Fractional Reserve Banking Is a Fraud (but It’s Genius)

The recent buyout of First Republic, the second-largest bank failure in the U.S. ever, has raised serious questions about solvency and liquidity across the global banking system. Banks are supposed to be stodgy operations: Customers deposit money into a bank account for safekeeping and withdraw it whenever they want to use it. And by and large that system works.

But banks need to make money, and most banks in the United States are basically free or low-fee accounts. So how do banks make money? By lending out customer deposits to risky businesses to make yield, of course.

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In reality, banks run like this: Short-term, safe customer deposits come in the door, the bank uses those short-term customer deposits to invest in long-term, risky assets in exchange for future financial returns and then the banks pray like hell that all the customers don’t want their deposits at the same time since short-term deposits are tied up in long-term assets.

This is fractional reserve banking (where only a fraction of customer deposits need to be held in the bank’s reserve) and it’s a widely-known fraud. And while this fraud is indeed a fraud, it has in a way been beneficial to society even though we would be more well-served to have a way to opt out of the fraud.

Basically if banks weren’t able to invest short-term, low-risk customer deposits into long-term, high-risk assets then the availability of investment capital for most of the crazy, world-changing ideas entrepreneurs come up with would have never been funded. Banks help us spread the risk of financial capital allocation.

In absence of banks participating in this genius we could instead have a financial system where the only financial capital that invests in long-term risky investments is the capital that commits to investing in long-term risky investments (see: narrow banking).

Therein lies the fraud. The fraud is that almost no one who deposits money into bank accounts knows that they are opting into this particular solution for the “collective action problem” of financial capital allocation.

Here’s the thing though, this genius has been kind of good for society. We’ve been tricked into making productive investments. Unproductive investments too, sure. But you’d be hard pressed to argue that we would have made more productive investments without the genius of fractional reserve banking.

The good thing is that banks do appear to be moving towards a more narrow model. Sure, it might get more expensive for companies to get capital since there will be less capital available if the fractional reserve banking system becomes less popular, but that’s fine. The people who invest in high-risk, potentially high-reward investments and assets should be the people who outright declare: “I want to invest in high-risk, potentially high-reward investments and assets.”

So, the modern financial system is built on “fraud and genius.” Does the latter excuse the former?

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