Shortly after I published A Belated Reply on Fractional Reserve Banking, Jeff Molby inquired of me via email. I sent him a short response with the intent of responding more completely, here. There were a number of good comments/questions raised by other readers, and I do intend to respond to them, in turn. These things take time, however, so for now, you’ll have to content yourself with my response to Jeff.

Jeff writes:

I don’t support the status quo, but I wouldn’t support a society where 100% reserves are required by law, either. The reserve ratio should be negotiable between any individual and his prospective bank.

For instance, I should be free to contract with a hypothetical bank for an account with the following characteristics:
– I can withdraw my funds at any time
– The bank may loan up to 10% of my funds in any way it sees fit (or maybe it’s restricted in some mutually agreed upon way)
– I am responsible for any losses incurred on that 10%
– I am not charged any sort of warehouse fee

So basically, I would be accepting a certain amount of risk in lieu of warehouse fee and the bank is trying to turn a profit by using the 10% in an efficient way.

This may or may not be a standard position… I just never hear anyone talk about it.

I think this position is more common than you think, in fact it’s similar to the model of banking that most people (who are not bankers, financiers, or economists) believe that we have. And there’s absolutely nothing wrong with this model. However, there’s a huge difference between loan-brokering (which is what you’re describing) and fractional reserve banking. The problem is that the status quo is essentially licensed theft, and to the untrained eye it looks and sounds very much like the sort of thing you’re describing. It’s not.

Insisting on the ability to withdraw your funds at any time means that the bank would be in breach if they could not satisfy your withdrawal demand. The fact of the matter is that once you agree to permit the bank discretionary control over how that 10% of your money is allocated, it’s impossible for the bank to guarantee, or for you to insist, that you may withdraw your funds “at any time”. Any contract or agreement of this sort would be contradictory in nature: the second clause permits the violation of the first clause.

If you mark 10% of your deposits as “loans” and accept that they may be in default, then you are bearing the burden of risk and your investments may rise (or fall!) in value. Although in practice you may be able to withdraw the entirety of your balance at any time, this is not guaranteed, nor can it be. The only enforceable claim you would have is if the bank failed to honor your demand for the 90% of your money that they agreed not to loan.

If you really just want to loan money, why can’t you? For starters, as a central bank the Federal Reserve manipulates the money supply and the interest rates. Members of this cabal (for all intents and purposes, these members consist of all banks) are able to borrow money into existence, and lend it at interest. This privilege puts the individual lender at a severe disadvantage, it also hamstrings people who don’t make any loans or carry any debt (by decimating their savings)^#:

Wage earners (most of us) are principally the last people to receive this newly created money, and they receive it only after enough time has passed and the primary and noticeable effects of inflation have rippled through the economy. If you wonder why prices rise, it’s because somewhere, someone else got access to a boat-load of newly minted greenbacks which nobody else knew existed (because in fact they did not exist) and used them to place competing bids on the purchases of real resources. — Fiat Credit Is Not a Loan (24 July, 2008)

Even still, until recently, individual lenders were able to find borrowers. But then the SEC banned interpersonal loans on sites like prosper.com which matched individual borrowers and lenders.  (The SEC has since relaxed its ham-fisted ban on Prosper lending.)

Because of the auction-like nature of these loans, even with a modest sum like $500 or $1000, a lender could distribute his investments across multiple borrowers, mitigating default risk. In a truly free market, you wouldn’t need a bank to loan your money, you could do it yourself, and pay the warehousing fees for the rest of your money with your loan proceeds.

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Note: In another recent comment, the question of whether one has a “right” to purchasing power was raised. I do not intend to answer that question presently, although if it were answered in the affirmative, there could be no conceivable justification for fractional reserve banking.