Fractional Reserve Banking

Article by Ben Doolin on Mar. 7, 2016



Many Libertarians speak very negatively about Fractional Reserve Banking.  While I do agree that the system we have today is criminal, the problem does not come from ‘Fractional Reserve’… it comes from fraud and monopoly.

Fractional Reserve Lending creates unlimited amounts of new money since new loans don’t represent a lending of savings… it is simply a journal entry in the bank’s books… effectively creating new money.  The bank creating the loan then borrows a fraction of the money lent, from another bank that has reserves in excess of their own reserve requirement or if total lending for the day increases… The Fed lends ‘newly created money’ to the bank to cover it’s reserve requirement.

The suggestion often made… is that ‘the gold standard’ limited the amount of new money created by requiring the issuing bank to have a corresponding amount of gold ‘in reserve’.

The problem with that idea… is that when we did have the gold standard… the nation only had about 30% of the money supply backed by gold… and it didn’t restrict lending.

The gold standard was forced to end because France started to collect US Currency and demand the gold which it immediately sold on the world market for a large profit.  It would have only been a few more cycles of them doing that to completely deplete the US gold reserves.  The gold standard didn’t work, because it relied on fixing the price of gold.  While they could enforce that in the US… they couldn’t control the price of gold for the rest of the world.

The System of Fractional Reserve Banking that we have now… represents fraud by omission.  The most important aspects of the system are not understood by the customers that it puts at risk.

The promise made by banks is that your money is instantly available… but still earns interest.  The problem is that that promise can’t be honored for more than a tiny percent of customers at one time.  If a large number of customers attempt to withdraw large amounts (or all) of their money, it’s called a ‘bank run’ and often precedes the failure of the bank… since it can not honor all its promises.

The same banks also operate almost completely in secret while being hugely leveraged leaving them exposed to bankruptcy as a result of a minor economic downturn… something few banking customers are aware of.  This secrecy is also what shut down the banking industry in ’08.  Because no bank could tell which other banks were ‘at risk for failure’… no bank would lend to other banks which locked up the whole system as it made new lending almost impossible.


The fact that The Federal Reserve is the only entity that can legally issue currency and create new money means that free market protections are eliminated.  This means that they can violate their customers in almost any way they want… without consequence.

The Fed has a policy goal of devaluing your money by 2% per year.  Would you use their currency if there was an alternative issuer that had a policy goal of increasing the value of your money by 2% per year?  The Fed also manipulates interest rates… currently at close to 0%.  If alternatives that were safer and paid more were available… would you still participate the The Federal Reserve system?  It is free market competition that protects consumers.  Customers in a monopoly system… are victims.


In a free market, fraud and violently enforced monopolies would be crimes with consequences.

That though, would not preclude fractional reserve lending.

First lets consider the alternative… 100% reserves.  That means that the bank would hold your money but would not lend it… since doing so would mean it’s not available for instant withdraw.  It also means that the bank would be providing a service for which it generates no revenue.  This means that in addition to not paying any interest, that type of account would likely have to have a large monthly fee.

For people that wanted a return on their money in exchange for taking some degree of risk… they could allow the bank to lend their money and ‘split the interest’.  No doubt banks would provide varying degrees of reserves or leverage designed to meet the risk / reward demands of their customers.

This though… would have to be completely transparent… which is to say that ‘your money might not be immediately available’ and the smaller the reserves and greater the leverage… the greater risk of the bank failing.  An example of money not being immediately available would be the bank agreeing to keep 10% reserves and experiences a ‘rush for cash’ that depletes that 10%.  In that scenario, you might have to wait for loan payments to come in to make a withdraw… a condition that would be part of the contract up front.

The other fraudulent aspect of unexplained risk… is leverage.  Today most major banks are massively leveraged in an effort to make a return in a low interest rate environment.  There are $4 quadrillion in open derivative contracts (like the credit default swaps that brought down the banking system in ’08).  Those derivatives have about 3% in assets backing them… which is to say that if the value of the open positions goes up 3% the banks have doubled their net worth but if they fall 3% the bank is completely broke.

They do this for the combination of greed (profit motive when combined with evil intent… like the fraud that supports our banking system) and the knowledge that all of the major banks expect to be bailed out when the market does go down… as the smallest ‘big bank’ today is now bigger than the biggest ‘too big to fail’ bank in ’08.  So, they have nothing to lose (losses covered by tax payers) and trillions to gain.

Still, this time round… there might not be enough money in existence (more or less what can be taken from tax payers) to cover losses from a major bank going broke… and that risk is not explained to bank customers.

Leverage could still work in a free market though… because of the lack of monopolies and the requirement of full disclosure.

A ‘normal bank’ would lend a percentage of what it takes in.  For example, it could take in $100,000 in deposits and make loans for $90,000… keeping a 10% reserve and paying some of the interest to the depositors.

A competitor could offer an interest rate ten times higher by employing leverage.  When they take in that $100,000 in deposits… they keep all $100,000 in reserves and make loans for $900,000.  As long as the risk was completely transparent… more risk for more reward… this would be completely fine.  To survive in a free market, they would have to be very good at what they do, to attract and keep customers… which would include accurately determining loan risk and monitoring the value of their currency, since a drop due to excess ‘new currency’ could lead to loss of market share or even bankruptcy.

So, I have no doubt that many will want security to the greatest degree possible and will only deal with banks that do not lend, holding 100% reserves.

On the other hand… people tend to save for retirement and want a secure return on their savings to live on without depleting their principal.  So, I expect that even conservative investors will want to take ‘some risk’ because safely going broke, is a possibility.  There will also always be gamblers… so no doubt there will be options that employ heavy leverage.

In conclusion, the problem is the crime of The State… not Fractional Reserve lending.