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Definition of FRB

Posts: 2
 Joe P
Topic starter
(@Joe P)
Joined: 3 weeks ago

On pages 19-21 of Central Banking 101, you explain how the intermediation theory of bank lending is false.  Banks don’t lend against deposits, they create deposits by lending.  Because of transaction volume and the ability to borrow reserves as needed, banks will have enough inter-bank money to settle their transactions.  You refer to this as fractional reserve banking (FRB).  I know it’s not what you intended, but the term FRB suggests that banks lend against reserves.  On pages 43 and 47 you show that banks are capital constrained, not reserve constrained.  (I assume you were referencing Basel III regulations.)  You also refer to this as FRB (page 43).  It seems to contradict your definition on page 21.  It looks like fractional capital banking to me.  Professor Richard Werner prefers to call it credit creation banking.  Or, because the term FRB has been around for centuries, are we using it as a catch-all that loosely refers to any system of lending constraint?  I’m not trying to split hairs.  For a layman, banking concepts are complicated and hard to understand.  Precisely defining terms would be very helpful.  Please elucidate.  

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Posts: 39
Joined: 1 year ago

Thanks for your interest and input. I will keep your points in mind when I update a new version.

I think of fractional reserve banking as banks holding an amount of liquid assets (central bank reserves or currency) that is only a fraction of deposit liabilities. So if a bank has $1000 in checking deposits due to others, but only $100 of currency in the vaults, then it is engaging in fractional reserve banking. It literally owes other people $1000 that can be withdrawn at any time, yet only keeps $100 in currency on hand (fraction of liabilities held as reserves). All banks operate on a fractional reserve basis. 

The way that a bank ends up this way is through credit creation. As you noted - banks create loans and deposits. Suppose a bank is started with $100, so it has $100 in cash in the vault and $100 in equity. Suppose  it then created $900 of loans, and thus $900 in deposits. Now we are in the situation as above where a bank has $1000 in deposits, but only $100 in cash. This is ok because usually not everyone withdraws money as the same time.