Before discussing fractional reserve banking, let’s go over the concept of full reserve banking. Suppose a bank takes in total deposits worth $100 million from its depositors. The bank promises the depositors that they may withdraw their deposits anytime. The bank, in this case, simply acts as a warehouse for the money deposited, collecting fees from the depositors in return. At any time, all deposited money remains within the bank; and at any time, any or all depositors may come to collect the money they have deposited. This is full reserve banking: all the deposits remain in reserve.
However, it is unlikely that all the depositors will arrive at an instance to demand all their deposits. Suppose the bank estimates that even if it simply holds on to $75 million, it will be able to meet the likely withdrawal demands of the depositors. Thus, the bank is able to lend out $25 million and earn interest on those loans. Due to these interest earnings, the bank is able to waive fees for its depositors, and perhaps even pay them a small amount of interest. This is fractional reserve banking. The bank is keeping only a fraction (here, 75%) of its deposits as reserve.
Rothbard asks the question, “Would fractional reserve banking be permitted in a free market, or would it be proscribed as fraud?” In the case above, the bank has lent out $25 million. Thus, if the depositors demanded any amount over $75 million at any instant, the bank would not be able to honor its promise. By lending, the bank has already entered a state of bankruptcy, although this bankruptcy will only be revealed if the depositors lose confidence and make a run on the bank. The bank has engaged in the act of issuing fraudulent promises worth $25 million. Which depositors will be defrauded, again, will only be revealed in the low-probability scenario of a bank run.
The bank is relying on the scenario in which its false promises is not caught. This is clearly immoral. The fact that a bank run is a low-probability scenario does not somehow make the fraud moral. It is simply not ethical to make promises we know are impossible to keep.
Legality, however, is a different matter. Governments all around the planet make special exceptions for banks. Most countries have set their reserve requirements to 10%; several have set it to zero! A grand con game is in play. Depositors do not realize that they are merely the unsecured creditors of their banks.
One final point: credit is still possible under full reserve banking. There are honest ways to lend. One way is through term deposits. With these deposits, depositors are only able to withdraw their money after a certain term expires, and the bank may lend out the deposits during this time. Other ways involve not using banks at all: someone with the money to lend may directly lend to the borrower under the terms they agree on. The depositor/bank/lender might still lose money in these cases; after all, lending involves an element of risk. However, the fraud is not systematically embedded into the banking system.
References
- Rothbard, Murray. What Has Government Done To Our Money? Chapter 1.