Fractional-Reserve Banking: Money as Debt

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.

Modern Practices

• 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

• 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.

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