Lesson 4 of 9
Posting a deposit and a loan
Fractional reserve banking is easiest to see as bookkeeping. Four postings, one small bank, and the number of spendable claims at the end of each step.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A deposit of cash changes what the bank holds and what it owes by the same amount. Nothing is created and nothing is spendable that was not before.
- Lending against a fraction of that deposit creates a second deposit balance without removing the first. Spendable claims rise; money proper does not.
- The reserve ratio the bank keeps sets how far that can go, and the constraint is redemption: claims presented for money proper the bank does not hold.
The clearest way to see what a bank does is to post the entries. Rothbard makes the same argument with balance sheets through the middle chapters of The Mystery of Banking, and the arithmetic below is built the same way with invented round numbers.
Where the balance sheet starts
Assets
- Money proper held · the bank's own capital, in cash$200k50%
- Owners' equity · nothing is owed to anyone yet$200k50%
Claims against the bank
Total$400k
Four postings
-
The bank opens. Owners put in $200,000 of money proper. Assets: cash $200,000. Liabilities and equity: equity $200,000. Spendable claims held by the public: unchanged.
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A customer deposits $100,000 of cash. Debit cash $100,000, credit the customer's deposit $100,000. The bank now holds $300,000 of cash and owes $100,000 on demand. The customer can spend $100,000 and has handed over $100,000, so nothing has been added. Everything outstanding is a certificate: fully covered.
-
The bank lends $80,000. It does not hand over cash from the vault. It writes a loan asset of $80,000 and credits the borrower's account with $80,000. Cash is still $300,000. Deposits are now $180,000. The original depositor can still spend $100,000 and the borrower can now spend $80,000. The $80,000 is fiduciary media.
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Some of it is presented. The borrower pays a supplier who banks elsewhere, and $80,000 of cash leaves. Cash falls to $220,000, deposits fall to $100,000. The loan asset stays. The bank now holds $220,000 against $100,000 of demand liabilities plus its own equity, and its reserve against deposits is what limits how often it can repeat step three.
What actually changed
Count the spendable claims after step two and after step three. After step two, $100,000. After step three, $180,000. No additional money proper entered the system at any point, and nobody gave up the ability to spend anything.
That is the whole of fractional reserve banking. The bank did not lend out the depositor's cash in the sense of handing it over; it created a second claim against itself and kept the first one outstanding.
What limits it
Redemption. A bank that has created claims beyond the money proper it holds cannot meet all of them at once, so it keeps a fraction back against ordinary outflows: withdrawals, and payments to customers of other banks.
Step four is that constraint arriving. A bank in a system of many banks loses reserves whenever its borrowers pay people who bank elsewhere, and the clearing between banks is what turns a single bank's caution into a system-wide limit. How tight that limit is, and what a central bank does to it, is the subject of the next three lessons.
Check yourself
After the deposit in step two, what has happened to spendable claims?
- They have risen by $100,000
- They are unchanged, because the depositor handed over what they can now draw
- They have fallen by $100,000
Show the answer
Answer: B.
The deposit swaps one form of purchasing power for another. Everything outstanding at that point is fully covered, which is a certificate rather than fiduciary media.In step three, where does the $80,000 the borrower can spend come from?
- From the depositor's cash, which is handed over
- From a new deposit balance created by the posting, with the original claim still outstanding
- From the bank's equity
Show the answer
Answer: B.
Cash does not move at the moment of lending. A loan asset and a deposit liability are created together, and the first depositor's claim is untouched.What limits how far the bank can repeat step three?
- The size of its equity
- Redemption: claims presented for money proper it does not hold, including payments to other banks
- The number of depositors
Show the answer
Answer: B.
Step four is the constraint arriving. In a system of many banks, clearing turns each bank's reserve caution into a limit on the whole system.Sources
- Rothbard, The Mystery of Banking, 1983, chapter VI on loan banking and chapter VII on deposit banking, including warehouse receipts, fractional reserve banking, and the relation between bank notes and deposits, where the same mechanism is worked through with balance sheets.
- Rothbard, The Mystery of Banking, chapter VIII, on the limits a competitive banking system places on credit expansion through redemption and clearing.
- Mises, The Theory of Money and Credit, German original 1912, English translation 1934, part three, chapter 16, for the categories the postings above create.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Every figure here is an invented round number chosen so the postings can be checked by hand. No bank is described, and real bank accounting carries capital requirements, settlement arrangements and regulatory reporting that this sketch leaves out entirely.
- That these postings occur is not disputed by anyone. What they imply, and whether the practice should be permitted, is disputed, and both sides are in this course.