Fraction ... Er ... Fictional Reserve Banking

George Washington's picture

Washington’s Blog.

As the New York Federal Reserve Bank explains on its website:

requirements affect the potential of the banking system to create
transaction deposits. If the reserve requirement is 10%, for example, a
bank that receives a $100 deposit may lend out $90 of that deposit. If
the borrower then writes a check to someone who deposits the $90, the
bank receiving that deposit can lend out $81. As the process continues,
the banking system can expand the initial deposit of $100 into a
maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In
contrast, with a 20% reserve requirement, the banking system would be
able to expand the initial $100 deposit into a maximum of $500
($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements
should result in reduced money creation and, in turn, in reduced
economic activity.

Of course, many Austrian economists have criticized fractional reserve banking. For example, Murray Rothbard wrote:

see how the fractional-reserve process works, in the absence of a
central bank. I set up a Rothbard Bank, and invest $1,000 of cash
(whether gold or government paper does not matter here). Then I "lend
out" $10,000 to someone, either for consumer spending or to invest in
his business. How can I "lend out" far more than I have? Ahh, that's
the magic of the "fraction" in the fractional reserve. I simply open up
a checking account of $10,000 which I am happy to lend to Mr. Jones.
Why does Jones borrow from me? Well, for one thing, I can charge a
lower rate of interest than savers would. I don't have to save up the
money myself, but can simply counterfeit it out of thin air. (In the
19th century, I would have been able to issue bank notes, but the
Federal Reserve now monopolizes note issues.) Since demand deposits at
the Rothbard Bank function as equivalent to cash, the nation's money
supply has just, by magic, increased by $10,000. The inflationary,
counterfeiting process is under way.

"Unfortunately, while banks depend on the warehouse analogy, the
depositors are systematically deluded. Their money ain't there."


19th-century English economist Thomas Tooke correctly stated that "free
trade in banking is tantamount to free trade in swindling." But under
freedom, and without government support, there are some severe hitches
in this counterfeiting process, or in what has been termed "free


First, why should anyone trust me? Why should anyone accept the checking deposits of the Rothbard Bank?


second, even if I were trusted, and I were able to con my way into the
trust of the gullible, there is another severe problem, caused by the
fact that the banking system is competitive, with free entry into the
field. After all, the Rothbard Bank is limited in its clientele. After
Jones borrows checking deposits from me, he is going to spend that
money. Why else pay for a loan? Sooner or later, the money he spends,
whether for a vacation, or for expanding his business, will be spent on
the goods or services of clients of some other bank, say the Rockwell
Bank. The Rockwell Bank is not particularly interested in holding
checking accounts on my bank; it wants reserves so that it can pyramid
its own counterfeiting on top of cash reserves. And so if, to make the
case simple, the Rockwell Bank gets a $10,000 check on the Rothbard
Bank, it is going to demand cash so that it can do some inflationary
counterfeit pyramiding of its own.


But, I, of course, can't
pay the $10,000, so I'm finished. Bankrupt. Found out. By rights, I
should be in jail as an embezzler, but at least my phoney checking
deposits and I are out of the game, and out of the money supply.


under free competition, and without government support and enforcement,
there will only be limited scope for fractional-reserve counterfeiting.
Banks could form cartels to prop each other up, but generally cartels
on the market don't work well without government enforcement, without
the government cracking down on competitors who insist on busting the
cartel, in this case, forcing competing banks to pay up...

Hence the drive by the bankers themselves to get the government to cartelize their industry by means of a central bank.

Similarly, Ron Paul wrote in October:

instability turns up, we see efforts to socialize the losses, but
rarely do people question the source of instability. Economist Jesús
Huerta de Soto places the blame on the institution of
fractional-reserve banking. This is the notion that depositors’ money
in use as cash may also be loaned out for speculative projects, then
re-deposited. The system works as long as people do not attempt to
withdraw their money all at once. In the face of such a demand, banks
turn to other banks to provide liquidity. But when the failure becomes
system-wide, they turn to government.


