Fractional-reserve Banking Considered Harmful

What is Fractional-reserve Banking (FRB)?

If you don't know what FRB is, this may come as a shock to you. It basically means that the bank steals some of the depositor's money and lends it to others. This means that the bank owes depositors more money than it has in its vault or the bank vault only contains a fraction of the money it should. Thus the bank reserves, which should be used whenever a depositor wants to withdraw money from his/her deposit account, covers a fraction of all depositors. Trouble will emerge when too many depositors try to withdraw their money at the same time; a so called bank run forces a bank to become insolvent.

How did we end up in this mess?

History of Fractional-reserve Banking

In the beginning, starting from the Roman Empire, banks were safe keepers of property. The property could be anything from jewelry, gold and other valuable assets that the depositor would like to safe guard from burglary. For some assets, e.g. wheat, it is unpractical to store things separately for each depositor. Instead a common barrel can be used to mix all depositors' goods. The terminology for this is irregular deposits. This makes it cheaper for the bank and will also bring down the cost of storage. In return the bank issued a note for which the amount (and sometimes quality) was stated. At any time, the depositor could take that note to the bank and claim the goods (or an equivalent amount) being stored at the bank. Putting money (usually gold coins around this time) in the bank was just another form of irregular deposit.

At some point, the bank owner became greedy and committed fraud by using the money stored in the vault (without depositor's consent) by granting loans to some other customer. At this very moment the bank has created money ex nihilo because the loan granted is some other depositor's money and does not exist. However, as banks are by definition non-transparent agents, it becomes difficult for anyone to take notice that fraud is being committed until the reserve becomes too low or if too many depositors claim their money back. At this instant the bank becomes insolvent and proof of fraud is revealed.

Rulers were typically not very forgiving if insolvency was discovered. As an example, in Catalonia (now a region in Spain) 1321 stated in law that the death penalty should be issued if banks breeched the depositor contract due to misappropriation. This law was practiced in 1360 when Francesch Castello was beheaded directly in front of his counter in strict accordance with the law.

Despite harsh penalties bankers could not resist making profits on fractional reserves. People started losing their confidence in the banking system altogether. A last attempt to restore some confidence was made by the creation of Municipal Bank of Amsterdam in 1609. The commitment made was to ensure a 100-percent reserve ratio to fulfill any obligation to return depositors' money, regardless of situation. This commitment lasted for over 170 (!) years and was tested 1672 when panic caused massive withdrawals due to threat of war (so called Third Anglo-Dutch War). Many banks became insolvent (Rotterdam and Middelburg), but Bank of Amsterdam proved they had 100-percent reserves. This event made Bank of Amsterdam famous and gained a lot of trust for having such high moral standards. Unfortunately, in the 1780s, the city of Amsterdam demanded a bank loan to cover costs of public expenditures, which forced Bank of Amsterdam to do fractional-reserve banking, and after that it went downhill.

At this point bankers tried to redefine terminology and said that deposits were not safekeeping property, but a loan to the bank. Thus, as with all loans, the bank is then granted to do whatever it wishes with the funds deposited. However, this is highly suspect from a juridical point of view. A loan contract comes with a term, which means that after the term expires, the property should be returned in full (sometimes with interest). Also, there are no "loans" for which the depositor can at any instant take it back, that's not how "loans" are defined.

Everything culminated in the Peel Act of 1844, where it was written in law that banks could issue money "ex nihilo" provided that the money created (from deposits) were loans only. Thus, counterfeiting was allowed as long as it was granting loans. This act laid the foundation of today's banking industry. At the same time of the Peel Act the central bank was invented because now it became explicitly legal to do fractional-reserve banking for which bankers demanded a lender of last resort if it were to fail its deposit obligations.

