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Bitcoin and Fractional Reserve Banking

Bitcoin and Fractional Reserve Banking

What would happen if Bitcoin became the base money of a fractional reserve banking system? Would it spell disaster for the anonymous crypto-currency? To answer this question, we have to look at the history of banking and the role government has played in both exacerbating and concentrating its risks.

Bitcoin is a cryptographic peer-to-peer currency with no central authority to issue new money or to keep track of transactions. Instead, these tasks are handled by a distributed network over which nobody has total control.

The Rise of the Bitcoin Banks

We are seeing the rise of Bitcoin as one of the first viable internet currencies where nobody is control. The growth in size, payments and goods and services offered are evidence of this. However, the future of Bitcoin may look quite different to its origins as a cypher-punk geek project. One possible future was alluded to by Gavin Andresen:

In the future the Bitcoin payment network might be used only by major banks and financial institutions, with large-value payments made to “settle accounts” periodically through the day. Small transactions might be bundled up by the banks over proprietary payment networks, as is done now with Visa and MasterCard or bank debit-card payments.

In other words, there is a distinct possibility that Bitcoin could ultimately become a reserve currency, used by financial institutions to settle payments between each other. Such institutions would hold accounts denominated in Bitcoins, just like modern banks hold accounts denominated in fiat currency. However, the actual Bitcoin wallet would be owned by the institution, rather than the individual.

There are a number of factors which could drive this trend:

Firstly, there could concerns over security, as less technical users opt for the safety of storing their wallet “in the cloud,” as opposed to on their computer. A physical device can be lost, stolen or hacked into by malicious software, while a bank account places the onus for security on the institution.

Secondly, institutions which process payments outside of the Bitcoin network will be able to offer faster transactions, as payments do not need to wait for the Bitcoin network to confirm them. This makes it more convenient to transact in Bitcon for day to day purchases, using a bank’s own payment network, alongside a debit card or near-field communications device. It would also take some of the network load off of Bitcoin, as banks would only settle the differences between their accounts in the network, rather than process every transaction.

Thirdly, banks may pay interest to those who hold Bitcoin with them, as well as issue credit. Their loans would also be issued in Bitcoin denominated accounts, and spendable within the banking system. Perhaps it could also be redeemable in Bitcoin, like today’s bank credit is redeemable in cash. However, this leads us to an interesting paradox:

… the arrival of Fractional Reserve Banking to Bitcoin.

There is nothing about Bitcoin which could prevent institutions using Bitcoin as the high-powered base money of a fractional reserve banking network.  The ability of banks to extend credit over and above their actual reserves depends solely on people’s willingness to accept such bank credit as payment for goods and services. In effect, a Bitcoin bank would be creating and issuing its own currency, backed by a promise of convertibility into Bitcoin on demand. Groups of banks could collude to accept each other’s bank credit, increasing the viability of their own Bitcoin credit and therefore their ability to make loans.

However, this future scenario seems quite at odds with the stated goal of Bitcoin. According to Bitcoin.org, a reason to use Bitcoin is to:

[b]e safe from instability caused by fractional reserve banking and central banks. The limited inflation of the Bitcoin system’s money supply is distributed evenly (by CPU power) throughout the network, not monopolized by banks.

This might seem paradoxical: one the one hand, Bitcoin presents itself as an alternative to the global fiat-money banking regime, and on the other, it could be used to enable a version of fractional reserve banking by itself. My view of this is that the paradox is superficial: the kind of fractional reserve banking which might arise around Bitcoin is fundamentally quite different from the kind we have in the banking system today.

However, before I explain why, it’s worth taking a detour to examine the nature of the fractional reserve system today, and precisely why it is unstable, exploitative and unsafe for society.

The Fiat Fractional Reserve Banking System and its Discontents*

The heart of any fractional reserve banking system is the ability of depositors to withdraw their cash at any time, while banking institutions have simultaneously lent out this money as long-term loans. This fundamental tension within the banking system is possible only insofar as the majority of bank depositors don’t try to withdraw their money at the same time. The system can, under those circumstances, maintain the illusion that its customers’ deposits are “in the bank”, whereas what they really have is a promise by a bank to pay the depositor a certain sum of money, on demand.

With the rise of digital banking, electronic payments became more common, reducing the need for cash. This meant that it became even easier to transact in bank credit – the bank’s promise to pay money – rather than money. In fact, the two are so interchangeable nowadays that the distinction is hardly noticed. What’s more, banks can simply settle the differences between their accounts at the central bank, further reducing their need for actual cash at any given moment.

The folly of this system has been noted by no less than Mervyn King, the governor of the Bank of England, who called it a “poor advertisement for human rationality”:

“Eliminating fractional reserve banking explicitly recognizes that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not co-exist with risky assets.”

