A Complication of Fractional Reserve Banking

One of the complications of fractional reserve banking is that a bank's demand deposit customer's can be held hostage, so to speak, to a bank's investment follies. Recent portfolio movements at the Bank of America illustrate this quite nicely.

According to Bloomberg News, the Bank of America has moved its Merrill Lynch derivatives unit to "a subsidiary flush with insured deposits." Officials at the Federal Reserve liked this move, because it gave some relief to the bank holding company. Moving bad assets off a balance sheet will do that. Officials at FDIC, however, understandably do not like the move, because such a move greatly weakens the balance sheet of the subsidiary, making it more likely to fail with the FDIC on the hook for the losses. The Bloomberg story reminds us that even three years after the financial crisis, things are not yet cleaned up.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

The frustrating thing is that banking does not have to be like this. It is possible to have deposits that are entirely secure. The way to do it is to practice 100 per cent reserve banking. Instead of allowing banks to lend out their clients demand deposits and create additional demand deposits out of thin air, banks could be required to maintain enough reserves to cover 100 per cent of their outstanding demand deposits all of the time. In such a banking environment, there would be no risk of clients losing their deposits due to foolish investments. Banks could still make entrepreneurial error and still exhibit losses, but there would be no link between their investment practices and their deposit banking.

As Guido Hulsmann notes in his article, "Free Banking and the Free Bankers," under 100 percent reserve banking,

[T]here could be crises of confidence, but there can be no crises of the payments system. This is because the monetary aggregate that is relevant for payments--the money supply in the larger sense, that is, money plus fiduciary issues--could not differ from the supply of money. Its quantity could only vary to the extent that the quantity of money varies.

The money supply plus fiduciary money (in our present system demand deposits not fully redeemable by bank reserves) would equal the money supply, because there would not be any fiduciary money. In which case there could be financial panics, but they would not inhibit a bank's ability to redeem its clients' checking deposits, because they would always have enough reserves on hand to redeem every penny. In such a happy environment, there would be no need for FDIC.