Fractional reserve banking

The expression "fractional reserve banking" describes a banking system where a par- ticular bank's liability, namely deposits, is used as means of payment. Deposits become means of payment when they are made transferable, either by cheque or by note, which is a cheque payable to the bearer without reference to the depositor against whose deposit it was originally issued. In this system we can distinguish two kinds of money: (i) legal money, issued by the central bank and held by both banks and non-bank agents as reserves, which are known as "narrow money", "high-powered money" or "monetary base"; and (ii) bank deposits, that is, bank money. The sum of these types of money is called "broad money".

The concept of the money multiplier makes it possible to define the link between "narrow money" and "broad money". Orthodox economists assume that the process begins when, for instance, 100 euros of monetary base, issued by the central bank, are deposited into Bank A. Bank A is not required to create a reserve of 100 euros, as happens in a full-reserve system, but can choose to establish a reserve equal to a frac- tion k of deposits, for example equal to 10 per cent of deposits. Then Bank A can lend out the remaining 90 euros. The loan recipient soon spends these 90 euros, and we can assume that the receiver of this amount deposits it to Bank B. Bank B is now in the same situation as Bank A: it sets aside 10 per cent of these 90 euros as reserves and lends out the remaining 81 euros. The process continues until the entire new monetary base will be used by banks to increase their reserves. As reserves correspond to 10 per cent of bank deposits, the maximum amount of deposits that can result from the initial creation of monetary base equal to 100 euros, corresponds to 1000 euros. Denoting by D the amount of deposits, by k the banks' rate of reserves, and by BM the monetary base, we obtain the following equation:

\( D= \left( 1/k \right) BM \)

The expression 1/k is called the "money multiplier": it calculates the maximum amount of bank deposits that corresponds to a new unit of monetary base, given a reserve ratio equal to k (see Realfonzo, 1998 for an analysis of the development of the theory of bank deposit multipliers).

Orthodox economists believe that central banks can control the quantity of bank deposits by managing the monetary base and that the money multiplier does not change the nature of banks. Cannan (1921, p. 31), for example, points out that banks do not create money but are intermediaries that lend what they collect: "If the total of bank deposits is three times as great as the total of coins and notes in existence we need no more suppose that the banks have 'created money'".

The analysis of heterodox economists is different. Schumpeter (1954, p. 1114), for instance, criticizes Cannan by stressing that banks create money when they receive a deposit, because they give the depositors an asset that "though legally only a claim to legal-tender money, serves within very wide limits the same purposes that this money itself would serve". This implies that depositors "lend nothing in the sense of giving up the use of their money. They continue to spend, paying by check instead of by coin. And while they go on spending just as if they had kept their coins, the borrowers likewise spend the same money at the same time" (ibid., p. 1114). Further, banks can create money when they grant a loan: in fact, they do not have to lend out legal-tender money. Against the obligation of the borrower, they can supply deposits: that is, an obligation of their own which is transferable by cheque. Schumpeter (ibid., p. 1114) concludes that the rela- tionship between deposits and loans described by orthodox theory should be inverted: "It is much more realistic to say that banks 'create credit', that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them."

The traditional Keynesian theory has not given particular attention to this point: Tobin, for example, developed a theory of financial intermediaries that neglected the banks' ability to create money (see Bertocco, 2011). On the other hand, this point is the core of endogenous money theory, elaborated by post-Keynesians, who invert the causal relationship between deposits and monetary base compared with orthodox theory (see Bertocco, 2010). The supporters of the loanable funds theory, too, follow- ing Wicksell's lesson, recognize the banks' capacity to create money, but they conclude that this fact does not modify the structure of the economic system with respect to an economy without banks. In order to challenge the loanable funds theory, which can be considered as the theoretical foundation of the mainstream, the main task of post-Keynesians is to explain why bank money is the crucial element to describe what Keynes defined as a "monetary economy"; that is, an economic system where the pres- ence of money radically changes the features of the production process (see Bertocco, 2013a, 2013b).

See also:

100% money; Bank deposits; Central bank money; Chicago Plan; Endogenous money; High-powered money; Monetary circuit; Money and credit; Money multiplier; Reserve requirements.