Comment: Clearing UP Confusion On Fractional Reserve Banking

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Clearing UP Confusion On Fractional Reserve Banking

I am neither for or against fractional reserve banking but I would like to clear up some widespread confusion on this topic. Back on July 1, 2013 the Daily Paul featured a video on “Fractional Reserve Banking Explained”.

The problem with the video about the fed study “Modern Money Mechanics” (MMM) is that it was originally published by the Chicago fed in 1961 and most recently revised in 1992 and printed in a final edition in 1994. The narrative in the video is all about what is commonly called the fed “Money Multiplier Model” which has been taught in standard economics 101 textbooks for decades as gospel but in fact is sorely out of date. Recent up to date research from the fed's own research suggests that this standard money multiplier model is wrong because it has the causality backwards. There is no statistical evidence to show that there is a transmission belt from fed interest rate targeting, to changes in bank reserves, to new loan origination. I refer to “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” by Seth B. Carpenter and Selva Demiralp 2010.

The standard money multiplier model creates the impression that the fed pushes money out into the commercial banking system which then leverages it up to ten times the original amount based on the 10% reserve ratio requirement.

Common wisdom perceives that fed injection of cash reserves via open market operations always ends up getting re-deposited and thus re-levered over and over again. However, if this is true, how is it that nearly $2 trillion of in excess reserves injected into the commercial banking system as a consequence of fed purchases of Treasury debt and mortgage backed securities from its QUANTITATIVE EASING operations lies idle on account at the fed as overnight excess reserves earning a mere 0.25%?

It is true that banks only have to hold 10% of a loan amount on account with the fed as reserves, but the causality begins with loan origination. After booking a loan, a convention known as “lagged reserve accounting” gives banks about 30 days to deposit the 10% reserve with the fed. In other words, the loan comes first and the 10% reserve requirement with the fed comes subsequently.

This means that the existence of $2 trillion in excess reserves held on account at the fed has absolutely no material impact on the ability or willingness of banks to make loans. Banks can make as many loans as they want to credit worthy borrowers regardless whether there are $2 trillion in excess reserves or $1. This issue was addressed in a the Financial Times / Alphaville article.

In other words, the process is based on loan demand pulling reserves out of the Fed as a consequence of the Fed's interest rate targeting mechanism, which in normal times means adjusting the fed funds rate. If loan demand is strong and a lot of banks are making loans, they will need reserves to deposit with the fed which they can borrow in the fed funds market from other banks that have more reserves on hand than they need.

However, if there is a net reserve deficit in the commercial banking system, competition among banks bidding for reserves can drive up the fed funds above the fed’s target. If so, then the fed will conduct open market operations to buy Treasury securities from primary dealers in exchange for cash reserves until the fed funds rate comes back down to target.

This means that by targeting the fed funds rate, the fed relinquishes control over the money supply. The fed cannot control interest rates and the money supply simultaneously any more than it is possible for someone to hit two birds with one arrow.

Fractional reserve banking is a hot button issue for many and clearly too much leverage is definitely not a good thing, but too little leverage may not be so good either. It may be that leverage is ingrained in in human nature as a function of risk taking. "I'll Have Another", the winner of the 2012 Kentucky Derby was rated at 15 to 1. Long before the creation of the fed, goldsmiths during the Renaissance realized that they could lend out 90% of the gold placed on deposit with them because it would be a rare event that more that 10% of gold depositors would come to claim their gold holdings at any one time. If the commercial banking system reformed itself along the model of full reserve banking, it makes me wonder how would an outright ban on leverage would be enforced?

Ed Rombach