Banks Can Perform Their Two Functions With 100% Reserves

Banks Can Perform Their Two Functions With 100% Reserves
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In a recent post at Forbes, John Tamny made some very strong claims against the Austrian School. In the present post, I want tellerto push back on just one of his points (though I think there are several problems with Tamny’s article). Specifically, Tamny claimed that the embrace of 100% reserve banking among some (but not all) Austrians is nonsensical. Here’s Tamny:

Those familiar with this column are well aware of how very much it venerates what’s known as “Austrian” economic thinking, or the Austrian School. Books by Ludwig von Mises are always nearby…[V]on Mises’s thinking has been hugely influential.

That’s why the modern evolution of the Austrian School is sometimes so disappointing. Without naming names of specific writers, the thought processes that inform the modern “Austrian School” more and more read as statist, monetarist in their conceit about what’s allegedly the proper supply of money and credit, and probably most offensive of all, the reasoning at times reads as Keynesian.

On the statist front, a recent Mises [USA] Daily referenced “fractural [sic–RPM] reserve banking” as “fraud and a violation of property rights, and should be treated as such.” In this case it’s well known that some Austrians have a major problem with “fractional reserve banking” whereby banks pay for liabilities (deposits) by virtue of turning those liabilities into assets (interest paying loans). This stance is downright strange. Fractional reserve banking is a tautology.

Banks aren’t in business, nor could they remain in business if they simply warehoused money. Instead, they borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away. The profits come from borrowing at one rate of interest, then lending longer term at a higher rate. To many Austrians, this non-coerced act of exchange between consenting individuals is a fraud, and needs to be treated as such by the state. The Austrians want government to restrain what they deem a violation of property rights.

Now back in 2012, here at these pages James Miller criticized Tamny on fractional reserve banking (FRB). In the present post, I want to focus narrowly on Tamny’s argument that by its very nature, banking MUST be based on fractional reserves: That’s what Tamny means when he says FRB “is a tautology.”

In the first place, if FRB is indeed a tautology, such that it’s silly to question whether banks should engage in the practice, it would be odd then for Ludwig von Mises–an inspiration to Tamny–to write:

Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media…

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of the fiduciary medium must necessarily lead to its breakdown. [Ludwig von Mises, Theory of Money and Credit, pp. 408-409]

For those unfamiliar with the term, “fiduciary media” are bank deposits that are not covered by the underlying base money. In other words, fractional reserve banking goes hand-in-hand with the existence of fiduciary media. Thus, if Tamny’s identification of FRB with the essence of banking is correct, then Mises must be arguing in the above passage that banking itself is doomed, and that only by prohibiting further activity by banks, can the credit system be saved. That’s obviously not what Mises means to say, and thus we should conclude that he (Mises) would disagree with Tamny’s argument in favor of FRB.

(I should  mention as a clarification that Mises’ views on FRB are quite nuanced, with the 100% reserve camp and the “free banking” Austrians both able to point to passages where it seems Mises agrees with that side of the argument. But my point is, since there is an open question on the matter, it obviously can’t be the case that Mises thought FRB was essential to banking itself. Tamny’s glib argument is clearly wrong.)

Let’s start with the basics: There are two functions that banks serve:

(1) They act as credit intermediaries, in which the banks take funds from savers and channel them to borrowers.

(2) They act as warehouses, in which the banks store their customers’ deposits in huge vaults and provide services such as check-clearing and ATMs.

Unfortunately, in modern times these two functions have been blurred together, such that even a writer at Forbes thinks they are the same thing (apparently). But on the contrary, we can at least conceive of the functions remaining distinct. When the banks act as credit intermediaries, the savers are not putting the money into a “demand” or “checking” account, but instead are truly transferring ownership of the money over to the bank, in exchange for a claim. For example, the saver can put the money in a “time-deposit” or “savings” account, which does not grant the right of immediate redemption. Or, more obvious, the saver can buy a Certificate of Deposit (CD) which has a well-defined maturity date in the future. There is no question in this case that the saver has transferred ownership of his money to the bank, which can then lend it in turn to a borrower. The bank earns money by charging a higher interest rate than it pays, thus earning the spread.

On the other hand, if customers want to enjoy the convenience of a checking account under a 100% reserve system, then yes they will have to somehow compensate the bank for it. The bank can’t pay interest on a genuine checking (“demand-deposit”) account, if the bank is to maintain 100% reserves. There are various ways the bank could earn its money. For example, it may have an annual fee to keep the account open, or it might charge a processing fee for each check written, etc.

In conclusion, let me stress that I am not taking a position in the vitriolic controversies over “free banking” in the Austrian community. (The two links above are good samples of that literature.) All I’m saying is that 100% reserve banking is possible in a market economy. Tamny is in good company (with the likes of George Selgin and Larry White, for example) if he wants to make the modest claim that FRB would thrive even in a genuinely open bank sector with no artificial government support for FRB. Yet Tamny went too far when he claimed that FRB is a tautology; it isn’t. And it’s important to clarify how 100% reserve banking could work, because most people don’t realize that there is a distinction between time- and demand-deposits.

  • Kevin L

    @Stefan, that is not the case. Under 100% reserves, the banks simply cannot allow two people to make a claim on the same underlying money. If depositors want to earn interest, then they must be willing to forego access to their money while someone else is borrowing it. For example, say I take you to lunch, and each of our lunches cost $10. I can't give the waitress one $10 bill and say, "It's ok, he's borrowing this $10, but it's still my $10, so we can use it to pay for both lunches." Yet that's analogous to what banks do under fractional reserve. I deposit $10, and the bank says I have $10 available for withdrawal. The bank takes the $10 and lends $9 of it to you, saying you have $9 available for withdrawal. Now the bank has $19 of demand liabilities, $9 of loan assets, and $1 cash. Now you could add the numbers another way, saying the bank has $10 of liabilities (my account), $1 cash, and $9 in future assets. The problem in that scenario is the maturities do not align. I may contractually demand my cash at any time, while you are not required to pay until some future point, meaning the bank could be $9 short of cash. That's why bank runs – a sudden drop in demand for deposits – can damage a fractional reserve system.

    Under 100% reserve, I would sell the bank my $10 in return for a claim on $11 at some future date. It would then sell you the $10 for a claim on $12 at that future date. I get my $11 when you pay the bank $12. Bank runs are not a threat because I cannot claim my $11 until my loan to the bank comes to maturity, which presumably would be some time after your loan comes to maturity. They still take the risk of you defaulting on your contract, but that is part of why they earn the $1 "spread", along with doing the leg work of matching savers and borrowers. Now if the bank is sound and trusted, I could sell my $11 claim on the bank to Bob for $10 and get my cash back, but then it becomes Bob who is investing the money for your loan.

    • Stefan

      Thanks. It was not clear to me that the third to last paragraph in the article was referring to a 100% reserves scenario.

  • Stefan

    So what you're saying is that there can be no credit issued under 100% reserve system. I wonder how many banks would stay afloat based on their non-interest income alone.

    • Chris Horlacher

      The article is about how 100% reserve banks CAN offer credit.

  • Stock Cash Services

    Great post this was you just give us the additional information regarding banks,good post by the way keep posting…

Profile photo of Robert P. Murphy

Robert P. Murphy is the Senior Economist at the Institute for Energy Research, and a Senior Fellow with the Fraser Institute. He holds a PhD in economics from New York University. Murphy is the author of Choice: Cooperation, Enterprise, and Human Action (Independent Institute, 2015) as well as numerous other books and hundreds of articles.

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