Problems for the Fractional Reserve Banker, Insolvency
This unfortunate turn of the legal system means that the fractional reserve banker, even if he violates his contract, cannot be treated as an embezzler and a criminal.
But the banker must still face the lesser but still unwelcome fact of insolvency.
There are two major ways in which he can become insolvent.
The first and most devastating route, because it could happen at any time, is if the bank's customers, those who hold the warehouse receipts or receive it in payment, lose confidence in the chances of the bank's repayment of the receipts and decide en masse to cash them in.
This loss of confidence, if it spreads from a few to a large number of bank depositors, is devastating because it is always fatal.
It is fatal because by the very nature of fractional reserve banking, the bank cannot honor all of its contracts.
Hence the overwhelming nature of the dread process known as bank run, a process by which a large number of bank customers get the wind up, sniff trouble and demand their money.
The bank run, which shivers the timbers of every banker, is essentially a populous uprising by which the duped public, the depositors, demand the right to their own money.
This process can and will break any bank subject to its power.
Thus, suppose that an effective and convincing orator should go on television tomorrow and urge the American public,
People of America, the banking system of this country is insolvent.
Your money is not in the bank vaults.
They have less than 10% of your money on hand.
People of America, get your money out of the banks now before it is too late.
The report is too late. If the people should now heed this advice en masse, the American banking system would be destroyed tomorrow.
This holocaust could only be stopped by the Federal Reserve and Treasury simply printing all the cash demanded and giving it to the banks.
But that would precipitate a firestorm of runaway inflation.
A bank's customers are comprised of several groups. They are those people who make the initial deposit of cash, whether gold or government paper money, in a bank. They are, in the second place, those who borrow the bank's counterfeit issue of warehouse receipts. But they are also a great number of other people, specifically those who accept the bank's receipts in exchange, who thereby become a bank's customers in that sense.
Let's see how the fractional reserve process works.
Because of the laxity of the law, a deposit of cash in a bank is treated as a credit rather
than a bailment, and the loans go on the bank's balance sheet.
Let us assume first that I set up a Rothbard deposit bank and that at first this bank adheres
strictly to 100% reserve policy.
Suppose that $20,000 is deposited in the bank. Then, abstracting from my capital and other
assets of the bank, its balance sheet will look as in figure 4. Figure 4, 100% reserve
banking, Rothbard deposit bank, simple T account, assets on the left, cash, $20,000. Equity
Receding Liabilities on the Right, Warehouse Receipts to Cash, $20,000
So long as Rothbard Bank receipts are treated by the market as if they are equivalent to
cash, and they function as such, the receipts will function instead of, as surrogates for,
the actual cash.
Thus, suppose that Jones had deposited $3,000 at the Rothbard Bank.
He buys a painting from an art gallery and pays for it with his deposit receipt of $3,000.
The receipt, as we shall see, can either be a written ticket or an open book account.
If the art gallery wishes, it need not bother redeeming the receipt for cash.
It can treat the receipt as if it were cash and itself hold on to the receipt.
The art gallery then becomes a customer of the Rothbard Bank.
It should be clear that, in our example, either the cash itself or the receipt to cash circulates
as money, never both at once.
So long as deposit banks adhere strictly to 100% reserve banking, there is no increase
in the Money Supply. Only the form in which the money circulates changes. Thus if there
are 2 million dollars of cash existing in a society, and people deposit 1.2 million dollars
in deposit banks, then the total of 2 million dollars of money remains the same. The only
difference is that 800 thousand dollars will continue to be cash, whereas the remaining
1.2 million dollars will circulate as warehouse receipts to the cash.
Suppose now that banks yield to the temptation to create fake warehouse receipts to cash and lend these fake receipts out.
What happens now is that the previously strictly separate functions of loan and deposit banking become muddled,
The deposit trust is violated and the deposit contract cannot be fulfilled if all the creditors try to redeem their claims.
The phony warehouse receipts are loaned out by the bank. Fractional Reserve Banking has reared its ugly head.
Thus suppose that the Rothbard deposit bank in the previous table decides to create $15,000 in fake warehouse receipts unbacked by cash, but redeemable on demand in cash, and lends them out in various loans or purchases of securities.
For how the Rothbard Bank's balance sheet now looks, see Figure 5.
Figure 5, Fractional Reserve Banking, Rothbard Deposit Bank, a T account.
Assets on the left, cash, $20,000. IOUs from debtors, $15,000. Total assets, $35,000.
The right hand of the T, equity plus liabilities, warehouse receipts to cash, $35,000. Total, $35,000.
In this case, something very different has happened in a bank's lending operation.
There is again an increase in warehouse receipts circulating as money and a relative decline in the use of cash.
But in this case, there has also been a total increase in the supply of money.
The money supply has increased because warehouse receipts have been issued that are redeemable in cash, but not fully backed by cash.
As in the case of any counterfeiting, the result, so long as the warehouse receipts function as surrogates for cash, will be to increase the money supply in the society.
In the society, to raise prices of goods in terms of dollars and to redistribute money
and wealth to the early receivers of the new bank money, in the first instance the bank
itself and then its debtors and those whom the latter spend the money on, at the expense
of those who receive the new bank money later or not at all.
Suppose if the society starts with $800,000 circulating as cash and $1.2 million circulating
as warehouse receipts, as in the previous example, and the banks issue another $1.7
million in phony warehouse receipts, the total money supply will increase from $2 million
to $3.7 million, of which $800,000 will still be in cash, with $2.9 million now in warehouse
receipts, of which $1.2 million are backed by actual cash in the banks.
