After the failure of Silicon Valley Bank (SVB), a good number of Americans are beginning to realize the dangers of fractional reserve banking. Reports show that SVB suffered a significant bank run after customers attempted to withdraw $42 billion from the bank on Thursday. The following is a look at what fractional reserve banking is and why the practice can lead to financial instability.
The History and Perils of Fractional-Reserve Banking in the United States
For decades, people have warned about the dangers of fractional reserve banking, and the recent ordeal of Silicon Valley Bank (SVB) has brought renewed attention to the problem. Essentially, fractional reserve banking is a system of bank management that holds only a fraction of bank deposits, with the remaining funds invested or lent to borrowers. Fractional-reserve banking (FRB) operates in almost every country throughout the world, and in the United States it gained much prominence during the 19th century. Before this time, banks operated with full reserves, meaning they held 100% of depositors’ funds in reserve.
However, there is considerable debate as to whether fractional loans occur these days, with some assuming that invested funds and loans are simply printed out of thin air. The argument stems from a Bank of England paper called “Money Creation in the Modern Economy.” It is often used to dispel myths associated with modern banking. Economist Robert Murphy discusses these alleged myths in Chapter 12 of his book, “Understanding Money Mechanics.”
A primer on the mechanics of fractional reserve banking written by economist Robert Murphy can be read here.
The FRB practice spread significantly after the passage of the National Banking Act in 1863, which created the United States’ bank charter system. In the early 20th century, the fractional reserve method began to show cracks with occasional bank failures and financial crises. These became more prominent after World War I, and banking, highlighted in the popular film “It’s a Wonderful Life”, became common at the time. To fix the situation, a cabal of bankers called “The Money Trust” or “House of Morgan” worked with American bureaucrats to create the Federal Reserve System.
After further problems with fractional reserves, the Great Depression set in, and US President Franklin D. Roosevelt initiated the Banking Act of 1933 to restore confidence in the system. The Federal Deposit Insurance Corporation (FDIC) was also created, providing insurance for depositors who have $250,000 or less in a banking institution. Since then, the practice of fractional reserve banking continued to grow in popularity in the United States throughout the 20th century and remains the dominant form of banking today. Despite its popularity and widespread use, fractional reserve banking still poses a significant threat to the economy.
The biggest problem with fractional reserve banks is the threat of a bank run because the banks only hold a fraction of the deposits. If a large number of depositors demand their deposits back at the same time, the bank may not have enough cash on hand to meet these demands. This in turn causes a liquidity crisis because the bank cannot appease depositors and it may be forced to default on its obligations. One bank run can cause panic among other depositors who bank elsewhere. Large panics can have a ripple effect throughout the financial system, leading to economic instability and potentially causing a wider financial crisis.
Electronic banking and the speed of information can lead to the threat of financial contagion
In the movie “It’s a Wonderful Life,” news of insolvency spread through town like wildfire, but bank-driven news these days can be much faster due to several factors related to technological advances and the speed of information. First, the Internet made it easier for information to spread quickly, and news of a bank’s financial instability can quickly spread through social media, news websites, and other online platforms.
Fractional reserve banking does NOT work, especially in the internet and social media age.
Information and fear spread far too quickly for an institution to react.
What used to take weeks now takes minutes.
A weak institution can be exposed and crash within hours.
Secondly, electronic banking has made transactions faster and people who want to withdraw can do so without physically going to the branch. The speed of online banking can lead to a faster and more widespread run on a bank if depositors feel that there is a risk of their funds becoming unavailable.
Finally, and perhaps the most important part of today’s differences, the interconnection of the global financial system means that a banking operation in one country can quickly spread to other regions. The speed of information, electronic banking and the associated financial system may very well lead to a much faster and more widespread contagion effect than was previously possible. While advances in technology have made banking much more efficient and easier, these arrangements have increased the potential for financial contagion and the speed at which a bank run can occur.
Fraud and “waves of credit bubbles with barely a fraction in reserve”
As previously mentioned, many market observers, analysts and renowned economists have warned of the problems with fractional reserve banking. Even the creator of Bitcoin, Satoshi Nakamoto, wrote about the dangers in the ground-breaking white paper: “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of violations of this trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve,” Nakamoto wrote. This statement highlights the risk associated with fractional reserves, where banks lend more money than they have in reserves.
Murray Rothbard, an Austrian economist and libertarian, was a strong critic of fractional reserve banking. “Fractional reserve banking is inherently fraudulent, and if it were not subsidized and privileged by the government, it could not long exist,” Rothbard once said. The Austrian economist believed that the fractional reserve system relied on deception and that banks created an artificial expansion of credit that could lead to economic booms followed by busts. The Great Recession of 2008 was a reminder of the dangers of fractional reserve banking, and it was the same year that Bitcoin was introduced as an alternative to traditional banking that does not rely on the reliability of centralized institutions.
So strange how America suddenly woke up and realized what fractional reserve banking is
The problems with SVB have shown that people have a lot to learn about these issues and about fractional banking as a whole. At the moment, some Americans are calling on the Fed to bail out Silicon Valley Bank, hoping that the federal government will step in to help. But even if the Fed saves the day regarding SVB, the dangers of fractional reserves still exist, and many are using the SVB failure as an example of why the banking system operating in this way should not be trusted.
Tags in this story
19th century, banking, banking, banks, Bitcoin, cyber security, privacy, digital transformation, economist, electronic transactions, FDIC, FDIC insurance, finance, financial contagion, financial crisis, financial institutions, financial markets, financial regulation, financial services, financial stability, fractional reserves , Global Economy, Information Security, Mises, Mobile Banking, Modern Day Bank runs, Murray Rothbard, Online Banking, Risk Management, Robert Murphy, Satoshi Nakamoto, Silicon Valley Bank, SVB, Technology, US Banking, White Paper
What steps do you think individuals and financial institutions should take to prepare for and mitigate the potential threat of financial contagion in today’s rapidly evolving digital landscape? Share your thoughts in the comments section below.
Jamie Redman
Jamie Redman is the news editor at Bitcoin.com News and a financial technology journalist living in Florida. Redman has been an active member of the cryptocurrency community since 2011. He has a passion for Bitcoin, open source and decentralized applications. Since September 2015, Redman has written more than 6,000 articles for Bitcoin.com News about the disruptive protocols emerging today.
Image credit: Shutterstock, Pixabay, Wiki Commons, Wall Street Mojo, It’s a Wonderful Life, Twitter
Disclaimer: This article is for informational purposes only. It is not a direct offer or solicitation of an offer to buy or sell, or an endorsement or recommendation of products, services or companies. Bitcoin.com does not provide investment, tax, legal or accounting advice. Neither the company nor the author is responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on content, goods or services mentioned in this article.
