# Why is fractional reserve banking allowed?

I learned about banks' fractional reserves and that revolted me. How is that not considered to be fraud?

The idea doesn't seem too sophisticated, on the contrary, it sounds very simple: the bank just loans money they don't even have and charges an interest rate (which is not low at all) on that virtual money. When I go to a bank to take out a loan, they will just type the amount of money in my account (but the money does not exist) and I will introduce the money into the economy (when I use that money to buy something).

Why are fractional reserves not considered fraud?

• -1 The question asks whether a certain value judgement should apply to FRB,, something ultimately not scientific. – Michael Greinecker May 30 '15 at 12:22
• So you have no real question and just want to make a political statement? I vote to close. – Michael Greinecker May 30 '15 at 16:05
• my real question is "Why fractional reserve banking is not considered fraud?". Do you know the answer? Thank you. – Mandrill May 30 '15 at 16:17
• This question is not off topic, nor should it be closed for being primarily opinion based. Guys, please read the labels: Primarily opinion based as reason for closing is w.r.t. the answers that you get. Yes, this question is opinion based, and some of the premises may be false. That doesn't necessarily make it a bad question. It is very possible to write a good and neutral answer to this, something along the comment that @denesp just made. – FooBar May 30 '15 at 19:18
• If this a genuine question, i'll put an answer up - the short answers are: pretty much every description you'll read of FRB is wrong to varying degrees, any description with the word ponzi in it is completely wrong, money is being created and destroyed by FRB, banks live off interest, and legacy system. Plus, it kinda sorta works - and we built an advanced technological and scientific civilisation with it in about 300 years, so unless you have any better ideas, we're stuck with it. Legacy systems. If you're a maintenance engineer I would imagine you know all about them :) – Lumi May 30 '15 at 19:21

I recommend a careful read of the Wikipedia page for Fractional-reserve banking because it seems you are confused about how fractional reserve banking works.
Banks only lend out money they have under fractional reserve banking and, in fact, strictly less than they have. Those funds are a mix of deposits, funds from other debt issuance, and bank equity. They don't lend out funds they don't have and they don't simply credit accounts at will in the way you suggest. When they credit a borrower's account with funds, they have to debit those funds from elsewhere on their balance sheet. So, lend-able funds go down as borrower's funds go up, and then the resulting loan is a new asset of the firm. While they do create money this way, they do so at the expense of these lone-able funds so the loaning out doesn't create new assets for the bank.

• The Wiki page is wrong. Banks are not intermediaries. They create their own liquidity by maturity mismatching. Also banks do not "only lend out money they have", because otherwise M2 would never be greater than MB. This is well known by Fed officials and not a conspiracy theory. That a balance sheet is balanced by debt and assets is not relevant as the time values changed. Balancing 100k in reserves to 100k in deposits is completely different from balancing 100k in tbills to 100k in deposits. Not enough space to explain all...but the original poster is more correct than you imaged. – user2662680 Dec 20 '15 at 15:42
• I don't follow but perhaps you could elaborate in your own answer – BKay Dec 20 '15 at 16:37
• I'm not trying to increase confusion, but from what I've read from bank of england publications, banks do indeed create money, but not without some limitation. bankofengland.co.uk/publications/Documents/quarterlybulletin/… bankofengland.co.uk/publications/Documents/quarterlybulletin/… – An old man in the sea. May 16 '16 at 16:45
• The Wikipedia page starts with the following: "[fractional reserve banking] involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve an amount equal to only a fraction of the bank's deposit liabilities". And to be absolutely clear, the "fraction" is less than 1! So fractional reserve banking does involve banks lending strictly more than their reserves -- this is pretty much the definition of fractional reserve banking. – user17900 Mar 31 at 9:42

This is meant to add to @BKay's answer. Here are some examples that might help to see what's happening when a bank makes a loan.

## A bank's balance sheet

The image below is text taken from Greg Mankiw's textbook Macroeconomics (7th edition, p. 555). This is a simplified version of a typical bank's balance sheet. Notice that reserves, loans, and securities are considered assets and that deposits, debt, and equity are considered liabilities.

## What happens when I deposit money into a bank?

Now, let's first consider what happens when someone deposits money into this bank. For example, suppose someone deposits \$10. The new money goes to the vault which may then be deposited in the bank's account at the Federal Reserve (the central bank). This is a new asset. At the same time, the new deposit is a new liability. All together, this will increase the reserves of the bank by \$10 and the deposits by \$10. Both the assets and liabilities of the bank increased by \$10.

