Shermin Voshmgir: March 28, 2024
This is an excerpt from the book Money, NFTs & DeFi. Other books in this series are: “DAOs & Purpose Driven Tokens” & “Web3 Infrastructure.” Read more on all books and previous editions here.
The term “Fractional-reserve banking” refers to a banking practice where banks only hold a fraction of their customers’ bank deposits as liquid assets in reserve, and are allowed to lend the remainder of the money to other customers, thereby earning money with their depositors’ assets. This practice has been adopted by most countries and stands in contrast with “full-reserve banking,” where banks are required to store the full amount of each depositor's funds in cash, so it can be withdrawn by the depositor at any point in time. In a full-reserve setup, customer deposits are not lent to someone else.
Fractional-reserve banking is a practice that predates the formation of governmental monetary authorities. It probably originated in 17th century Europe, when goldsmiths and similar service providers realized that most depositors of gold would not ask to redeem their gold deposit at the same time. Depositors preferred to leave their gold coins in safekeeping of the goldsmith – in exchange, they received a promissory note for their deposits, which they then used as a medium of exchange for commercial transactions. Goldsmiths started to generate income from charging interest on loans, offering deposit and note issuing services, and gradually turned their business into interest-paying and interest-earning banks.
Promissory notes themselves were not a new concept, but date back to the Code of Hammurabi and have also been used by other ancient civilizations such as the Han Dynasty in China. Earlier variations of promissory notes were used in Europe by the Romans and became popularized with the Templars during the crusades. Before setting out on their pilgrimage, the Templars issued promissory notes to pilgrims against their deposited valuables with a local Templar preceptory. Upon arrival in the “Holy Land” they could use this note to retrieve the funds deposited at home.
Modern Practices
Fractional-reserve banking practices were eventually adopted by all financial institutions – including central banks. Today, fractional-reserve banking has become a practical instrument for monetary policy authorities such as central banks to expand the money supply of the economy with support of private banks. On the flip side, fractional-reserve banking increases the risk of depositors losing money, if a bank cannot meet the demands of its depositors.
- RRESERVE REQUIREMENTS Today, central banks or similar governing authorities determine the mandatory minimum reserve requirement of depositor money that banks need to maintain either as cash in their own bank, or as the private bank’s balance in the central bank’s balance sheet. Minimum reserves have been calculated to meet average expected withdrawing volumes of depositors. These reserve requirements only guarantee liquidity to pay bank customers their money within a statistically determined “normal” range of expected withdrawal rates. In extraordinary times – if there is a so-called “run on banks,” where more than the normal number of customers want to withdraw their money at the same time – the bank will not have enough reserves to pay back its depositors.
- BANK RUN In normal economic times, fractional-reserve banking works quite well. Depositors usually only want to withdraw their money simultaneously if they lose trust in one bank in particular or the financial system as a whole. Historically, this only happens when depositors lose faith in the ability of one or several financial institutions to pay out their deposit. Bank runs caused the demise of many early banks and were the reason for the financial crisis between World War I and World War II. As a result, reserve requirements and other default mechanisms offered by central banks were adopted. Today, a defaulting bank can borrow or sell assets to call in liquid short-term loans, or resort to the central bank as the “lender of last resort.” Banks can either have a “liquidity crisis” or a full fledged “solvency crisis.” A liquidity crisis is a serious but only short-term problem –where a bank has enough assets, it just can’t turn them into cash fast enough to meet the demand for withdrawals. This liquidity problem can be bridged by calling in short-term loans. A solvency crisis is much more serious, as it means that a bank or similar financial institution just doesn’t have the assets to pay back short-term loans. A lender of last resort or other government institutions can still choose to bail out the financial institution if they think that they are “too big to fail” and the collateral damage of default would be too big. This type of bailout, however, is ultimately paid by taxpayers and highly controversial.
- MONEY AS DEBT The practice of fractional-reserve banking enables money creation by commercial banks. This is due to the fact that there are two types of money in a fractional-reserve system: (i) central bank money and (ii) commercial bank money. Central bank money is created by central banks and includes all forms of accepted money issued by the central bank, such as banknotes and coins, electronic money loaned to commercial banks, precious metals, commodity certificates, etc.). Commercial bank money refers to all forms of credit issued including checking accounts and savings accounts. The total money supply consists of the central bank money (called “base money”) plus commercial bank money. Each time a commercial bank gives out a loan, the global money supply of a currency grows beyond the amount of the underlying money (base money) that was created by the central bank. This means that new money, in the form of credit (or debt), is created whenever a bank gives out a new loan. The money supply is contracted when a borrower pays back the principal on the loan. Due to fractional-reserve banking, the money supply of most countries is much larger than the base money created by the country's central bank. When the media writes about the central bank printing money, they often refer to the fact that a Central Bank chooses to increase the money supply by allowing the issuance of more debt through monetary policy instruments, thereby increasing the overall money supply. This newly created money does not directly flow into the real economy. Instead, commercial banks can now issue more loans to individuals or businesses. Except for a certain amount of paper money, money is never actually “printed.”
