In praise of fractional reserve banking

Fractional reserve banking enables banks to create money out of nowhere, as if by magic. Accordingly it has long been attacked from both the far left and the far right of the political spectrum.

However it does not just survive — it is almost universal. The reason is that it has many economic benefits for society. The attacks on it are so misguided that few people bother to write in praise of fractional reserve banking, because they have better ways of spending their time.

Last year I received some correspondence from a reader of this website expressing religious concerns about banks creating money. I answered the enquiry and also turned it into my November 2023 column for the magazine "Islamic Finance News." You can read it below.

Fractional reserve banking benefits humanity, but with occasional crises

I always like to hear from readers via the email address I publish on my personal website to make me easy to contact. In October someone wrote to me after reading my 2nd October 2019 IFN column “Islamic banks also create money.”

My 11 February 2016 IFN “Letter from Amin” explained the importance of distinguishing between religious questions and empirical questions. Point (1) is religious, so each Muslim needs to make up his own mind, and I refused to debate it with him, although I disagree with the reader’s point.

Point (2) is an empirical point, and the reader is asserting its universal truth, regardless of whether the finance provided is conventional or Islamic, since both conventional and Islamic banks charge for providing finance, at essentially similar rates.

Such wealth transfers can happen when governments artificially limit the price of credit, particularly at times of high inflation. This has the technical name “financial suppression.” However, there is no overall evidence that the banking system unduly favours borrowers over savers; they contract with the bank to receive different services.

Most of the incoming email was about the harm to the real economy from fractional reserve banking, building on point (2) above, which is an empirical question. The question applies for both conventional banking and Islamic banking, since my IFN article shows that the operations of both create money.

Short correspondence established that my reader had his mind firmly made up about this empirical question, and he also showed no evidence of any formal education in economics, so I discontinued the correspondence to save time.

Wikipedia explains “Fractional reserve banking” quite well. The article says that almost every country in the world uses it. I don’t know the exceptions but would guess that North Korea might be one!

The main reason it is almost universal is that expanding the supply of credit enables more economic activity. For example, businesses can invest in more fixed assets and inventory, while individuals have greater capacity to purchase residential property for example. More economic activity makes societies richer.

The downside is that things can go wrong, either at the level of the individual bank or at the level of the entire banking system. The regulatory system is designed to minimise the risk of individual banks getting into trouble, but it will happen from time to time. A key regulatory goal is to minimise losses to depositors, so that shareholders bear the cost of failure.

Sometimes, as with the depression of the 1930’s or the 2008 global financial crisis, there is a risk of systemic collapse; governments have successfully intervened to prevent it. While such risks need to be minimised, I regard them as an unavoidable byproduct if society is to continue to enjoy the benefits of fractional reserve banking.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.