Part 1: Historical Background
The story that's usually told about the origin of fractional reserve banking is told about ancient goldsmiths. Goldsmiths stored precious metals in their vaults and people came to them to store precious metals on their account. And, over time, the goldsmiths realized, you know, if I lent this gold out and put it out there in the community in some sort of an investment, then I could made a profit and return the gold to the vault before anybody is the wiser.
Is that really how banking began? I don't think so. I don't think history will support that story. But it's a useful story, and it's a useful story because it reminds that resources that sit idle in some vault really aren't of much value to the community and that if you can put those resources to work for productive investment, you can make a profit and the community is enriched in the process.
So why is it useful to learn about fractional reserve banking? I don't think economists really understand why some nations grow faster than other nations, but one thing that seems pretty clear is that nations that provide an environment that's good for investment tend to do a lot better than those that don't. And we can think about that environment very broadly. We can think about laws that protect property rights. W can think about low taxation of investment income. We can think about nations that embrace free trade. All of these things are good for the accumulation of capital and for investment. And we can also think about it in terms of specific markets and institutions that help facilitate resources into investment.
And I think that's what the story of banking is all about. I think it's more useful to think about banking arising from a particular need—investment—than to think about banking that arises simply because they're a bunch of gold that's sitting in some goldsmith's vault. I think when you think about the need and the problem that banking is solving, then I think you have a deeper understanding about the process that's going on.
Are banks really necessary for investment? Probably not. I mean direct finance occurs in many economies and, in fact, in the United States direct finance is a more important part of the facilitation of investment than is banking. Direct finance is where an individual wants to lend money to a major corporation either through buying stock or buying bonds and that corporation puts those funds to use to expand, to grow, and to pay a rate of return. But a significant share of American investment is funded through banking. The banks channel funds not only to big businesses, but also to small businesses, and importantly to households as well.
So what are these institutions that funnel money to investors? Well, we call them banks, but I think really banks have a very narrow connotation. I really think we ought to talk about financial intermediaries. And by that I mean I want to talk about institutions that take in funds from a number of savers—oftentimes, small savers—and find useful investment opportunities for these funds. So why do these financial intermediaries exist? What is the problem that they're trying to solve that can't immediately be solved by direct finance?
The problem is one that economists call "asymmetric information." You want to lend somebody some money with the expectation that you're going to be paid back with a profit in return. Well, how do you know that the person actually has a good investment opportunity? And once you give them the money, how do you know they will follow through with the obligations that they made to you?
Financial intermediaries specialize in this sort of information. They specialize in being able to distinguish between the good loans and the potentially bad loans. And then once they make a loan, they specialize in being able to monitor the behavior of the borrower so that they're more secure in getting their funds back. This is a very difficult undertaking, and an undertaking than most of us can't do. Banks do it for us for a fee.
Does the financial crisis cast doubt on the ability of financial intermediaries to pick the good loans and to be able to monitor the behavior of the good loans so that investments get repaid? I think the problems of the crisis we've just been through is the exception that actually proves the rule. There were a lot of complications and problems that were associated with the recent financial crisis. But from the perspective of banks, how they solve the asymmetric information problem—I think two things are pretty clear. First is that standards were reduced, which is that banks didn't rely on their information about particular borrowers and how they were using the money as effectively as they might have done in the past. And, moreover, these loans were being bundled and sold off to others so they weren't actually on the bank's balance sheet, which means that they weren't necessarily monitoring very closely the good ones from the bad ones. These were very complicated financial instruments.
And so I think what we saw is that these financial institutions kind of got away from their bread and butter, so to speak—that they weren't solving the asymmetric information problem as, perhaps, carefully as they once did. And when they didn't, problems ensued. These are some of the broad reasons why it's important for students to understand fractional reserve banking and financial intermediation in general.
Part 2: How Fractional Reserve Banking Works
There are specific reasons why it's important to understand the whole process of fractional reserve banking, and that is a lot of what economists calls "money" is generated through the process of fractional reserve banking. You can think of money as having two origins. First, in the old days, economists used to call "outside money"—sometimes "central bank money" in your textbook, probably—"base money." This is the currency, or the reserves, that are created by the central bank, the Federal Reserve, and [that] get put into the financial system.
It's called base money because on top of that rests the financial system, which generates a different type of money, "deposit money." Deposit money, sometimes called "inside money," is money that's generated through the process of fractional reserve banking. Banks take in a deposit, they let out a loan, the loan becomes another deposit, which becomes another loan, and so on and so forth. Through this process of financial intermediation, through the lending and deposits and lending and deposits, a different type of money is created that rests on top of base money. We call that deposit money, or inside money.
You have to understand the process by which banks turn deposits into loans to fully understand the totality of what we call money in an economy and to understand how the policies of the central bank affect the money supply. In your classrooms you'll learn that there are various tools of monetary policy, all designed to control the quantity of money in circulation. These tools work through that process, and predominately through the banking system. So, for example, the Federal Reserve can change reserve requirements to force banks to hold more or less reserves in their vaults and, therefore, to allow more or lesser inside-money creation.
For example, if the Federal Reserve were to lower reserve requirements, that would ordinarily allow banks to lend out more money, which would create more deposits, which would allow the fractional reserve banking system to create an increasing quantity of money in circulation. Conversely, if the central bank increases the reserve requirement the process will work in reverse, deposits will be contracted, and the money supply will shrink.
Outside money, base money is put into circulation by the Federal Reserve, and generally through the banking system, by the buying and selling of securities in the open market. The Federal Reserve can alter the amount of base money in the economy and, on top of that, the whole financial system can then expand loans and create more deposits through fractional reserve banking. So as a technical matter, it is kind of important to understand this process if one is going to truly understand the tools that the central bank brings to bear.
Monetary policy is generally conducted in the United States through open market operations. When we buy or sell U.S. government securities in the open market, this puts more reserves or less reserves into the banking system. So if we buy U.S. government securities in the open market, that's freeing up reserves into the financial system, which then become loans and deposits on which they then multiply.
Of course the process also works in reverse, when people suddenly decide to withdraw deposits from financial intermediaries, deposits that have now been lent out as various forms of investments. There can be all sorts of liquidity problems in the financial system. This was one of the important responsibilities that the Federal Reserve was given at its founding. We were to act as a lender of last resort so that banks always had a market to sell otherwise good assets to get the reserves necessary to pay off depositors in times of crisis.
Part 3: The Importance of Fractional Reserve Banking
I think one of the important benefits of fractional reserve banking is it pools together a lot of smaller savings, and it's able to lend it out in a variety of markets, some of them to big business but also to smaller enterprise and to households—institutions that banks, because of their location, because of their understanding of the needs of the small business and the needs of their community, are probably in a pretty good position to know about.
So I think the primary benefit of banking, of financial institutions in general, is the information they bring to the table for lending out money that most of us just don't have, that most of us would find too expensive to get.
I think one of the reasons the goldsmith story has such appeal, especially with students, is because there's a common fiction that when you put money into a bank, it sits in that vault. Of course, you know that you're being paid interest to put your money in that bank, and that interest comes from somewhere. You know that, when you think about it, the bank is investing that money for you, and from the profits of those investments comes the interest that you get paid. So your money isn't really sitting idle in some vault. It's going to work.