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The norms of modern banking are something that most of us take for granted. Few ever question the inner mechanics of such transactions we engage in daily. However, banking has been steeped in a fog of mystery due to complex operations and seldomly failing to fulfill any obligated services. Beyond questioning the functions or internal workings of modern banking even fewer people recognize that most people are participating in a fractional reserve banking system. In a random survey of average people, you will be hard-pressed to find anyone aware of what fractional reserve banking entails nor any intimate understanding of its implications. That is to be excepted considering this is a niche area of expertise that is truly the domain of an economist, banking/ financial specialist. This assumption relieves us of any responsibility to cultivate a better understanding of these systems. After all, this is best left to the experts. How do we know whether there any inherent risks associated with fraction reserve banking? Do we just assume that due to the fact it is the most common banking system that it is the most effective and secure? Better yet, is it even a moral system of banking, or is deceptive by design and tantamount to fraud?

Over the past several decades, a controversy has been brewing among monetary economists concerning fractional reserve banking, Modern economic theorists of the Austrian School who are generally hard money advocates, find fractional reserve banking to illegitimate to its core. Equating it fraud and perceiving it to be antithetical to a free market in money. Whereas free-banking (an economic school that is arguably an outgrowth of the Austrian School) do not see fractional reserve bank as immoral. Rather, such institutions could not only ethically co-exist with 100 % reserve banks but also flourish. Any ethically questionable operations were the byproduct of government intervention and mutually exclusive from the banking practice (p.8). While their Austrian counterparts insist that the practice not only supports the monetary objectives of the state but owes its existence to the state (p.9, p.15-17).In this series of essays, we will examine the ethical arguments for and against fractional reserve banking. To present an unbiased account of the controversy.

What is Fractional Reserve Banking?

Before we can embark upon discussing the ethics of fractional reserve banking is important that we define what it is. On a high level, fractional reserve banking is a system in which banks are required to only hold a fraction of money deposited as reserves. This is done to enable banks to make loans. The recipient of the loan receives a transfer of deposited money upfront which they are expected to pay interest on. The bank customer who deposited the money that was lent out theoretically will receive the money-back in their account with sustained interest. This is done to expand the economy through “freeing capital for lending”. This is done without the depositor relinquishing their claim to this money. Effectively creating more money titles than physical money held on reserve at the bank (p.3)  The foundation of this banking system is fastened to the assumption that most customers with savings accounts will not simultaneously withdraw all of their savings at once. Otherwise, this could lead to what is known as a bank run. A phenomenon where the bank as completely depletes their liquid reserves. Since they are only mandated to hold a relatively small portion of reserves on hand.

Reserve requirements typically hovering around 10 % (presumably applicable to central banks).  Most reserve requirements are contingent on the bank’s size. Banks holding less than $15.2 Million in reserves are exempt from maintaining reserve minimums. The requirement of 10% reserves is applicable to banks holding over $100.2 million in deposits. Per the Garn-St Germain Act  banks are free from any reserve requirements for their first $2 million held. This legislation was initially passed by the Regan administration as a means of relieving pressure on banks as the federal reserve significantly increased interest rates. Banking institutions that hold excess reserves or amounts of deposited money above reserve requirements are entitled to interest payments. Under the Financial Services Regulatory Relief Act of 2006, these interest payments are allocated by the Federal Reserve.

As mentioned above fractional reserve banks issue more money titles than currency on hand. Through this process, they engage in form of indirect “money” creation. The loan itself treats the money titles as being equally as valid as actual currency notes. When the loan is issued the bank “credits” the borrower’s account with an amount equal to the loan, mimicking a transfer of physical cash. The methodology of money creation on the part of fractional-reserve banks has been distilled down to a science. Guided by the money multiplier principle. This concept broadly describes how “.. initial deposit leads to a greater final increase in the total money supply”.  More specifically how much commercial bank money ( demand deposits that can be utilized for credit and debit purposes, basically your residual after reserve requirements) using a defined unit of central bank money. Central bank money is any medium of exchange that these institutions acknowledge as being money. The correct proportion of “money” creation is determined by the below equation:


M=  Money Multiplier, R= Reserve Requirement

13 thoughts on “Is Fractional Reserve Banking Ethical- Part I- An Introduction

  1. Reblogged this on The Most Revolutionary Act and commented:
    98% of money in circulation is created (out of thin air) by private banks when they issue loans. Especially in light of massive public debt related to the COVID economic crisis, there are growing calls to end this debt-based system of money creation. Government doesn’t need to borrow money (from banks or anywhere else) to fund deficits. Most have the power to issue the money directly into the economy and to pay off existing debt with government-created money.

    Liked by 1 person

    1. You certainly make some excellent points. Thank you for the reblog. MMT and corresponding policies are certainly concerning to say the least.

      However, I do want attempt to provide an unbiased account of the free-banking and Austrian perspectives on the matter.


  2. An Impressive preamble! I will be reading parts 2-4 of this collection as soon as time permits me. Milton Friedman, of the Chicago school, has a fascinating chapter within his book “Capitalism and Freedom” in which he specifically addresses the practice of fractional reserve banking. It was definitely eye-opening to discover how one person’s deposit (or a certain portion of their deposit) soon became another person’s withdrawal or loan. I also acquired some knowledge about bank failure [or in the case of this article “bank run?”] and the catastrophic economic implications that accompany it.

    Liked by 1 person

    1. That’s excellent to have that background knowledge. Most people are completely clueless of how this system works.

      To be fair, if the system hasn’t failed you what is the incentive to be familiar with its inner mechanics? The consequences of its failure can be quite profound.

      Liked by 1 person

      1. Yes. However, when the system does produce unfavorable circumstances for those that rely on them, opportunistic politicians may step in and exploit the popular feelings of the time to gain power. For example, they may attempt to paint the occasional reality of high prices as a consequence of “greediness” on the part of sellers. Although we understand that assuming “greed” to be the cause of high prices is very illogical, many don’t.

        Anyway, they should really consider teaching these economic principles more broadly in our educational institutions.

        Liked by 1 person

        1. If we had a population that was economically literate, politicians wouldn’t be able to rely on the standard bargaining chips to win votes (the promise of nominally “free” services).

          While I agree with your points, I don’t believe the invested interests would ever let that happen. Enlightened voters would actually expect accountability. Not lofty promises.

          Liked by 1 person

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