The fractional reserve system’s alchemy enables it to extend credit to businesses, rather than use up a scarce supply of funds. The banks’ ability to lend is constrained only by its reserve requirements, and the market’s perception of its financial strength. This has certain advantages to businesses, who enjoy an abundant supply of credit in the good times, limited only by their ability to productively invest it. However, the system has some less fortunate consequences, as evidenced by the most recent banking crisis:

  • The debt imperative. Since the majority of money in circulation is in fact bank credit, the overall level of indebtedness in the economy is close to the entire money supply. It is impossible for everyone to pay off their debts, as the money required to do so has to be introduced into the system as more debt. If people stop borrowing, the money supply begins to shrink, and there is less money available to service debt.
  • Misallocation of credit. Problems arise when banks misallocate credit. Bank credit can be created to fuel harmful speculation, to manipulate markets, as well as to create asset bubbles. The positive feedback loop whereby banks continued to expand credit on the basis of rising house prices, which they were also causing, can have drastic consequences for the real economy.
  • Exacerbation of the business cycle. The business cycle, whereby production expands and contracts, is exacerbated by banks extending too much credit (increasing the money supply) when times are good, and restricting credit too harshly (decreasing the money supply) when times are bad. Economic performance is affected by the money supply, which is in turn a function of banks’ often foolish lending.
  • Usurpation of wealth. Because banks increase the money supply when they issue bank credit, and often do so in excess of the economy’s capacity to productively invest it, they create inflation. Such inflation erodes the value of savings, and is the reason why most fiat currencies have strongly depreciated since their inception. Furthermore, banks charge interest on practically the entire world’s money supply – a huge and seemingly arbitrary transfer of wealth from the productive economy to the banking system.

Returning to Bitcoin, we can see that a future scenario in which the above system is replicated would repeat its disastrous results. However, as I have already said, there are some reasons to believe that a fractional reserve system based around Bitcoin would be much less dangerous to the economy and society. To see why, we have to go back in history to the Free Banking Era in the United States.

The Free Banking Era (1827 – 1862)

The firm paid my wages in wildcat money at its face value. – Mark Twain

The Free Banking Era was perhaps the most interesting stage of American financial history. Between 1827 and 1862, responsibility for regulating banks was dissolved to the states, many of which pursued laissez-faire strategies, allowing unchartered banks to exist as long as they adhered to basic reserve requirements, capital ratios and interest rates. In all other respects, the states treated individual banks much like any other private corporation: they did not enjoy any special guarantees such as deposit insurance (though there were some voluntary schemes.) Banks were certainly never bailed out or prevented from collapsing. Most significantly: banks were not permitted to issue Federal reserve note money. Bank credit had to be extended in the bank’s own credit notes – often derogatorily referred to as “wildcat money” because of its precarious nature. Underlying bank credit was a promise that bank notes could be redeemed in specie – namely, gold or silver.

During this period, there was a large increase in the number of banks, as well as increase in the rate of bank failures. Bank money was recognised to be inherently risky, since no Government support existed to guarantee its value if the issuing bank failed to make good on its redemption promise, or went bust. Furthermore, because bank money wasn’t legal tender, nobody was forced to use it. This imposed a further discipline on banks: their money was only as good as the market’s belief in their financial strength. It was commonplace for bank notes to trade at a discount the further they travelled from their issuing banks. An industry of middlemen arose who bought up notes out of state and brought them back to redeem them – another source of constraint on the banks’ ability to issue credit.

While the conventional view of this period is one of instability and endless banking collapses, judged as a whole it was actually more stable than the system we have today. The reason is that risk was transparent: individuals entered into voluntary agreements with banks, which they knew carried risks. They were therefore more careful about where they placed their money. Banks in turn had to be more careful about how much credit they could extend, because they lived and died by the market’s perception of their financial position. While the system saw banks collapse around the edges, the structural integrity of the system was greater – its resilience lay in its diversity. Today, the inherent risk of fractional reserve banking is assumed by the entire system, and ultimately by society, should the entire edifice need rescuing from collapse.

Incredibly, this view of the Free Banking Era is supported by another famous central banker, Alan Greenspan:

Throughout the free banking era the effectiveness of market prices for notes, and their associated impact on the cost of funds, imparted an increased market discipline, perhaps because technological change–the telegraph and the railroad–made monitoring of banks more effective and reduced the time required to send a note home for redemption. (…)

Part of this reduction in riskiness was a reflection of improvement in state regulation and supervision. Part was also private market regulation in an environment in which depositor and note holders were not protected by a safety net. That is, the moral hazard we all spend so much time worrying about today had not yet been introduced into the system.

Bitcoin’s Free Banking Era

The important lesson for Bitcoin’s future is that fractional reserve banking is not inherently problematic. It is the combination of fractional reserve banking with Government which creates problems. The often overlooked cornerstone of this support is the Government’s willingness to treat bank issued credit as if it were legal tender: enforcing its acceptance as payment for debts. This guarantees the value of bank credit, while displacing the risk of bank failure onto society.

If a fractional reserve banking system is ever built around Bitcoin, it will be a lot more like the system under the Free Banking Era than what we have now.  The main reason will be that bank credit will be sharply distinguished in the marketplace from actual Bitcoin.

Online Bitcoin banks technically exist already, insofar as there are services willing to hold Bitcoin on behalf of their depositors. It is not too hard to imagine a time when such banks will also want to issue their own credit, by simply crediting accounts in their ledger system beyond their ability to redeem it for Bitcoin. If this does happen, it will be up to the marketplace to evaluate the desirability of such service against the risks they entail. It may be that a fractional reserve Bitcoin system never gets off the ground for that reason. In either case, the distinguishing mark of Bitcoin – its decentralization – will ensure that this will be a conscious choice rather than an inevitability.

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