no fraud unless that bank intended to make bad loans that could not be sold or not borrowed against after six months.

Now, suppose that these six month CD's are instead one month CD's. The bank has to borrow new money every month. It might become impossible, but there is nothing faudulent as long as the bank didn't plan all along to stiff the holders of the CD's.

Suppose the CD's are one week. One day?

Now, one day "CD's" are interesting, because these can be used as money. Automatically rolling over overnight deposits allows checks to be covered on any day.

The banks aren't promising to pay off "on demand." They are promising to pay off tomorrow. And, like usual, they can either sell the loans or borrow new money to pay off old money.

Of course, it could be 4 hour deposits, or 1 hour deposits, or 1 second deposits. Milisecond? nano second?

And so, what is the difference between this a "payable on demand?" Nothing of any real significance. And so, it is fraud if the bank says "payable on demand" because the Block/Rothbard theory that this really means "storing your money." But, if the bank promises to pay the money after a one nanosecond wait, it is just a credit contract with the riak that the bank may not be able to sell its loans or else obtain new loans in one nanosecond.

The reality is that Block and Rothbard believe that fractional reserve banking has bad consequences. And they don't want to oppose it for that reason. So they come up with a strained argument that their desire to violate freedom of contract is really enforcing rules against fraud.

Any depositor who thinks that banks store money in checkable deposits is delusional.

Ajay writes:

Bill, of course any bank can still be insolvent or illiquid with normal loans, though not with full-reserve banking, nobody has claimed otherwise. The reason to take FRB out of the equation is to take away systemic liquidity risk, caused by credit contraction after bad investments are liquidated, and rampant inflation. Any individual institution that makes loans still has to worry about liquidity or solvency problems. As for your twaddle about one-day or one-second CDs and the like, what such theoretical nonsense ignores is that banks can plan for 3-month or 1-year CDs not being renewed and allocate their loans and cash accordingly. It is impossible to plan for 1-day deposits, as it is potentially possible that the entire deposit base can be pulled out on any given day. In reality, 1-hour or 1-day CDs are also impossible because they imply that money can only be pulled out at certain hourly or daily intervals, which nobody would actually do, and you still have the problem of planning for a bank run on such short time deposits. You may be right that the primary problem with FRB is not property/contract rights, but that doesn't mean that it isn't also a valid argument against FRB. As for your view of delusional depositors, I suspect that if you actually bothered to gather the data, you would find that more than 90% of depositors are ignorant of this fact, as I stated above, and therefore "delusional."

Bill S writes:

According to CDS spreads, the cost for insuring against a US Treasury default has risen sharply since the beginning of the year:

"On the surface nothing remarkable is happening – the 30 year US Treasury bond yield recently hit an all-time low of 3.88%, as investors sought a safe haven during equity market turbulence. Yet while nominal bond yields have declined, the credit risk component of US Treasuries has been on an increasing trend since last year. According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily - from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year. In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets."

Patri Friedman writes:

Micha Ghertner & I think of this argument as a sort of litmus test for whether an Austrian is rational. The rational Austrian will either realize or quickly admit that fractional reserve banking can be duplicated non-fraudulently simply by being an explicit feature of the contract with the depositor. The irrational Austrian seizes onto the idea with their teeth and refuses to let it go.

This is unrelated to the question of whether FRB leads to instability, and is/isn't a bad thing. Those are not clearcut. But the idea that FRB must be fraud is pure wingnuttery.

Ajay writes:

Given that most depositors are almost completely unaware of such a contract, the so-called "irrational" Austrians do have a point. The "rational" Austrians, such as yourself, do have a point also that one can always write a contract that redefines property rights in such an idiosyncratic way. The arguments still stand though that most of these depositors are not knowingly signing such a contract, as evidenced by their ignorance of its terms, and the fundamental problem that FRB causes periods of money stock contraction and creation that are highly pro-cyclical, potentially leading to vicious cycles of inflation and deflation that highly exacerbate business cycles.

scineram writes:

What makes you think most depositors are not aware that instead of paying fees the bank lends out their money to pay them interest?

Bill Woolsey writes:

My "theoretical" example of overnight deposits isn't theoretical. There is a large market in them now. Because of restrictions on banks paying interest to business on checkable deposits and reserve requirements on checkable deposits, overnight borrowing by banks developed into a large business. By rolling over the overnight loans, this allows depositors to collect on the part of the money they need on any day to cover payments on that day. "Depositors" lend overnight rather than hold money in checkable deposits.

Of course, the bank that borrows over night operates on the exact same principle as a bank issuing "demand deposits." There is nothing "irrational" about it. There is a risk
that you won't be able to come up with the funds needed to make payments.

If there was some effort to outlaw fractional reserve banking as fraud, then overnight deposit accounts would replace all checkable deposits. Unless, of course,they were banned as well.

Claiming that overnight lending is impossible--well, wrong. Claiming that it is risky and unsafe--well, granted. But the point is whether arguments about who owns gold in the warehouse work when no one is promising to pay "on demand," but rather are promising to pay off in the near future.

As for "systemic risk," a run can develop because depositors lose faith in a bank that issues one month CDs. As deposits come due, the bank must pay them off and no one makes new deposits. The bank must sell loans and cut off new lending because it is receiving no new deposits.

