In a free banking system, various banks issue their own banknotes which are redeemable for the gold that they hold. The banks set their policies independently and compete with other banks in the free market. This is distinct from the central banking system we experience today, where a central bank dictates key requirements the chartered banks must obey, and these banks issue a single fiat currency.

One important decision a bank needs to make in a free banking system is how much reserves it shall hold on to at any moment to meet the withdrawal demands of the depositors. If the reserves are less than 100% of the deposits, the bank engages in fractional reserve banking. (Setting aside the question of morality of such a system, free banks with fractional reserves have emerged in the free market and operated for a long time in the past.)

What keeps these independent banks from setting a reserve that is too low? How does the market enforce a lower bound on the percentage of reserves a bank would hold? Or, equivalently, how does the market enforce an upper bound on the issuance of inflationary money substitutes (here, claims on deposits in excess of the reserves held)?

  1. Extent of the clientele of the banking system: There would be people/entities who would not want to deal in banknotes at all. In order to deal with such entities, the banks would have to keep adequate amounts of the money (the base asset, perhaps gold).
  2. Extent of the clientele of each bank: The amount of money substitute (banknotes) creation a bank may create would be proportionate to the size of their clientele. If a bank has two clients who only transact among themselves, the banknotes move from one client to another and no claim on the base asset is ultimately made. But suppose a client deals with a client of another bank, the banknotes issued by the first bank reaches the second bank, which then demands from the first bank a commensurate payment in money (the base asset). This compels the banks to hold reserves.
  3. Confidence of the clients in their banks: The confidence of the depositors is key in this system. If they suspect that their bank is financially unsound, there will be a run on the bank, actualizing its bankruptcy. This holds even if the banks coordinate amongst themselves to accept each others’ money substitutes without demanding settlement in money. In this case, anti-fractional reserve system advocates (Anti-Bank Leagues) would emerge, advocating for bank runs, compromising the reputations of the banks.

These factors would force the banks to exercise prudence and maintain sufficient reserves. Those not careful would run the risk to being revealed to be bankrupt, and subsequently compelled to exit the banking industry.

References

  1. Rothbard, Murray. What Has Government Done To Our Money? Chapter 1.
  1. The Immorality of Fractional Reserve Banking