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Fractional-reserve banking

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As a model of how money is actually created, it is 'neat, plausible, and wrong.' The fallacies in the model were first identified by practical experience, and then empirical research.
—Steve Keen[1]

Fractional-reserve banking is a relatively simple but wrong way of describing the banking system. As always with bad economics, it is popular partly because older academics have a vested interest in defending the idea, but also because it serves a useful political purpose for plutocrats. Namely, it basically denies that banks control the money supply of the modern economy. This allows the rich to place the onus of controlling the money supply upon governments, specifically by cutting expenditure on the grounds that it creates inflation (it can, but it presently doesn't).

Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower’s money account
—Lord Adair Turner, formerly the UK's chief financial regulator[2]

When they lend money, banks create money out of nothing. They can do so with no deposits at all, since that money is in electronic form. Obviously, this would be impossible if this was done physically, as in pre-electronic banks. The difference between lending $100,000 and $10,000,000 of physical objects is the difference between handing someone two handfuls (2.4 kilos) of gold and shipping them a truck laden with 240 kilos of it. The difference between lending those sums electronically can be a single keystroke. Accidentally creating millions of dollars' worth of objects is rare. Doing so electronically happens all the time, such as when instead of giving this man the $100,000 overdraft he asked for this bank manager gave him $10,000,000.

Neat, Plausible[edit]

Monetarists assume that the Federal Reserve can influence banks' lending by setting the Fractional Reserve Rate. They assume that this is possible because they assume that banks can't lend without deposits. Ergo they believe that increasing the amount of each deposit that a bank must 'keep' and not lend reduces the amount of lending, that decreasing the Fractional Reserve Limit increases lending, and that using a central bank to directly increase or decrease a bank's reserves will cause it to increase or decrease the creation of new loans respectively. More broadly this belief sits well with their assumption that banks and lending don't affect the economy, or that if they do then it is in a way which never changes and can therefore be safely ignored.

This sounds plausible because Neoclassical economists have a holistic ideological vision in which everyone's economic activities - including those of governments and banks - are just like those of the individual person or household. It seems like common sense that if you cannot physically lend $50 to your friend who has forgotten their wallet, then banks must not be able to lend money unless they already have some. Likewise, it seems like common sense that governments can't spend money unless they take the same amount or more in the form of taxes. While some people are aware that it is possible for governments to spend more than they take, Neoclassicists ensure that these people believe that it will create hyperinflation, which is Satan.

At an academic level, the Fractional Reserve theory has only been able to survive through the ongoing process of purging and no-platforming its critics. Even before the concept was created in the 1970s, it was manifestly apparent that the lending did not require deposits. Yet the inconvenient reality was simply assumed away.[3]


If Fractional Reserve Banking really explained how the actual banking sector worked, there would be a credit crunch every few minutes as the banks waited for people to make deposits. Everyone would pay for almost every ordinary expense with cash, and no-one would ever use credit cards unless they were willing to wait minutes, hours, or even days for the payment to go through.

Instead, banks just create the money they need to get by without paying much - or any - attention to the level which they are nominally supposed to 'keep'. This is why the top-down Quantitative Easing implemented by Japan for two decades and Bernanke+Obama et al. in the Great Recession did not increase lending to businesses and consumers.

The quantity of reserve balances itself is not likely to trigger a rapid increase in lending [...] the narrow, textbook money multiplier does not appear to be a useful means of assessing the implications of monetary policy for future money growth or bank lending. - Seth Carpenter, Federal Reserve associate director,Money, reserves, and the transmission of monetary policy: does the Money Multiplier exist? p.29

Just as they did in Japan, EU-US banks used the vast majority of the QE funds for the productive (for them) purposes of lending the money one each other with above-inflation rates of interest, where it has sat ever since. In both cases they used a little to buy back their own stocks, buy each other's stocks, buy stocks in other companies, and inflate asset bubbles. Nowhere have they increased lending to businesses or consumers, because the present and predicted future returns on doing so were lower. Of course, Neoclassicists are divided between saying that neither of these examples count because we didn't use allow them to create enough QE money - or that all the things which happened instead of what they predicted must actually be good things because anything which can be done to make money must be good for society, or else it couldn't be done. Classic! [5]

Stopped Clock[edit]

Austrians hate the Franctional Reserve concept not because they understand that it does not apply in reality, but because they have their own equally nutty model of how things 'should be done' instead.

The very thought that a bank may do something other than sit in front of your money and watch it grow mold makes some people foam at the mouth.[6] Many get very quiet if you ask where the interest on their liquid savings accounts would come from then.

The same people often howl that government intervention in the banking system is filthy socialism because it is not their favored economic policy. Safe to say this is often ignoring history, when before there was regulation of fractional reserve banking by the Federal Reserve things were much more exciting for depositors, what with all the constant banking crises and all.

