Fractional reserve banking (FRB): Looking back, looking forward

Posted by Manjesh Roy on 27 January 2015

The Reserve Bank of India (RBI) has relaxed certain banking norms, following the announcement in the Union Budget 2014-15 to ease availability of finance for infrastructure. As per its circular of 15.07.2014, banks can issue rupee denominated plain vanilla unsecured, uninsured bonds of minimum 7 years tenure to finance infrastructure and affordable housing. Incremental funds deployed by banks to these sectors will be exempt from Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) norms on the liability side and also from priority sector lending (PSL) targets on the asset side. RBI has calibrated these relaxations such that the maximum benefit accrues from 2020 onwards, starting from 2014.

These relaxations are expected to reduce funding cost of banks by 50 to 100 bps. Editorials that have routinely denounced SLR and PSL norms in the past as repressive and intrusive, have now advocated caution over the relaxations granted for these bonds. It is argued that liability for banks arising out bonds is on par with any other liabilities (deposits) and hence the need for caution while removing the reserve (CRR) requirement.

How valid is this concern? To answer this question, we take a quick tour of origin of money and fractional reserve banking (FRB). For longer version, see 'Aam Aadmi's guide to Money, Banking and Gold standard’, by the author at SLR and PSL norms are not discussed further as they are not monetary tools.

Transactions between members of primitive communities were through mutual co-operation (credit) and direct exchange of goods / services (barter). Addressing the limitations of barter, physical markets and indirect exchange of goods evolved wherein goods were first exchanged for a popular commodity (like cowrie shells, salt, metals, grains etc), which in turn was exchanged for the preferred goods. Thus, commodities which were the medium of exchange, emerged as money. Over time, within metals, gold (and silver) emerged as money across civilizations, unconnected by modern transportation and communication.

From coins, receipts for gold deposited with goldsmiths emerged as the medium of exchange in medieval Europe. When some devious goldsmiths issued fake receipts, it sowed the seeds of, what is now know as, FRB, wherein the fake receipts constituted the ‘lending’. Hence, Prof. Murray Newton Rothbard remarked that banks are ‘already and always insolvent’ in ‘What Has Government Done to Our Money?’ ( Further, as perceptively pointed out, bank ‘runs’, reveals and does not create this insolvency. 

Subsequently, with the onset of central bank and fiat currency, banks hold reserves (CRR) with the central bank in the form of currency, instead of gold. As eloquently phrased by Peter L. Bernstein, when a bank lends, the borrower’s account increases without any corresponding decrease in anybody else’s account. Thus, under FRB, bank credit creates money.  

What are the consequences of FRB? First, the monetary impact. Money that is created out of nothing through FRB, can also disappear into nothing! The stock markets crash of 1929 in US rendered leveraged ‘investors’, instantly insolvent. This set off a ‘run’ on the banks that lent to these ‘investors’. In the ensuing panic and bank holidays, one third of banks collapsed with direct impact on money supply. Now, as GDP is the measure of the money spent, the consequence of bank collapse on money supply and hence on GDP, is elementary. The resultant shrinkage in US economy by one fourth, is labeled as the great depression. Preposterously, the ‘main stream’ still attributes the depression to the limitations of gold standard and not as the inherent flaw of FRB!

FRB unhinges money creation from real economic activity, with serious non-monetary implications as well.  As money accumulates only with those who have access to credit, producers stand immiserized, resulting in and perpetuating inequality. Comrades misattributed this inequality to capitalism, while Prof. Thomas Piketty has quantified it in ‘Capital in the Twenty First Century’. Second, the environmental impact. Infinite amount of money can be created by central banks under FRB which sustains increased borrowing, which in turns finances increased production which in turns engenders unnecessary consumption, also labeled as ‘growth’. As 'growth' happens on a base of finite natural resources, the results on environment is predictable.

Cut to the present, if banks were to be funded only by bonds, as advocated by Rothbard, then only the borrower gets to spend. In other words, banks lending through bonds would not create money, the merit of which ought to be self evident.

The idea of bond funding of banks was mooted by economists from the University of Chicago in 1933 in the aftermath of the great depression. As per this Chicago Plan, banks’ function would be split into two; “1) deposit taking - with 100% deposits readily available for withdrawal and 2) lending - financed by investors willing to take risk” (The Economist, June 7, 2014). Prof. John H. Cochrane has presented a modern avatar of Chicago plan in his recent paper, ‘Towards a run free financial system’, which has received critical attention.

Perhaps, bond funding of banks is ‘an idea whose time has come’ and RBI has stumbled upon it, serendipitously! RBI’s measures in this regard, though tentative and nano, are nevertheless steps in the right direction and needs to be welcomed whole heartedly. The quest ought to make bond funding of banks 100%. As money is only a medium of exchange, civilized society ought not to allow its fake creation. 

S. Manjesh Roy
The author works for the financial market regulator of India, however the views expressed are personal.
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