The firms that cannot borrow from that bank purchase less from other firms. Those other firms cannot pay off their bank loans. This causes depositors to stop lending to those other banks.

It doesn't have to happen that way, of course. But I can tell a systematic risk story about banking without demand deposits.

Further, banks don't have to create demand deposits to have monetary effects. If the only loans avaiable are one year loans, the typical person will need to hold more money in their portfolio and fewer loans to be able to take care of emergencies and take advantage of opportunties. If banks make one year loans and issue one month deposits, then one can hold less money and more deposits. You only need to wait one month. The one month CD is more liquid than the one year loan, and so it is a better substitute for money. This reduces the demand for money and has inflationary effects just like banks borrowing with banknotes or demand deposits. (I am not suggesting that it is the exact same effect, but rather that there is a continuum)

Fractional reserve banking may be unstable. Perhaps it should be banned. Maybe freedom of contract has bad effects on the economy in this paticular situation. But it isn't fraud.

Oh, and fractional reserve banking pre-existed both deposit insurance and central banking.

And by the way, before government banned the practice, banks often had explicit option clauses where they promised to pay interest when they were unable to pay off banknotes on demand. The clause required that interest be paid until the banknote could be paid off.

As for the 90% figure of people believing that banks pay depositors for the privelidge of storing their money, please cite some polling data.

I realize that sophmore business and political science undergraduates are not a random sample, but I ask about 250 people about this every year for about 20 years. The number of people who think banks are in the storage business is close to zero.

Ajay writes:

scineram, common sense? I don't have any polls to back it up but I'm pretty sure what such surveys would find, as most people have no idea how banking works.

Bill, there is a market for corporate overnight deposits, largely spurred by regulatory arbitrage, but my point was that it wouldn't work for consumers, as they wouldn't stand for a waiting period before they could access their supposedly liquid checkable deposits. Not sure why you're repeating that overnight deposits are as risky as demand deposits when I already said that's why they wouldn't work. Nobody's talked about banning anything, that's the preferred solution of statist dimbulbs. As for the argument about who owns the cash in the safe, you do address that problem when you move from demand deposits to short-term deposits and get rid of the money multiplier inflation that is the result of such vagueness about property rights, but you also create a new problem for the banks in that they have to very carefully manage the amount of time deposits vs loans. If you merely move all the demand deposits to one-day CDs, that doesn't really get rid of money multiplier inflation as you just have to wait for one day to pull your money and a bank run on 1-day CDs would still be impossible for banks to plan for. If you keep your money in a mix of vault cash and 3-month CDs however, both problems are solved.

You can tell a systemic risk story about banking without demand deposits but it has no punch. There is still systemic risk without FRB, as you point out, but it is greatly reduced. Imagine how much worse your recession scenario is when the money stock is simultaneously deflating as a result of failed banks and lost depositor confidence. Yes, the spectrum of available time deposits has monetary effects but so what? It's a much more stable system, if the time deposits are sufficiently large, as the added anchor of monetary deflation isn't dragging the whole system down. I don't see what freedom of contract has to do with FRB, you could invoke freedom of contract in practically any situation. I wouldn't ban FRB, just let people choose the reserve ratios of their choice, implying they would know what a reserve ratio meant. What percentage of the populace do you think knows what that is? Less than 0.1%? Yes, FRB pre-existed central banks and the FDIC but so did bank panics by at least a century, your point is? Interesting escape clause with the non-redeemable, interest-paying banknotes but since it's just a way to prop up FRB, I think it's a waste of time. I highly doubt that your survey data of even the biased sample you cite is accurate, particularly if they were the result of a professor asking his students, "Surely you all know that banks lend out most of your money and don't just keep it in a safe?" I expect very few students to truthfully answer, "Yeah, that's what I thought, am I wrong?"

Frants writes:

FRB is fruad for one simple reason, you supply 10 tickets for a claim to an apple, when in fact you can only supply 1 apple. You charge people a fee for that ticket for that apple, the 9 tickets for which you do not have 9 apple. You made a profit laying about what you have, not because the other 9 apples are somewhere else.

FRB is fruad, its not this or that or you have a choice or up or down, IT...IS...FRUAD. When ever you tell someone you have something that you do not have, it is called lying. In the money business, when you charge people the use of money against assets that you do not own, it is called fraud.

Try asking a judge why it was wrong to try and pass the 9 $10 bills, that you coppied at work, as loans to friends and charging your friends $1 for the use of that $10 note.

Fractional Reserve Banking = money counterfeiting.

It.......IS........fraud, period.

Ajay writes:

Frants, I completely agree with you and I'm smiling and laughing as I read your necessary emphasis on the facts. Too many free-market FRB supporters are willing to countenance the FRB delusion simply by stating that such a contract can theoretically be written, therefore it's fine. However, let me push you a little bit. If there is no FRB, would you have everyone hold their full reserves in vault cash, hence allowing the government to completely control the currency base through the printing of a fiat currency? Would you have them stick to a stable currency total or a mechanical growth rate? Or are you one of those antiquated gold-standard supporters? I support none of those and have my own preferred solution but I wonder what you support.

scineram writes:

I agree now with Bryan on two counts.

1. The idea that frb is fraud is false.
2. The idea that frb is fraud is crazy.

Freedom of contract anyone?

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