Are there any limits to this process?
Why, for example, does the Rothbard bank stop at a paltry $15,000, or do the banks as a
Why doesn't the Rothbard Bank seize a good thing and issue $500,000 or more, or umpteen millions, and the banks as a whole do likewise? What is to stop them?
The answer is the fear of insolvency. And the most devastating route to insolvency, as we have noted, is the bank run.
Suppose, for example, that the banks go hog wild. The Rothbard Bank issues many millions of fake warehouse receipts. The banking system as a whole issues hundreds of millions.
The more the banks issue beyond the cash in their vaults, the more outrageous the discrepancy and the greater the possibilities of a sudden loss of confidence in the banks.
A loss that may start in one group or area and then, as bank runs proliferate, spread like wildfire throughout the country, and the greater the possibility for someone to go on TV and warn the public of this growing danger.
And once a bank run gets started, there is nothing in the market economy that can stop that run, short of demolishing the entire Jerry-built fractional reserve banking system in its wake.
in its wake.
Apart from and short of a bank run, there is another powerful check on bank credit expansion under fractional reserves,
a limitation that applies to expansion by any one particular bank.
Let us assume, for example, an especially huge expansion of pseudo-warehouse receipts by one bank.
Suppose that the Rothbard deposit bank, previously hewing to 100% reserves, decides to make a quick killing and go all out.
Upon a cash reserve of $20,000, previously backing receipts of $20,000, it decides to print unbacked warehouse receipts of $1 million, lending them out at interest to various borrowers.
Now the Rothbard Bank's balance sheet will be as in Figure 6.
Figure 6, one bank's hyper-expansion.
Rothbard Deposit Bank, a T account, assets on the left, cash $20,000.
IOUs from people, $1 million.
Total, $1,020,000.
Liabilities on the right, warehouse receipts to cash,
Everything may be fine and profitable for the Rothbard Bank for a brief while, but there
is now one enormous fly embedded in its ointment. Suppose that the Rothbard Bank creates and
lends out fake receipts of one million dollars to one firm, say the Ace Construction Company.
The ACE Construction Company, of course, is not going to borrow money and pay interest
on it, but not use it.
Quickly it will pay out these receipts in exchange for various goods and services.
If the persons or firms who receive the receipts from ACE are all customers of the Rothbard
Bank, then all is fine.
The receipts are simply passed back and forth from one of the Rothbard Bank's customers
to another.
But suppose instead that the receipts go to people who are not customers of the Rothbard
Bank, or not bank customers at all.
Suppose for example that the Ace Construction Company pays one million dollars to the Curtis
Cement Company, and the Curtis Cement Company for some reason doesn't use banks.
It presents the receipts for one million dollars to the Rothbard Bank and demands redemption.
What happens?
The Rothbard Bank, of course, has peanuts, or more precisely, $20,000. It is immediately
insolvent and out of business. More plausibly, let us suppose that the Curtis Cement Company
uses a bank, all right, but not the Rothbard Bank. In that case, say, the Curtis Cement
Company presents the $1 million receipt to its own bank, the World Bank, and the World
The Rothbard Bank presents the receipt for one million dollars to the Rothbard Bank and
demands cash.
The Rothbard Bank, of course, doesn't have the money and again is out of business.
Note that for an individual expansionist bank to inflate warehouse receipts excessively
and go out of business does not require a bank run.
It doesn't even require that the person who eventually receives the receipts is not a
Customer of Banks
This person need only present the receipt to another bank to create trouble for the Rothbard
bank that cannot be overcome.
For any one bank, the more it creates fake receipts, the more danger it will be in.
But more relevant will be the number of its banking competitors and the extent of its
and its own clientele in relation to other competing banks. Thus, if the Rothbard Bank
is the only bank in the country, then there are no limits imposed on its expansion of
receipts by competition. The only limits become either bank run or general unwillingness to
use bank money at all.
On the other hand, let us ponder the opposite, if unrealistic extreme, that every bank has
only one customer and therefore there are millions of banks in a country.
In that case, any expansion of unbacked warehouse receipts will be impossible, regardless how
small.
For then, even a small expansion by the Rothbard bank beyond its cash in the vaults will lead
One force, of course, could overcome this limit of calls for redemption by competing banks, a cartel agreement among all banks to accept each other's receipts and not call on their fellow banks for redemption.
While there are many reasons for banks to engage in such cartels, there are also difficulties, difficulties which multiply as the number of banks becomes larger.
Thus, if there are only three or four banks in a country, such an agreement would be relatively simple.
One problem in expanding banks is making sure that all banks expand relatively proportionately.
If there are a number of banks in a country and banks A and B expand wildly while the other banks only expand their receipts a little, claims on banks A and B will pile up rapidly in the vaults of the other banks and the temptation will be to bust these two banks and not let them get away with relatively greater profits.
The fewer the number of competing banks in existence, the easier it will be to coordinate rates of expansion.
If there are many thousands of banks on the other hand, coordination will become very difficult and a cartel agreement is apt to break down.
An example of a successful cartel for bank credit expansion occurred in Florence in the second half of the 16th century.
There, the Riese Bank was the dominant bank among a half dozen or so others and was able to lead a tight cartel of banks that took in and paid out each other's receipts without bothering to redeem in specie.
The result was a large expansion and an ensuing long-time bank crisis.
It is likely that the establishment of the Bank of Amsterdam in 1609, followed by other
100% reserve banks in Europe, was a reaction against such bank credit-generated booms and
busts as had occurred in Florence not many years earlier.