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Fractional-reserve banking consists in banks lending out more money than they actually possess. This can also be seen as "money creation", or at least "money substitute creation"-- the claim on the bank (e.g. checking account deposit) is practically equivalent to cash-in-hand.

A short-seller borrows shares in a stock, sells them on the market, buys them back later, and returns them to the lender. This becomes a "naked short" if the borrowed shares "do not exist", i.e. are "share substitutes" credited to a short-seller's account without being backed by specific shares. Thus naked-shorting relies on a practice of "fractional-reserve brokerage".

Fractional-reserve banking is widely accepted while naked-shorting is widely considered unethical and is in most cases illegal. This confuses me because, per the above logic, they seem to be the same practice, just with a different asset class. In both cases, an abstract financial asset in the form of a claim on a backing asset (bank cash reserves or broker-held equities) is "created from thin air". In both cases, the existing stock of the asset in devalued by the creation of extra units, i.e. inflation.

Am I missing something? Are fractional-reserve banking and fractional-reserve brokerage, for lack of a better term, "structurally equivalent"? If not, what are the important differences in their economic effects?

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    $\begingroup$ This question is not about economics and so should be closed. Regarding of its illegality, that is not an economic question. Let me ask you different question. Both alcohol and cannabis are addictive, can harm health, and in fact alcohol overuse causes more deaths than cannabis. So under what logic only cannabis is illegal? That is question for lawmakers and politicians, not biologists $\endgroup$
    – 1muflon1 ♦
    Feb 4, 2021 at 21:22
  • $\begingroup$ I disagree with this comment. A few points: (1) I would assume that 99.9% of questions on this board have already been asked/addressed by scholars, so not sure what your point is. (2) The relative harm of cannabis/alcohol consumption is indeed a biological question. The biological conclusion is the input for lawmakers; (3) Similarly, the economic effects of creating money and/or equities by banks/brokerages is a question for economists. My question is basically asking for a theory under which frac-res equity creation is "harmful" but money creation isn't, as this would justify the status quo. $\endgroup$
    – Sean Mackesey
    Feb 4, 2021 at 22:37
  • $\begingroup$ you are right regarding 1 that was actually a tidbit not a criticism - I will actually delete first part of that comment because you are right about that. However, then you have to rephrase your question. There is plethora of policies that are demonstrably harmful for the economy (bad coal subsidies, bad zoning laws etc) that are not just legal but mandated by law, and there are various beneficial economic activities that are illegal. If you are interested in whether naked shorting has more economic harms than benefits then you have to rephrase your Q - also then the comparison $\endgroup$
    – 1muflon1 ♦
    Feb 4, 2021 at 22:41
  • $\begingroup$ To fractional reserve system is unnecessary a benefit vs cost of economic activity can be discussed on its own terms. Opinion based questions whether something should or not be legal would be off topic - but fact based answerable questions of what are positive/negative effects of a question would totally be on topic. $\endgroup$
    – 1muflon1 ♦
    Feb 4, 2021 at 22:42
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    $\begingroup$ This question is just asking for opinions. The only way I can see it being rescued is to just leave it at a more technical, value-free question: is naked short selling economically equivalent to fractional reserve banking? (I’d say that it is not.) $\endgroup$
    – Brian Romanchuk
    Feb 5, 2021 at 2:10

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There’s no inconsistency between allowing fractional reserve banking and banning naked short selling. Banks generally lend out money that they borrow (setting aside capital lent), and if one lends out a stock that one has borrowed, that’s not a naked short position, it’s just a plain short. What’s illegal about “naked” shorting (in the U.S.) is selling a stock that one hasn’t either borrowed or determined that one can borrow within the delivery timeframe (currently two days for equities).

The restrictions around money are actually in quite a bit tighter— if a bank were to enter into a transaction that required that it deliver funds and it failed to do so because it couldn’t borrow enough money, it would not be acceptable for the bank to say “oops we thought we could borrow the money sorry” and just pay a small fee (as with equities, where one pays a fails charge). It would instead be an event of default(1), which is more or less the end for a bank.

(1) “Generally, a bank is closed when it is unable to meet its obligations to depositors and others.”

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  • $\begingroup$ Thanks for your answer, but unfortunately I'm still confused. Don't banks lend out more money than they have (or have borrowed)? Isn't that almost the definition of fractional-reserve banking? That the sum of deposit accounts exceeds the cash reserves? I don't see the difference between lending (creating a claim on) a dollar one doesn't have and lending a security one doesn't have. $\endgroup$
    – Sean Mackesey
    Feb 5, 2021 at 4:05
  • $\begingroup$ No, banks do not lend out more money than they have borrowed. Their liabilities (money they’ve borrowed) plus their capital (their owners’ money) always equal their assets (money they’ve lent). The thing about fractional reserve banking is just that if bank A lends out some of its deposits to Bob, and Bob deposits his money in bank C, you’ll see more total deposits than you’ll see “reserves” which are liabilities of the central bank. But nowhere in there is someone lending out money that hasn’t been borrowed. $\endgroup$
    – dismalscience
    Feb 5, 2021 at 4:19
  • $\begingroup$ To put it more directly, if I’m a bank, it’s totally cool for me to lend out deposits (which are money I am borrowing from depositors). I’ve borrowed money and I’ve lent it out. That’s what banks do. Totally fine. Similarly, if I’m a broker-dealer, it’s fine for me to borrow a stock (or even just confirm that I can borrow it soon), and then sell it. That’s totally fine! What I can’t do is just sell a stock that I can’t borrow. But just the same, if I’m a bank, I can’t lend money that they haven’t borrowed. $\endgroup$
    – dismalscience
    Feb 5, 2021 at 4:25
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    $\begingroup$ I’m afraid you’re fundamentally mistaken about what fractional reserve banking means. Banks that are not central banks do not “regularly create IOUs” for dollars they don’t have on hand. They’re bound by the settlement constraint and subject to liquidity regulation, which would be irrelevant if they were just allowed to “create IOUS” when they couldn’t deliver cash. Banks are allowed to deliver cash they’ve borrowed into settlement if they don’t have it as reserves, but they have to get it from somewhere. This settlement constraint is also the difference between shorting and naked shorting. $\endgroup$
    – dismalscience
    Feb 5, 2021 at 12:44
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    $\begingroup$ Discussing a blog post and the appropriateness of the metaphors used within is not really within the bounds of this site. You asked about fractional reserve banking, which is where total deposits exceed reserves. Even in fractional reserve banking, interbank settlement still happens in reserves, and reserves have to be borrowed if a bank doesn’t have them on hand for settlement. Only the central bank can create reserves. That blog post goes off somewhere else and talks about physical cash vs. “electronic,” which isn’t a relevant distinction for reserves. Your question has been answered. $\endgroup$
    – dismalscience
    Feb 5, 2021 at 13:05

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