Home / Opinion / Views /  Ignore the bad takes – fractional reserve banking is a cornerstone of prosperity

Since the failur​​e of Silicon Valley Bank and the US regulator’s move to shutter another weak bank, Signature Bank, social media has been rife with uninformed tirades against fractional reserve banking, in which banks hold in reserve only a small portion of their total assets or liabilities and lend or invest the rest.

One strand of the social media campaign is Republican opportunism – trying to use the bank failure and the selling pressure on banks in general to attack the Biden presidency. The other, albeit lacking an overt political motive, is equally misconceived, with some tweeters picking up the threads of the anti-fiat-money crusade of cryptocurrency zealots that preceded last year’s crypto meltdown.

Let us be clear on one thing. There is not only nothing wrong with fractional reserve banking. It has been one of the main drivers of growth and prosperity across the world, allowing society’s savings to be converted into productive capital while minimising costs and optimising returns. It stands alongside the limited liability joint stock company as a force for good, enabling prosperity, risk-taking, broad-based growth and steadily improving living standards.

A bank performs three functions. It agglomerates society’s savings into large pools that can finance large projects. Individual savers have different time horizons – that is, how long they can make their savings available to others – while those who use savings as capital to create value have diverse periods for which they require capital. Banks match the time profiles of assets (the loans made by the bank) and liabilities (the deposits by savers), chiefly by pooling deposits of different maturities and servicing depositors who reclaim their deposits out of the pool.

The third valuable function banks perform is to lower the cost of capital, both by creating money to lend, and by reducing transaction costs of agglomerating capital and identifying worthwhile recipients of the capital at their disposal. In the absence of banks, the huge information gaps that separate savers and investors would not only make capital scarce but also hugely expensive.

These are, of course, quite apart from the services banks provide as secure custodians of the capital companies receive. They also facilitate transactions via cheques, electronic transfers and instruments such as cards.

Imagine a situation in which banks are not available to mediate savings to investors. Traditional actors such as money lenders or modern electronic platforms that enable peer-to-peer lending would perform the function. Both kinds of loans are costly and can finance only relatively small loans.

What about bond markets, you might ask. Don’t they disintermediate lending? When a company issues bonds, investors need to put in a lot of effort to identify viable, secure projects. They are aided by rating agencies, merchant bank advisory, brokerage research and the like. But if the bond-issuing entity goes under, savers lose their shirts.

When a bank makes a bad loan, the bank takes the hit, and only in the rarest of cases are depositors required to share in the loss. Banks are supported by deposit insurance, supervision and regulation by a banking regulator, and fortified by capital adequacy norms, additional capital buffers to absorb any loss, periodic stress tests, and insolvency proceedings to recover salvageable value, apart from their reserves.

Banks can operate because they are required to keep as reserves only a small proportion of the deposits they receive. In India, the credit-to-deposit ratio for banks rarely goes up to 1, although it could be significantly higher because depositors do not need to reclaim their deposits all at once in the normal course of things. The exception is when a bank faces a run on its deposits – that is, most depositors decide to take out their money because they believe the bank is going broke and will soon be unable to repay them.

Social media can amplify the power of such rumours and banks do face the risk of unfounded runs. The net effect might be to make relatively small banks unviable. Governments tend to bail out large banks when they are in serious trouble because to let them fail is to endanger the stability of the entire financial system. Depositors know this and may prefer to eschew small banks altogether in favour of large ones. But this is more of a theoretical possibility than a practical one.

Safety in size has been true ever since the slew of banking failures during the Great Depression in the 1930s, and yet small banks have mushroomed and survived. This is because banks run on confidence, and every bank does not require the ultimate guarantee of state support to win confidence.

Sound regulation and swift intervention to douse the fires will go a long way to secure public confidence in banking. In the absence of confidence, paper currency itself has no value. If money can be trusted, so can fractional reserve banking.

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