## What happens when a bank makes a loan?

Now, what happens when a bank makes a loan? Suppose a bank makes a loan to someone for \$10. In the picture, it's clear that this will increase the amount of loans from \$500 to \$510. Now, remember that loans are considered assets. That is, the borrower has an obligation to pay the bank back. But, where will the money come from? A few things can happen. One example of what could happen is the following. The bank could use its reserves. In this case, reserves would drop from \$200 to \$190. However, in a fractional reserve system, banks have reserve requirements. The ratio of reserves to deposits must stay above a certain percentage. More realistically, loans might go up by \$11 (because of interest), reserves down by \$10, and owner's equity up by \$1.

(However, I believe that often times, a bank might issue the loan but immediately sell the new asset to another party, while taking only a small cut.)

## The benefits of fractional reserve banking

Economists typically agree that the fractional reserve system adds some instability to the economy. However, it also adds many great benefits as well. There is a big literature about the trade-offs here and the many functions of (fractional reserve) banking, in general. (One of the most important economic functions is that it allows us to better smooth out liquidity shocks. See an important paper by Diamond and Dybvig).

There is simply too much to get into here. You might consider opening a new question that specifically asks for a list of the summarized benefits. Also, check out Mishkin's Money and Banking book (undergraduate level) or Microeconomics of Banking by Freixas and Rochet (graduate level, but still very accessible).

Economics is inherently political, so political questions and thus political answers are very appropriate. To pretend that economics is not political is to make it an end to itself and not a means.

The realistic answer to your question is that fractional banking is allowed because of a combination of factors.

• Public ignorance
• Political power of the banking sector
• Ignorance of banking concepts by academia
• And the lack of imagination in coming up with alternatives

A derivative question of yours that was implied and is appropriate to answer is if banking is good for the common welfare of a nation. It is not. You will see many complicated equations and examples that obfuscate this, but the concepts are simple. Banks issue more promises for money then they have. These promises are errantly accepted the same as real base money and this create inflation and volitionality. It is a system in perpetual need of assistance from central banks and would quickly collapse in a liquidity fire without their assistance.

Another way of looking at banks is that they engage in maturity mismatching. They buy long term assets and borrow short term to finance this. This is very risky. If my short term debt is no longer rolled over (and I lost trust from investors/depositors), the game is up.

So what are the alternatives? Allow the public to hold debt-free deposits directly at the central bank. In the USA only private banks can hold Fed deposits. But if we allowed the public to hold deposits (and checking accounts/debit cards) with the Fed, we wouldn't need fractional deposit banking, we wouldn't need to bail it out and we wouldn't have its inflation. Here is a proposal of how such an idea could work: http://wfhummel.cnchost.com/nationaldepositorysystem.html

• The fact that this is downvoted is proof that SE doesn't know what it's doing. – D J Sims Feb 29 '16 at 1:30
• @Mustang Criticisms like this, especially one so sweeping and vague, goes into the meta discussion, not as a comment to an answer please. Taking a screenshot of the question and this answer and making a post will probably allow you to elaborate more. – Kitsune Cavalry Feb 29 '16 at 1:38
• But the accepted answers are also sweeping and vague. – D J Sims Feb 29 '16 at 1:41
• Maybe you feel that way, but at least they have some sort of argument. Your comment is literally just "this is bad". Ok, why? This answer is literally just saying that fractal reserve banking is harmful because of maturity mismatching, but generally FRB is about clearing the liquidity market. Some people who don't need the money right now give it to those who want to invest, but don't have the liquidity for it. There's only so much I can write in a comment, but if you feel differently about the answer make a case for it! – Kitsune Cavalry Feb 29 '16 at 1:56
• To say that FRB is mainly about liquidity is astoundingly inaccurate. If the reserve requirement is 10%, a commercial bank can create 10 times the money they hold. This is how the money supply grows. – Jason Kelley Apr 27 '18 at 23:00

A simpler way to answer this question is to say that Fractional Banking allows currency to do more work. If I stop stuffing my savings into my mattress and bank them instead, and then the bank lends it out, then that money is doing double work. A central bank is there to make sure this process - the creation of credit - is orderly by essentially insuring private banks. No modern system of production based on demand can exist without it. Either mass poverty or forced labor and forced investment are the historic alternatives.

The only alternative I can see is for the gov't to take over the entire insurance industry. This would be essentially a system of Social Security for companies.