Macroeconomic effects[edit]

In the USA, UK, Australia and much of the developed world all economic growth requires the exponential increase of private debt. This is the ultimate product of the banking system created by the Neoliberal-Neoclassical revolution, which has allowed debts to compound and wealth-extraction from the population to increase. Banking is one of the three principal sectors which maximise the unearned income of plutocrats by extracting value from the wage-earning population, the others being Insurance and Real Estate.

Without a biblical-style cancellation or restructuring of debts, this process will continue until de facto plutonomy and debt-slavery of virtually the entire world population result. [7]

Historical existence[edit]

Fractional Reserve Banking did actually exist in the days when banks kept physical objects such as gold and paper currency which could be withdrawn. In those days it was important for regulators to ensure that banks kept more than the bare minimum of valuable objects to-hand, since the banks naturally wanted to keep as little of them in-house as possible in order to maximise their profits - yet those could be withdrawn, possibly causing a bank run. While many imposed limits on how much could be withdrawn at once in order to limit the amount that they had to keep on hand, lowering the withdrawal amount in a crisis could actually cause more panic and therefore more to be withdrawn as a larger number of depositors showed up demanding their money back. Many small banks in the US went bust as a result of depositors losing confidence in them, which is why the Federal Reserve bank was created to establish Fractional Reserve limits and give gold or cash-money to insolvent banks in an emergency. It also limited the risk that the depositor's insurance (FDIC) would kick in every time one too many people came into the bank asking for cash.


While banks can't literally print their own money in a system with a central bank, they can increase the money supply. In a system of fiat currency, banks' monetary base (i.e., what is actually in the "vaults") is made up of money which can be supplied by the central bank in time of need. However, when banks make loans above their reserve (which is pretty much always), it adds to the money supply, specifically what economists call "M2" and "M3" (depending on the type of loan), which are considered less "liquid" than the monetary base. Thus, lending can (but not necessarily will) cause demand-pull inflation.

In the world of electronic banking, banks can now create "money" out of thin air, through create accounts. When someone spends these accounts, they are transferred to another bank, then this is lent on an interbank market (FED funds, LIBOR), to give reserves to banks who need it. [8]

It is always possible to still get a run on the bank if too many people demand money in excess of the reserve. A simple analogy is airline seating. Airlines know a few people will cancel, so they overbook flights by selling more tickets than seats. A run on the bank is like everyone showing up to the flight and no cancellations. (Or the plot of Mel Brooks' The Producers, when the play they'd over-sold shares of unexpectedly became a hit.) Bank runs are prevented in modern banking systems by the creation of a lender of last resortWikipedia's W.svg to avoid short-term liquidity shortfalls.

The fractional reserve system itself takes no account of the risks of the loans banks make. If the reserve requirement was set to 100%, interest accumulated in deposits and the generation of loans would be nearly nonexistent. However, no banks would run out of money, as long as they had absolutely no costs. This has traditionally been policy favored mostly by Scrooge McDuck, and Austrians, but has gained currency in certain circles following the 2008 crash, and has been advocated by economists Laurence Kotlikoff, John Kay and John Cochrane as well as the Financial Times' chief economics commentator Martin Wolf, and Iceland look to be heading towards implementing full reserves.[9]

The Conspiracy Theories[edit]

Fractional reserve banking is the subject of numerous conspiracy theories. They usually revolve around or have their roots in anti-Semitism in the form of Jewish banker conspiracies like the Rothschild family controlling the world. This usually ties in to conspiracies about the Federal Reserve as well as gold buggery or sound money. Sometimes the cry of "fractional reserve banking is fraud!" is a cover for some kind of economic woo or scam — usually of the "don't trust banks, put your money in my Ponzi scheme instead" variety. Sometimes these theories are just the result of people failing to understand abstract concepts.

Multiplier effect[edit]

The multiplier effect, or money multiplier, refers to the effects of a bank lending money over its reserve requirements as explained above. By law, banks are required to keep x% (depending on the locale and type of bank) of the total money they lend out in reserve. The resulting amount of money is 1/x multiplied by an original deposited amount, where x is the required reserve ratio in decimal form. For example, a bank is required to have a 20% reserve. Alice deposits her $1000 paycheck into the bank. The bank is able to lend out $800 to Bob, who buys a used car from Charlie, who deposits the $800 into another bank. The bank turns around and lends $640 to Denise, and so on down the line until there is $5000 in the system.

While it may seem a bit like smoke and mirrors to someone unfamiliar with economics, imagine instead of cash it was something with 'obviously' more use such as tools. We all need tools to work, but the vast majority of time we own the tool we aren't using it. So we put the tools in a tool bank, so that others can use it while we are not. If we only need the tools for about 20% of the time, the result is that the bank causes there to be effectively 5 times as many tools in the system. That it's currency instead of tools doesn't change the effect.

