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Fractional reserve banking

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dmuldoon posted on Mon, Feb 9 2009 11:38 AM

Hello,

 

I am a layperson only recently exposed to the Austrian school of economics.  I'm fascinated by it and I'm buying what you're selling.  I do have a question:

 

I've read a few books by Murray Rothbard and he's critical of the fractional reserve banking system.  What I do not understand:  without fractional resreve banking, how can money be loaned and how could a bank possibly pay me interest?  I certainly understand the risk of fractional reserve banking, especially when rerserve requirement is very low but I don't understand what the alternative is.

 

Thanks.

 

Don

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Verified by dmuldoon

Thanks for your answer.

 

But - how do you loan the first dollar?  i.e., if, as a bank, all my deposits must be backed, isn't 100% of my money not loanable?

 

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Answered (Verified) Bogart replied on Mon, Feb 9 2009 12:12 PM
Verified by dmuldoon

This is an easy answer:

There are a bunch of ways to get money without making fractional reserve loans on deposits that users can claim immediately:

1. Most Common: Issue equity.  That is you sell ownership in a bank, normally done through stock holders but can be done through a mutual system.  In either case the investors are not contractually obligated to be paid the money back.  Understand that if the bank makes more than the interest rates then the investors get more money paid back.  There are many more insurance companies that use the mutual system and it has advantages.

2. Contract deposits now for money later.  A certificate of deposit is an example.  The agreement for higher interest rates means the depositor has limit access to their deposit unlike a checking account or passbook savings.  This method includes selling long term bonds.

 

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Verified by dmuldoon

In all likelyhood there would arise, in a stateless society, two different kinds of institutions.

The first would be a true financial intermediary, who would facilitate the loaning of money. There profits would be the result of arbitrage. For example, person A comes to the bank offering them money for 5% per annum, they would then lend this money at a rate higher than that and (e.g. 6% per annum) and then pocket the difference as a profit.

The second would be more like a warehousing business with whom individuals would conduct a monetary irregular deposit contract. The bank would charge a sum of money in order to guard the gold (or whatever other commodity) and this is how they would make money.

"You don't need a weatherman to know which way the wind blows"

Bob Dylan

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Verified by dmuldoon

dmuldoon:
how do you loan the first dollar?

You have to get a depositor (or an investor) to allow you to do so. That's what a CD is for example. Remember you only need to maintain 100% backing for demand deposits.

The definitive work on this subject from an Austrin perspective is De Soto's book Money, Bank Credit, and Economic Cycles. It's available online in pdf format here.

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They will answer:

You can only lend out as much money as you have. So if a bank has X amount of $'s in deposits, it can only lend out X $'s.

So if it pays 3% in interest on deposits, and makes 5% on loans, it would in theory make profit.

Ixtellor

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I think I am going to sticky this thread, because this must've been asked at least a hundred times by now (not the OP's fault), so that it's readily available for future participants to see.

Freedom of markets is positively correlated with the degree of evolution in any society...

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Verified by dmuldoon

Thanks for your answer.

 

But - how do you loan the first dollar?  i.e., if, as a bank, all my deposits must be backed, isn't 100% of my money not loanable?

 

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Answered (Verified) Bogart replied on Mon, Feb 9 2009 12:12 PM
Verified by dmuldoon

This is an easy answer:

There are a bunch of ways to get money without making fractional reserve loans on deposits that users can claim immediately:

1. Most Common: Issue equity.  That is you sell ownership in a bank, normally done through stock holders but can be done through a mutual system.  In either case the investors are not contractually obligated to be paid the money back.  Understand that if the bank makes more than the interest rates then the investors get more money paid back.  There are many more insurance companies that use the mutual system and it has advantages.

2. Contract deposits now for money later.  A certificate of deposit is an example.  The agreement for higher interest rates means the depositor has limit access to their deposit unlike a checking account or passbook savings.  This method includes selling long term bonds.

 

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Suggested by eliotn

Banks today perform two seperate functions.

  1. Warehouse money
  2. Make loans

These two activities are not neccesarily linked. What fractional reserve banks do is the monetary equivalent is renting out furniture left in a U-Store it.

Peace

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Verified by dmuldoon

In all likelyhood there would arise, in a stateless society, two different kinds of institutions.

The first would be a true financial intermediary, who would facilitate the loaning of money. There profits would be the result of arbitrage. For example, person A comes to the bank offering them money for 5% per annum, they would then lend this money at a rate higher than that and (e.g. 6% per annum) and then pocket the difference as a profit.

The second would be more like a warehousing business with whom individuals would conduct a monetary irregular deposit contract. The bank would charge a sum of money in order to guard the gold (or whatever other commodity) and this is how they would make money.

"You don't need a weatherman to know which way the wind blows"

Bob Dylan

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Verified by dmuldoon

dmuldoon:
how do you loan the first dollar?

You have to get a depositor (or an investor) to allow you to do so. That's what a CD is for example. Remember you only need to maintain 100% backing for demand deposits.

The definitive work on this subject from an Austrin perspective is De Soto's book Money, Bank Credit, and Economic Cycles. It's available online in pdf format here.

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I cannot see how fractional reserves would not arise. Too much benefit for potential banks and borrowers.

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Benefit? Like the business cycle?

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Becoming insolvent is very beneficial.

"You don't need a weatherman to know which way the wind blows"

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Suggested by viresh amin

You know, banks would not have done it if it was not beneficial to them. And borrowers like more lending.

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It was only beneficial because they had help, from the state.

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I think you would see banks from time to time engage in fractional reserve banking. Although we might see deposits move to a more secure bank, it is in the interest for the bank to try to balance fractional reserves and the rate of withdraws - they fail, but they would still try.

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They were not helped by the state. Only quite lately.

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