The core of the problem is the conglomeration of two distinct functions
of a bank. The first is warehousing, whereby banks keep money safe and
provide checking, ATM access, record keeping, and online payment,
services for which consumers are traditionally asked to pay. The second
service the bank provides is a loan service, seeking out investments
and putting money at risk in search of return.


The institution of fractional reserves mixes these functions, such that
warehousing becomes a source for lending. The bank loans out money that
has been warehoused—and stands ready to use in checking accounts or
other forms of checkable deposits—and that loaned money is deposited
yet again in checkable deposits. It is loaned out again and deposited,
with each depositor treating the loan money as an asset on the books.
In this way, fractional reserves create new money, pyramiding it on a
fraction of old deposits. An initial deposit of $1,000, thanks to this
“money multiplier,” turns into $10,000. The Fed adds reserves to the
balances of member banks in the hope of inspiring ever more lending.


As customers, we believe that we can have both perfect security for our
money, withdrawing it whenever we want and never expecting it not to be
there, while still earning a return on that same money. In a true free
market, however, there tends to be a tradeoff: you can enjoy the
service of a warehouse or loan your money and hope for a return. The
Fed, by backing up fractional-reserve banking with a promise of endless
bailouts and money creation, attempts to keep the illusion going.


The history of banking legislation can be seen as an elaborate attempt
to patch the holes in this leaking boat. Thus have we created deposit
insurance, established the “too-big-to-fail” doctrine, and approved
schemes for emergency injections to keep an unstable system afloat .

And at least some people claim that the fractional reserve banking system is guaranteed to create unsustainable levels of debt.

From Fractional to Fictional Reserves

But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.

As the above-linked NY Fed article notes:


practice, the connection between reserve requirements and money
creation is not nearly as strong as the exercise above would suggest.
Reserve requirements apply only to transaction accounts, which are
components of M1, a narrowly defined measure of money. Deposits that
are components of M2 and M3 (but not M1), such as savings accounts and
time deposits, have no reserve requirements and therefore can expand
without regard to reserve levels.

And as Steve Keen notes - citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research &
Statistics and Monetary Affairs, Federal Reserve Board, 2007-54,
Washington, D.C:

 The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.

So huge swaths of loans are not subject to any reserve requirements.

the repeal of Glass-Steagall, deposits have been used to speculate in
every type of investment under the sun, using insane amounts of
leverage. Instead of the traditional 10-to-1 ratio, the giant banks and
hedge funds were using much higher levels of leverage.

For example, Congresswoman Kaptur told Bill Moyers that while - on paper - there are 10-to-1 reserve requirements, banks like JP Morgan were using 100 to 1 leverage. She said that, with derivatives, leverage might be much higher.

And remember that most of the credit in our economy is actually through the shadow banking system, not through traditional depository banking.

As the Washington Times wrote in February 2009:

“Before last fall’s financial crisis, banks provided only $8 trillion of the roughly $25 trillion in loans outstanding in the United States,
while traditional bond markets provided another $7 trillion, according
to the Federal Reserve. The largest share of the borrowed funds - $10
trillion - came from securitized loan markets that barely existed two
decades ago. . . .


Mr. Regalia [chief economist at the U.S. Chamber of Commerce] said ... 70 percent of the system isn’t there anymore,’ he said.”

Bernanke, Summers, Geithner and the boys have been working as hard as they can to re-start the shadow banking system,
and traditional loans to individuals and small businesses have
plummeted. So the percentage of shadow banking system lending to the
all lending has probably skyrocketed again.

The NY Fed continues:

the Federal Reserve operates in a way that permits banks to acquire the
reserves they need to meet their requirements from the money market, so
long as they are willing to pay the prevailing price (the federal funds
rate) for borrowed reserves. Consequently, reserve requirements
currently play a relatively limited role in money creation in the
United States.

In other words, as we've repeatedly written, reserves can be obtained once a binding loan commitment is made.

