Fractional Lending and the Economy of Promises

Those who are critical of the current global-capitalist economic system, particularly those suspicious of banks, frequently center in on the principle of fractional reserve lending as central to the abuses endemic in the current financial order. The arguments against fractional reserve lending are many: it introduces instability into the financial market by floating loans conjured out of thin air and backed by nothing; it is fundamentally dishonest because it operates not unlike a ponzi scheme; that it is unjust because the lender always has a power denied the borrower (the power to create money out of nothing but promises to pay), and that it is essentially an anti-Catholic concept because it divorces the buyer and lender from trade in real, tangible goods and instead is based around the exchange of fictions created on paper that only have reality because they have the force of law. Much could be said about fractional reserve lending, and there are those who adamantly defend it as a necessity in any vibrant economy. This article will merely sketch the basics of fractional reserve lending and point out a few objections to the practice from a Catholic-Distributist standpoint.

How Fractional Reserve Lending Works

First, let us define our terms. Fractional reserve lending is a form of banking whereby the bank only maintains a small fraction of the total amount of its customers' deposits as reserves. The vast majority of deposits are lent out, and the bank keeps a fraction on hand as what is called a "reserve ratio."

For example, suppose I deposit $100 into my bank. According to what we are taught in middle school, that $1,000, so long as I do not spend it, will just "sit there" in the bank's "vault" collecting interest. This was often explained to us in terms of the prudence of investment, demonstrating how letting our money sit in the bank will actually make us money.

However, as we come to find out as adults, our $1,000 does not, in fact, sit in the bank. Most of it will be lent out. Let's follow where that $100 goes and how my deposit of $100, far from just sitting inactively in a vault, will actually be used to pump almost nine times as much debt into the economy.

When I deposit my $100, the bank enters $100 onto my account and adds these funds to its overall balance sheet. I receive a piece of paper affirming that I have deposited $100 at the bank (call it Bank A) and can get it back in full at any time. I go away happy.

However, the bank does not want the money to sit idle. It wants to use my money to make money. It does this by loaning out my deposits to others at interest. However, the bank cannot simply loan out the funds of all its depositors; that would be irresponsible. It must maintain some cash on hand in case I, or anyone else, comes back to get my $100 back. Therefore, the bank will only loan out most of my money; a small fraction of all deposits will be saved on hand. How much will be reserved is determined by law; currently, in the United States, the reserve requirement is 10%. So the bank is free to loan out $90 out of the $100 I deposited, keeping $10 in reserve.

You might wonder, how can the bank maintain an adequate amount of reserves at only 10%? If it has, for example, $20 million in deposits, how can ten percent of that ($2 million) be enough to satisfy depositors in case they all come back looking to withdraw their funds? The answer is that bankers realized long ago that depositors will never all show up on the same day to withdraw their money. Thus, they never need to have 100% of funds on hand. 10% is more than enough, as less than 10% of depositors will show up on any given day to withdraw money. When more than 10% do, there is a run on the bank, and the bank will usually have to close.

So the bank can lend out $90 of my $100. Suppose it lends it out to somebody else in the form of a $90 check. Notice that at this stage, money has been created out of thin air. While retaining $100 on its own balance sheet, Bank A has issued a $90 check to the borrower who will either cash or deposit it at his own bank. My $100 deposit has generated another $90 of value. But correspondingly, there is now $90 more debt issued as well.

The money given to the borrower will eventually get deposited somewhere, call it Bank B. Now, we know Bank B must keep 10% of this $90 on hand but is free to loan out the other 90%. So Bank B loans out $81 of the $90 and retains $9 on hand as the required 10% reserve. Another $81 has been created out of thin air and will eventually make it into Bank C. Bank B retains that $90 in its depositors account while loaning $81 of it out, and Bank A still retains (on paper) my $100 deposit while loaning $90 of it out. By the time we get to Bank C, my $100 deposit has created $171 of "new money" ($90 + $81).

How long can this go on? In our example, it can go up to twenty cycles ("Bank T") before the reserve amount reaches zero; with larger sums, one could follow this through 94 cycles; basically it can go on until the reserve amount reaches near zero. In our example, starting with an initial deposit of $100, by the time we get to Bank T, there is $878 in circulation and the reserve amount of Bank T would be $1.35. So, starting from $100, $878 has been created. This is how fractional reserve


There are many objections to fractional reserve lending:

Since the bankers do not simply create money out of thin air (which is wonderous enough as it is) but do so at interest, it can be argued that the fractional reserve system is usurious.

