Following the collapse of Silicon Valley Bank (SVB), many Americans are becoming aware of the dangers of fractional reserve banking. According to reports, SVB suffered a massive bank run on Thursday as customers attempted to withdraw $42 billion. Below is what fractional reserve banking is and why this practice can lead to economic instability.
The History and Dangers of Fractional Reserve Banking in the United States
For decades, people have been warning about the dangers of fractional reserve banking, but the recent ordeal of Silicon Valley Bank (SVB) has brought the issue back into focus. Basically, fractional reserve banking is a system of bank management in which only a portion of a bank’s deposits are held and the remaining funds are invested or lent out to borrowers. Fractional reserve banking (FRB) operates in almost every country in the world and became widely known in the United States in the 19th century. Prior to that time, banks operated on a full reserve basis, where they would reserve 100% of depositors’ funds.
However, there has been considerable debaterecently as to whether fractional lending is taking place, with some suggesting that investment funds and loans are simply being printed out of thin air. This debate stems from a Bank of England paper calledMoney Creation in the Modern Economy.” It is often used to dispel myths about modern banking. Economistarticle Robert Murphydiscusses these alleged myths in chapter12of his book “Understanding Money Mechanics.”
The FRB method became largely popular after the passage of the National Banking Act of 1863, which created the US banking charter system In the early 1900s, occasional bank failures and financial crises began to crack the fractional reserve method. After World War I, this became more pronounced, and the bank runs featured in the popular movie “It’s a Wonderful Life” were an everyday occurrence at the time. To remedy the situation, a cabal of bankers known as the “Money Trust” or “Morgans” worked with the U.S. bureaucracy to create the Federal Reserve System.
After more problems with fractional reserves, the Great Depression ensued, and U.S. President Franklin D. Roosevelt initiated the Banking Act of 1933 to restore confidence in the system. The Federal Deposit Insurance Corporation (FDIC) was also created to insure depositors who held only $250,000 or less in banking institutions. Since then, the practice of fractional savings banking has continued to gain popularity in the United States throughout the 20th century and remains a mainstream banking practice today. Despite its popularity and prevalence, fractional reserve banking remains a significant threat to the economy.
History of FDIC deposit limits. pic.twitter.com/e0q1NkzW6n.
– Lynn Alden (@LynAldenContact)March 12, 2023
The biggest problem with fractional reserve bankingis that banks only hold a fraction of deposits, which can lead to a run on them. If a large number of depositors simultaneously demand their deposits be reimbursed, the bank may not have enough cash on hand to meet their demands. The result is a liquidity crisis because the bank cannot appease depositors and may be forced to default on its obligations. The failure of one bank can cause panic among other depositors depositing elsewhere. A major panic can spread throughout the financial system, leading to economic instability and a broader financial crisis.
“So it’s called fractional reserve banking”
. “What’s happening to the fractional”
“It used to be 10%. But now it’s 0” pic.twitter.com/iBbH6yxDXn.
– foobar (@0xfoobar) . 3/12/2023
Electronic Banking and Speed of Information Foster Threat of Financial Contagion
In the movie “It’s a Wonderful Life,” news of insolvency spread through town like wildfire, but news of recent bank runs can travel much faster due to several factors related to advances in technology and the speed of information. First, the Internet has made it easier for information to spread quickly, and news of bank runs to spread rapidly through online platforms such as social media and news sites.
Fractional reserve banking does not work, especially in the age of the Internet and social media.
Information and fear spread too fast for institutions to react.
What used to take weeks now takes minutes.
Weak institutions can be exposed and crash within hours.
– The Wolf Of All Streets (@scottmelker) . March 12, 2023
Second, electronic banking has sped up transactions, allowing those who want to withdraw to do so without physically going to a branch. The speed of online banking could lead to faster and more widespread attacks on banks if depositors perceive that their funds are at risk of becoming unavailable.
Finally, perhaps the most important difference today is the interconnectedness of the global financial system, where a bank failure in one country can spread quickly to other regions. The speed of information, electronic banking, and connected financial systems are very likely to have a much faster and more widespread contagion effect than was possible in the past. While technological advances have made banking more efficient and easier, these mechanisms have increased the potential for financial contagion and the speed at which bank runs can occur.
deception and “waves of credit bubbles with little or no reserves”
As noted above, many market observers, analysts, and prominent economists have warned about the problems with fractional reserve banking. Satoshi Nakamoto, the creator of Bitcoin, also wrote about the dangers in hiswhite paper: “Central banks must be trusted not to let currencies fall, but the history of fiat money is full of breaks in that trust. Banks must be trusted to take custody of our money and transfer it electronically, but banks have lent money in waves of credit bubbles and have hardly kept a fraction of it in reserve,” Nakamoto writes. This statement highlights the risk of fractional reserve banking, where banks lend out more money than they have in reserves.
Murray RothbardRothbard was an Austrian economist and libertarian who was a strong critic of fractional reserve banking. Rothbard once stated that “fractional reserve banking is inherently fraudulent and could not exist for long if it were not subsidized and privileged by the government.” Rothbard, an Austrian economist, believed that fractional reserve banking relied on deception and that banks could artificially expand credit, causing booms and busts The Great Recession of 2008 is a reminder of the dangers of fractional reserve banking, which does not rely on the credibility of centralized institutions It was also the same year that bitcoin emerged as an alternative to traditional banking.
So it is strange that America suddenly woke up and realized what fractional reserve banking
– Erik Voorhees (@ErikVoorhees) March 12, 2023
The SVB issue showed that people have a lot to learn about these issues and fractional banking as a whole. Currently, some Americans are asking the Fed to bail out Silicon Valley Bank in the hopes that the federal government will bail them out. But even if the Fed bails out SVB, the dangers of fractional reserve banking still exist, and many use SVB’s failure as an example of why we should not trust a banking system that operates in this manner.
In today’s rapidly evolving digital environment, what steps do you think individuals and financial institutions should take to prepare for and mitigate the potential threat of financial contagion? Share your thoughts in the comments section below.
Image Credits: Shutterstock, Pixabay, Wiki Commons, Wall Street Mojo, It’s a Wonderful Life, Twitter .