As William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

on how monetary policy has been conducted for several decades, banks
have always had the ability to expand credit whenever they like. They
don’t need a pile of “dry tinder” in the form of excess reserves to do
so. That is because the Federal Reserve has committed itself to supply
sufficient reserves to keep the fed funds rate at its target. If banks
want to expand credit and that drives up the demand for reserves, the
Fed automatically meets that demand in its conduct of monetary policy.
In terms of the ability to expand credit rapidly, it makes no

Bernanke has proposed the elimination of all reserve requirements:

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

And - according to Steve Keen - about 6 OECD countries have already done
away with reserve requirements altogether (Keen confirmed that
Australia requires no reserves; I know that Mexico doesn't require
reserves; and Canad, New Zealand, Sweden and the UK supposedly require no reserves as well).

How Can An Insolvent Company Have Any Reserves?

Everyone knows that banks are required to have reserves, and that the giant banks supposedly have massive sums of excess reserves.

But does that really mean anything when everyone who runs the numbers says that the giant banks are (once again) insolvent?

if we took away mark-to-the-moon valuations, forced the big boys to put
their SIV off-sheet liabilities back onto their balance sheets, and
stopped all of the fraud, spinning and other hanky-panky (of which
Lehman's Repo 105s were just a tiny part), it would be obvious that the
too big to fails were deeper into the hole than Wiley Coyote after he
fell of the cliff and hit the ground.

So any "reserves" that the TBTFs have are fake, courtesy of the taxpayer, Uncle Sugar, and plain old puppetry .

We no longer have a fractional reserve banking system. Reserves are just a fiction.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Never_Put_Down's picture

so if the financial businesses can inflate the money they have on reserve by 10 times or more, doesn't that mean when the reserves start declining, the loses will inflate by the same proportion?

moneymutt's picture

I don't think reserves matter, either a bank wants to lend or doesn't, either they have creditworthy customers that the bank expects to grow and be able to pay their interest and principle or they don't see anyone they want to risk lending I think the contraction comes from pessimism and fear from crashing economic cycle, not reserve requirements, they basically don't exist in real world...

Blithering ORSA's picture

0% reserves gives you infinite M1.  What could go wrong?

Madcow's picture








Duuude's picture

So tha Squid and tha Dancing Hippos are untouchable...problem is Mickey is having a helluva time mopping up his deluge of debt...Tha Squid and tha Hippos simply arrange their dance accordingly...Fantasiastic...

Stranger's picture

Who needs reserves when you can borrow unlimited liquidity from the Fed at 0%?

Goldmember's picture

Next post should be: Is inflation an increase in prices as the pundits argue, or is it an increase in the money supply, causing distortions/malinvestment and prices to stay level when they would otherwise fall?

AnAnonymous's picture

Entrepreneurship is directly related to the management of the level of accountability. To get a high level of entrepreneurship, it is required to reward the positive consequences of an action while lessening the consequences of negative actions. Having people suffering from the bad consequences of their actions get them to confine to well under controlled course of actions, routine work and suppress entrepreneurship.

The removal of the reserves requirement flows logically in a society that looks at entrepreneurship.
Banks need to find back their entrepreneurship spirit.

Duuude's picture

So WTF, tha Squid as a bank has unlimited reserves?

BlackBeard's picture

Well.  If I could borrow 1 dollar @ 0.25% and lend 10$ out @ an average of 13% and I'd jail..wait.

Rick64's picture

Whats next? Abolish all accounting rules.

mikla's picture

Whats next? Abolish all accounting rules.

We already pretty much did that -- revised FASB suspending mark-to-market accounting, no reserve requirements on commercial deposits and the entire derivatives markets, enabling overnight sweeps from all demand deposit accounts so banks can day-trade your checking account (that theoretically had a reserve requirement), etc.

So, there literally are no rules anymore.  Secured creditors take a back seat to unsecured creditors.  The illegal fraud is huge, but the legal fraud is so much larger.  There is no contract, no law, no rules, no precedent.

No sane person could possibly trust any statistics or performance report by any financial institution, nor sovereign, in today's world.

That's saying a LOT.