- MONEY MULTIPLIER Since bank reserves are always less than the amount a bank owes to their depositors, the ratio of the total money supply to base money is referred to as the “money multiplier.” The level of the money multiplier depends on the reserve requirement ratio and other requirements that are defined by financial regulators. Private banks are authorized to issue credit up to a specified multiple of its reserves, and this multiple is determined by central banks and similar financial authorities.
- DEPOSIT GUARANTEES are a mechanism provided by Central Banks to protect consumers to a certain extent. In the EU, the deposit guarantee is 100,000 Euro per person per institution. Deposit guarantees are usually regulated by central banks but paid for by the credit institutions themselves. In the event of insolvency of a bank, investors are – in theory – entitled to their deposit guarantee.
Monetary Policy Authorities & Policies
Historically, central banks were created to regulate bank-credit creation by imposing parameters such as reserve requirements and other mechanisms to maintain the stability of the banking system. Their main role was to make sure that banks remain solvent and have enough funds to meet demand for withdrawals. Over time, their role has grown, and they started working hand in hand with governments to influence macroeconomic parameters such as interest rates, inflation rates, unemployment, and the international balance of payments of their country.
Their general activities are usually related to adjusting the money supply to balance inflation while stabilizing economic output of an economy and employment rates. While taxation and government spending are also important monetary policy tools, they take much longer to legislate, and the effects are more long term. This is one of the reasons why in more urgent economic situations, governmental institutions tend to “quick fix” economic problems by adjusting the money supply, instead of deploying longer term and potentially more sustainable fiscal and monetary policies.
The monetary policy mechanisms of a currency depend on the type of money used. Back when gold and silver were used as money, the supply of money was determined and limited by the actual supply of the precious metals and the limits of physically minting coins, which meant that the monetary supply was determined by market dynamics of the gold and silver market. This is why European rulers invested so much money in the discovery and colonization of the Americas and other continents – they were hoping to find gold and silver to be able to mint more coins. This led to periodic gold rushes – when Columbus returned from the Americas with gold and silver, or much later, when gold was discovered in California.
The mining of new gold and silver sources from abroad led to short-term growth in wealth for the extractors of that gold – predominantly, the Europeans at the expense of the indigenous populations. However, in the long run, the supply shock of these gold coins led to inflation in Europe, and the value of gold went down. In the 18th and 19th centuries, the rate of mining could not keep up with the growth of the economy, which led to deflation.
In a fiat-based monetary system – which was effectively introduced by US President Richard Nixon in the 1970s – money is not tied to the value of gold; instead, it is issued through fractional-reserve banking which is controlled by central banks. Today, monetary policy authorities have varying degrees of autonomy from the governments that created them.
- INFLATION An unsustainable monetary policy can have significant negative effects on an economy in the medium to long run. Effects could include hyperinflation, stagflation, recession, high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse. At the time of writing this book, the world economy might be at the brink of hyperinflation which can be largely attributed to 15 years of so-called “quantitative easing.” It was first deployed by the US federal reserve and eventually also other monetary policy authorities and central banks worldwide to cope with the collateral damage of the global financial crisis (2007-2009). Quantitative easing refers to the practice of central banks buying government bonds and other financial assets such as stocks, corporate bonds or municipal bonds, thereby increasing the size of the central bank’s balance sheet. The goal is to inject cash into the economic system to maintain economic growth when standard monetary policy instruments have become ineffective. While quantitative easing as a short-term tool can help an economy out of a recession, long-term application of this tool can bring the risk of creating higher inflation. Prior to 2009, quantitative easing was a rather unconventional monetary policy tool, but after the global financial crisis, it has become somewhat of a standard practice. Empirical evidence has shown that there is a direct relationship between the rapid or continuous growth of the money supply and long-term price inflation.
- EXCHANGE RATE The exchange rate of a currency refers to the price at which two currencies can be exchanged against each other. They can be “floating” or “fixed.” Floating exchange rates means that the price is determined by supply and demand on foreign exchange markets. Fixed exchange rates are controlled by governmental institutions that intervene in the market to buy or sell their currency to balance supply and demand and keep the price at a fixed target rate.
Read more in the book Money, NFTs & DeFi.
REFERENCES
This link will lead you to a website that contains all the references to the source materials used for the research of the chapter, and should also provide a reading list for all those who are interested in a deeper dive into the topics presented.