But beyond that, we should note that this system of creating money only does so by introducing money as debt. Each new amount of money introduced into circulation is introduced in the form of a loan. Now, it is estimated that about 95% of the money in our financial system comes from loans issued from banks. This means that the amount of money in circulation is directly proportional to the amount of debt issued. So, the answer to the question, "How much money is there?" is very closely related to the question of "How much debt is there?"

Even more serious is the problem that the fractional reserve system of creating money only introduces the principal into the economy, not the interest. For example, suppose a bank, using fractional reserve lending, generates a $1,000 loan. $1,000 is created out of thin air and that money is put into the economy. But the loan is given out at interest, which means of course that the borrower will owe more than the $1,000. This isn't too problematic on an individual level, but when we realize that over 95% of our money is created by fractional reserve loan generation, it becomes evident that the system, as it now stands, can never introduce enough wealth into the money supply to pay for itself. There will always be a chronic lack of money that stifles production and investment, which in turn leads to an escalation of more debt. In fact, for the system to be sustainable, it presumes that some people will fall through the cracks and default on their loans. It has to be this way, since there is never enough wealth in the money supply to cover both principal and interest. Therefore, for fractional reserve lending to be sustainable, certain individuals must fail.

A system that creates the wealth to cover principal but never the interest creates artificial scarcity that throws people further into debt. Such a system cannot be considered just or really sustainable.

Some criticize the current system of government deposit insurance, government fiat currency as the base money, the Fed as the lender of last resort, bailouts, etc. as inefficient and illegitimate and creating a moral hazard; in other words, if deposits are backed by the FDIC, what incentive do the banks have to lend responsibly?

Some object to fractional reserve lending on the basis that it is misleading. The vast majority of people believe that their money is "sitting" in the bank and have no idea it is being lent out at interest. Discovering this truth can be very disconcerting if it happens during a financial crisis. In the past, people who have gone to the bank during bank runs only to be told that their money is not there have dragged the bankers out and lynched them. Of course, fractional reserve lending is no secret, but nevertheless most people do not understand that this is the way the banking system works.

From a Distributist standpoint

From the viewpoint of a Catholic influenced by Distributistism, the biggest problem with fractional reserve lending is that we are dependent upon a system that generates wealth at interest and enslaves people to debt. Any system of banking and lending we move towards ought to not be a system that systemically depends upon the issuance of debt and of people falling through the cracks.

Our nation needs to find a way to create money freely without interest. Currently, both the fractional reserve system and the creation of money ex nihilo by the Federal Reserve only introduce money into the money supply by doing so at interest. According to our Constitution, Congress ultimately has power over the printing of money, but this power has been ceded to the Federal Reserve and the banks. This ought not to be; our Congress ought to directly take charge of the issuance of money and do so free and clear without plunging us into more debt each time a dollar is printed.

Banks, of course, will still issue loans, and they will still do so at interest. If banks are still to engage in fractional reserve lending, the reserve requirement should be raised, perhaps not to 100%, but much higher than 10%. This would have the effect of introducing less money into the economy, but it would ultimately strengthen the value of our currency since it would halt the flow of cheap, easy money that has been such a bane to our financial system.

The issuance of money should also be tied directly to the productive capability of the nation, thus grounding the value of the currency in something real and tangible. Currently, it is grounded only in the will of the bankers to lend or not lend based on ephemeral, speculative factors. Grounding the issuance of money in the productive capacity of the nation will prevent the rise of speculative bubbles and encourage more responsible lending. It is uncertain how this would be done, however; some have suggested a sort of National Credit Office or something similar that would ensure that money generation is tied to productive capability. One thing is certain though - it cannot be left up to the whim of banks. Currently we have a financial; sector driven by debt and supported by nothing but loans and promises to pay - an economy of promises. We need to come down from the dream world and reestablish our economy in a firmer foundation.

I am no economist, and this article only touches on some of the most basic questions regarding the fractional reserve system; it will fall to others to further examine these issues and propose solutions. But one thing is certain - no reform of our economy is complete without a reform of our financial sector and how money is generated and moved in this country. The current state of our banking system is responsible for more economic mischief than anything else and it must be addressed.