The multiplier effect is generally regarded as a simplification in academic and policy making circles. The Bank of England has stated that "while the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality",[10] and the multiplier model "has not featured at all in the recent academic literature". Charles Goodhart, the UK’s pre-eminent monetary economist and former member of the Bank of England's Monetary Policy Comittee has stated that “as long as the Central Bank sets interest rates, as is the generality, the money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-Keynesians ... have been correctly claiming for decades, and I have been in their party on this.” [11]

In the Post-Keynesian view, the multiplier is an ex-post facto accounting identity (or, in other words, a legal fiction). The reason for this is that a bank can make any loan it deems worthy and then borrow money from either the interbank loan market (a market in which banks lend excess reserves to each other)[12] or the Fed discount window to meet reserve requirements.

Bank capitalization, charters, and the Glass-Steagall Act[edit]

Banking regulation is much stricter than regulation in other industries and the financial sector. To apply for a bank charter, the owners (usually bank holding companies[13]) of the bank's capitalization are required to be debt free. Banks are supposed to be unencumbered rock solid investments.[14] Once the charter is granted the bank then can receive deposits, i.e., a debt owed to depositors encumbered by the bank's capitalization. The combined value of the banks capitalization, along with its ability to lend other peoples money (depositors money) equals the bank's balance sheet.

If a part owner of a bank holding company were to take on private debt, and sold his stake in the bank to satisfy the debt, that could reduce the bank's capitalization, drive down the value of other shareholders stake, curtail the bank's ability to lend, and affect the economic growth and activity in the surrounding neighborhood. Thus holders of bank charters are strictly regulated and supposed to be responsible with a proven track record in managing their own financial affairs.

The Glass-Steagall Act strictly regulated bank's and bank charter owners ability to use bank assets (i.e., a bank's capitalization, depositor's money, and earnings from its capitalization and depositors money). Under Glass-Steagall banks were limited to collecting interest off of lending depositors money (which a portion was paid back to depositors) or brokering deals -- bringing buyer and seller together and making a fee off the transaction without using the bank's own cash. Repealing Glass-Steagall opened the door to proprietary trading -- removing the heretofore strict requirements of banks to only invest or engage in the most conservative activities, and allowing them to purchase with bank stock and earnings, riskier assets with potentially more lucrative return, such as sub-prime mortgages[15] and insurance companies loaded with potential risk and liabilities.

The Volcker Rule, named after former Federal Reserve Chairman Paul Volcker and part of the Dodd-Frank Fin Reg bill aimed at Wall Street reform, is an effort to allow the Federal Reserve stricter oversight of bank holding companies ownership and activities, which is difficult due to confidentiality agreements and privacy rights.[16]

The United States is the only country in the world to have ever imposed the segregation of consumer banking and investment banking which existed under Glass-Steagall.

External links[edit]

See also[edit]

Icon fun.svg For those of you in the mood, RationalWiki has a fun article about Fractional-reserve banking.



  1. Steve Keen, Debunking Economics - The Naked Emperor Dethroned? p.308
  2. Martinez, Raoul, Creating Freedom: Power, Control and the Fight for Our Future (Edinburgh, 2016), accessed at,+as+too+many+textbooks+still+suggest,+take+deposits+of+existing+money+from+savers%22&source=bl&ots=PCrJyDmPc4&sig=6JFaITQbHpXBZK5cOh2ifMTI1us&hl=en&sa=X&ved=0ahUKEwi18tG5-PHWAhVCmpQKHbz8CgIQ6AEILjAB#v=onepage&q=%22Banks%20do%20not%2C%20as%20too%20many%20textbooks%20still%20suggest%2C%20take%20deposits%20of%20existing%20money%20from%20savers%22&f=false
  3. Keen, Steve, Debunking Economics – The Naked Emperor Dethroned?, second edition, (New York, 2011) p.307-312
  4. printed in Keen, Steve, Debunking Economics – The Naked Emperor Dethroned?, second edition, (New York, 2011) p.313
  5. Hudson, Michael, Killing the Host: How Financial Parasites and Debt Destroy the Global Economy (Baskerville, 2015) pp.82-84
  6. Those guys are really against fractional reserve banking? I really didn't expect that these guys want to destroy capitalism.
  7. Hudson, Michael, Killing the Host: How Financial Parasites and Debt Destroy the Global Economy (Baskerville, 2015) p.158
  8. Commercial banks by far create more new money daily by interbank lendingWikipedia's W.svg than the Federal Reserve does. Depositing loan proceeds drawn on one bank with another bank creates new money (the same money appears as an asset on both bank's ledgers). The daily reconcilation of accounts between banks - cashing checks drawn on each other's accounts, and banks with surplus deposits helping a bank with a lot of loan activity in one day causing it to fall below reserve requirements, also affects interbank lending, See here Note 7.
  12. In Great Britain interbank borrowing is done at the LIBOR rate. In the United States, commercial interbank borrowing to meet reserve requirements is done at the Federal Funds rate, also known as bankers cost of funds.
  13. Defintion: bank holding company
  14. Bank Holding Company Act. Capital Adequacy Guidelines:Risk-Based Measure.
  15. Regulation Y Revised, Federal Reserve Bank of San Fransisco.
  16. The "Volcker Rule": Proposals to Limit "Speculative" Proprietary Trading by Banks, Congressional Research Service, June 22, 2010.