Fractional-reserve banking is a system where a bank is allowed by a government (or central bank) to keep a fraction of its reserves (deposits) on hand for immediate withdrawal by its customers, while using the remaining money elsewhere (such as funding new loans). It is contrasted with full-reserve banking, which requires a bank to have 100 percent of its deposits on hand (in reserve) to all its customers on demand.
As an example, consider a new bank that has 100 customers. Each customer opens his account by depositing one dollar, resulting in a total of 100 dollars of deposits that is held by the bank. Under fractional-reserve banking, a bank would be allowed to have only a fraction of that deposited money (say 10 per cent) in reserves (i.e. 10 dollars in cash at the bank). Under full-reserve banking, this would not be allowed; the bank must have all 100 dollars (a full reserve) ready for the people who deposited their money.
Fractional-reserve banking has existed for centuries. In past times, currency often consisted of precious metals (such as gold). When people put their currency in the bank, the bankers came to realise that the full amount of deposited currency was not withdrawn by its customers on a given day. In these cases, bankers had two options; to leave the deposited money alone (and ready for withdrawal at any moment), or to use it for other purposes (and hope that customers would not all come to the bank at once to withdraw their money, a phenomenon known as a bank run).
A customer's proof of depositing gold in the bank was through a receipt issued by the banker. In effect, the receipt functioned as a written promise by the bank to redeem the receipt back into gold when demanded by the customer (i.e. when a withdrawal was made). This system formed the basis of banknotes. While the paper receipt itself had no monetary value, it was backed by the gold held by the bank and its promise to pay this to the depositor.
In more recent times, governments introduced legal tender laws, which deemed that government-printed banknotes could be legally used for the payments of goods, services and debts. However, unlike historical banknotes (which were issued by banks and backed by gold), modern-day banknotes are not necessarily backed by anything, effectively meaning that money could be printed out of thin air (i.e. by fiat).
Fractional-reserve banking allows a bank to essentially create money. Returning to the example of the bank with 100 dollars in deposits, the law may allow the bank to keep a fraction of those deposits in reserves (e.g. 10 percent or 10 dollars). With the remaining money (90 percent or 90 dollars), the bank is allowed to issue that money as a loan to another customer. This allows for more money to exist, and to circulate in the economy. However, with more money circulating in the economy, producers of goods and services may see this as an opportunity to raise their prices. This leads to inflation, meaning that the value of a dollar will fall (i.e. a dollar buys less goods and services than it used to).
The size of the fraction in fractional-reserve banking (the reserve ratio) is determined by a government or central bank. This allows the state to influence the monetary policy of its citizens. In 2007, the central bank of China noted the high amount of investment that was taking place (i.e. an investment boom). The central bank decided this amount of investment was too high, and therefore raised the reserve ratio to 13 percent. This was an attempt to reduce the amount of investment that was occurring at the time, which was held as a way of preventing inflation.
Support of and opposition to the concept
Supporters of fractional-reserve banking point out that without it, large amounts of money would sit unused in bank vaults. It would be much more difficult to generate wealth  or increase the money supply, and it is possible that interest rates for loans would be much higher than they otherwise would be.
On the other hand, critics have charged that fractional-reserve banking contributes to inflation, distorts the economy, allows the government to intervene with personal transactions, and contributes to bank runs that can be prevented. Ron Paul equated fractional-reserve banking with fraud. David Chilton concurred with this view and noted that if the same practice was undertaken by individuals, it would be counterfeiting and therefore illegal. The practice has also been labelled as a "licence to print money", and linked to breaking the Eight Commandment. Gary North has also stated:
|“||Fractional reserve banking is prohibited in the Bible, for two reasons: 1) it violates the prohibition against false weights and measures because it creates money, and 2) it violates the principle against multiple indebtedness.||”|
- Brown, E. "This Crisis Has an Exit"; Asia Times; June 7, 2011
- Associated Press. "Chinese central bank raises reserve ratio again"; USA Today; October 13, 2007
- WiseGEEK. What is Fractional-Reserve Banking? (n.d.)
- Risdon, P. Fractional Reserve Banking (March 12, 2010)
- The Daily Paul. Fractional Reserve Banking is Fraudulent - Ron Paul on CNBC (January 1, 2010)
- Chilton, D. Rich Christians in an Age of Guilt-manipulators: A Biblical Response to Ronald J. Sider; Institute for Christian Economics; Tyler. Page 380, (1981)
- Art Branch Inc. Fractional Reserve Banking. (2011)
- Mission to Israel. The Eighth Commandment. (n.d.)
- North, G. Tools of Dominion: Case Laws of Exodus; Institute of Christian Economics; Tyler. Pages 755-756, (1990)