Credit Expansion and Entrepreneurs

Entrepreneurs take ideas, invest money in them, perform research & development, and finally (hopefully) sell products and make profit. This business cycle span over several years, so money invested in the early stage takes a long time to flourish. It turns out that credit expansion (i.e. ex nihilo money creation), performed by banks, rewards goods and services closest to consumption. As banks create money it also means that the purchasing power of the existing money (in the population) is decreasing, so wealth is being redistributed. This means that the relative price differences between investment (e.g. an entrepreneur in its stage of research & development) becomes more expensive compared to those closer to consumption. Therefore, expanding credit means that we get shit products cheaply, whereas goods and services with high quality get more expensive.

In terms of a nation's wealth, this can't be good. A nation should ensure that long term investments create goods and services for the coming generations. As an example, look at England's "Help to Buy" scheme, which drives up prices on house holds (inflation). However, an entrepreneur is also an agent in this environment and thus this inflation makes the research & development of the future product much more expensive because of its extended timeline.

Credit expansion does not bring anything good with it. A bank's privilege to create money ex nihilo must be stopped as it is hurting society and entrepreneurs in particular. Of course, the banks themselves get insanely rich, because they use the printing press to print more money for themselves (there's commission on loans, which usually is a percentage of the total sum granted). This means that the purchasing power drops for the rest of us except for the banks.

The Case of Bitcoin

There have been numeral proposals on how to end this corrupt system: Money based on the gold standard, eliminate central banks (so they cannot bail out banks that go bust), prevent banks from creating money ex nihilo, let depositors become share holders in the bank, etc. All of these ideas were proposed by the Austrian School of Economics before the Bitcoin invention. However, with Bitcoin things start to get really interesting.

Bitcoin = No more Fractional Reserves

For first time in human history it now becomes possible to become your own bank. The cost of safekeeping your own bitcoins (via safe wallets) is virtually zero, so you don't need to deposit it at a bank. This means that the bank won't have any deposits to begin with, so there's nothing to apply fractional-reserve on. Therefore, the only way banks can get funds into their system is to accept investor's money (with interest) and engage in a formal loan contract. This means that the bank is free to invest the money (and perhaps split profits according to the contract). In return the investor cannot touch the money until the term of loan expires. This is basically what banks offer today via "saving accounts", although the interest rates are ridiculously low (precisely because banks can perform credit expansion).

Private Investors

Bitcoin offers incredibly interesting things that can be built on top of the blockchain. One aspect is the concept of "colored coins". Creating colored coins is rather easy, as you route your coins through a specific address used as genesis or color. Any coin that can be traced back to that genesis address will be prescribed a certain property. For example, you can track shares of a company that way.

Now comes the mind-blowing part: Suppose you eat hot-dogs at a stand that you particularly like. At that instant, you could chose to invest on an agreed price of the colored coin a.k.a. shares of the hot-dog stand company. This can be done anonymously. As the hot-dog company expands and make profit it can choose to pay dividends to its share holders. It's relatively easy to identify the colored coins and find the non-colored coin transaction for it, thus returning the dividend to their proper share holders. Thus, in this scenario, regular customers can become investors instead of entrepreneurs relying on banks granting loans.

This is more efficient than a banking/loan system because the whole point with a market economy is that it is extremely difficult to get the information you need to make the right decision on investing or not investing. However, satisfied customers can usually pinpoint which merchants to trust and therefore make a better call on whether it is worth investing or not.

I'm not saying that these forms of investments would work for all cases; some entrepreneurs require more resources and funds at the initial phase than these types of "micro investments".


The fractional-reserve banking is a disease that needs to be cured. The medicine is called Bitcoin and it will revolutionize money, loans and investments. It will steer society towards productivity and reward entrepreneurs. It will end banks from creating money ex nihilo and retain the purchasing power of every citizen. It will make capital flow to where it should be, globally; optimized for innovation and prosperity.

If you look Bitcoin this way, there'll be no desire to go back. So I would say: Either this way or reinstate the Catalonian law from 1321; making it the Max Keiser way (KR438, 9:00-9:30).