Ripped Chunk's picture

Pedal to the metal!

moneymutt's picture

Gw- nice summary once again. I go with Steven Keen on this, basically loan/credit/debt comes first and reserves, what little or non-existent they might be come second, this is what the facts of the ground and money "stats" always show. If folks are in expansive moods and want credit and banks in good  mood and think they can lend money and get paid back, they make what they see as any viable loan, increase credit, reserves MIGHT follow later.  I think monetary reality in the stats proves the banks essentially get to create money/credit for next nothing.

So as long as we have this system, we are at mercy of wickedly self-reinforcing loops of expansion and contraction that get amplified by the ease of creating money for nothing. And then when you add in how derivatives allowed things to be levered up even more... Even if no fractional -non-reserve system, investors can certainly get carried away and throw dumb money at a bubble (see the folks that floated Countryside money, bought craps MBS). 

However, the thing that really irritates me is regular folks paying banks for something that the banks essentially create from thin air and then, in addition to this, banks infinite leverage creates inherently unstable systems. Also irritatign is rampant criminal fraud non-banks engage in to wrest reall money from investors. 

And agree with Keen, cavaliers of credit will always get carried away, who wouldn't, so we must have new system.

William Wallace's picture

What gets to me is the cynical fraudulence of Keynesian propaganda.  Their argument goes like this--

We don't know what causes the business cycle.  It's just a part of nature.  But we do know how to handle the business cycle: it's by deficit spending and reducing interest rates during a recession.

It's all a cover for expanding government and using government to enrich banks.  It's a lie that works for government and banks, but hurts everyone else--and ultimately destroys the nation.

The banks cause the problem, and then government, in purporting to solve the problem, acts to enlarge its own power and create more debt.  The cycle repeats until extinction.

moneymutt's picture

interesting point...i don't have an ideological opposition to govt in general, but our govt has clearly been captured and does not represent the interests of average citizen, when we have a problem, the only reform we get is something the enriches a parastical class of crony businesses, inside investers and bureaucrats, and only throws small crumbs to regaular folks so they can "sell" it.  So to the extent state power is corrupted it can be a powerful force of tyranny, sort of like a corrupt local police force is likely more dangerous than no police force...

so we have banksters and bureaucrats working hand in glove to screw us with most folks ignorant of the many ways they bleed us. As you point out, it only stops with extinction...

Hephasteus's picture

How many keynsians does it take to screw in a feigned ignorance lightbulb?

LeBalance's picture

when within the fractional reserve theivery the practice of loaning from A to B to C to D gives rise to new reserves at each subsequent letter, is it surprising to any one that the reserve would similarly become marginalized?  It is certainly interesting to see how brazen the practice is, but it should not be a cause for shock.

Cognitive Dissonance's picture

"when within the fractional reserve thievery the practice of loaning from A to B to C to D gives rise to new reserves at each subsequent letter,"

I think of it as holographic reserves. The really interesting thing about a holographic picture is that you can cut it in half, and cut each resulting piece in half, and so on and so on and so on. Each resulting piece has the entire original holographic picture in the piece. No matter how many times you cut it in half, you always have all the information of the original in each piece. Sort of like DNA.

So this fractional reserve banking thingy really is like quantum mechanics, sorta maybe like. So by dividing you multiple. Yeah, that's the ticket. :>)


wake the roach's picture

Yep, the party's over... Tomorrow we will wake up and to pay the bill...

And try to explain to pappy why his 58 chevy now smells like cigarettes and vomit ;-)...


Bear's picture

Fictional Reserve System promoted by the Federales Reserve Bank headed by Ben Brankrupto  

Shameful's picture

Excellent piece!  Love the Rothbard reference, he does have a great way of breaking things down.

I'm a little surprised they are so open about having no reserves.  Though I suppose when you are already insolvent and have a gov guarantee why not go for broke.  Leverage level, to inifinity and beyond!!!

mikla's picture


I'm also surprised they are so open about having no reserves.  However, if the ponzi is coming to an end, maybe they think this "disclosure" will help avert the lynch mob?  "Hey, we TOLD you there were no reserves!"

It's turtles all the way down!