This is my blogchalk:
United States, California, San Jose, English, Hindi, Male, 31-35, Watching movies, Reading, Writing.

  Web ashishniti.blogspot.com   
New Blog

Ashish's Niti

Niti in Sanskrit means policy/strategy/vision. This blog hosts my political views, along with news and commentary. This blog has moved here.

Wednesday, August 11, 2004

Fractional Reserve Banking

Micha Ghertner brings good points on fractional reserve banking.
Catallarchy � Fractional Reserve Banking Reconsidered

Why? As Randall already mentioned, so long as all the parties involved are informed, there is no issue of fraud. Certainly, fractional reserve notes contain an element of risk, but then so do many other tradable objects of value, such as stocks and bonds. Why all the fuss over not-fully backed currency? Would these same Austrians who object to fractional reserve banking also object to the trading of penny stocks on grounds of fraud?

My understanding of how fractional reserve banking works is as follows:

A depositor (let's call him A) deposits, say, $100 dollars into his bank account. This increases reserves of that bank held at the central bank by the same amount. Now, the bank is allowed to loan, say, 90% of that amount (10% fractional reserve requirement) to another customer (let's call him B). Now, B has $90 in his bank with the bank's total reserves held at the central bank to be $190. Now, why should Govt. (or the central bank) allow this to happen? Isn't central bank itself sharing some of the risk of that fractional-reserve backed loan?

If the central bank says to its member bank that in order for it to loan X amount for a period of N, same amount of its reserves also need to be restricted (cannot be allowed to be withdrawn), then the member bank has no choice but to fund loans with term deposits instead of demand deposits.

Thus, choice of fractional reserve banking or full reserve banking be decided by the central bank (i.e. the one who issues the currency notes and one who backs the cheques). If there is a free market in currency then we could have combination of both.

In such cases, prices of goods will also reflect the quality and quantity of the currencies (reserve requirement, loan quality of its member banks and so on). Just like various Govt. currencies today are considered more or less risky/valuable.

Fractional reserve banking requires Govt. to monitor loan quality while fully backed reserve banking does not.

Creative Commons License
This work is licensed under a Creative Commons License.