Are Fractional Reserve Bank Deposits Money?
The issue of fractional versus 100 percent bank reserves has been much debated. One of major disputes is whether fractional reserve banking (FRB) is inherently fraudulent, or whether the mix of cash and other assets to be held against liabilities is a business decision, to be made by banks and customers? This article will show that attempts to construct a nonfraudulent FRB result in assets that are not money.
Deposit Banks, Credit Banks, and Fractional Reserves
The article starts from a world in which gold is the monetary commodity. One hundred percent reserve deposit banks accept gold in exchange for a bank deposit or banknotes. Credit banks are distinct from deposit banks. They are financial intermediaries that accept funds (not deposits) as loans, and then seek profits by lending the money out at a higher rate.
In his book on banking, Huerta de Soto argues that deposit banking is coherent from a legal standpoint when it is 100 percent reserve, and that before they became a standard feature of banking, fractional reserve banks were understood to be fraudulent by banks and customers alike.
Nonfraudulent Fractional Reserve
We shall try to construct a fractional reserve financial institution that overcomes the problem of consumer fraud. Starting with a credit bank, where the customers supply loans to the bank which are liabilities on its balance sheet, a fraction are loaned out. The bank agrees to meet requests for withdrawals on a best-effort basis.
When loaning money to a fractional reserve financial institution, the customer must sign a disclosure in which they are fully informed that withdrawals are merely requests for the bank to consider and will be met only as long as there is enough cash on hand, at the discretion of the bank. Withdrawals may be denied if cash is not available, or even if the bank simply wishes to conserve equity to protect against loan losses or to purchase other assets.
What happens if a withdrawal is denied? By construction, the bank is allowed to do this and is not in default. However, to get some idea of how this might be handled, we will walk through the history of how fraudulent banks have handled defaults.
When a fraudulent bank runs out of gold and cannot meet the next customer withdrawal, it is bankrupt. What happens then? The bank would go into bankruptcy court. The depositors, as creditors of the bank, would become equity holders in its assets. The settlement would distribute the bank’s remaining assets to all creditors, with those depositors receiving a share of the equity, perhaps in the form of stock. If a bank held a portfolio consisting of bonds, home mortgages, credit card receivables, and small business loans, dividing them up among thousands or millions of depositors into equal assets would be difficult. The bankruptcy court might sell off the assets to
Article from Mises Wire