Practical analysis for investment professionals
27 January 2016

Is This the End of Fractional Reserve Banking?

Is This the End of Fractional Reserve Banking?

Switzerland’s Vollgeld “Full Money Initiative”

I can pretty much guarantee you that the biggest story not being covered in the traditional business press right now is that Switzerland will hold a referendum to consider ending fractional reserve banking (!).

Yes, you read that correctly. That paragon of the banking industry is voting on whether to deconstruct banking as it has been practiced for centuries. In case you cannot read German, let me share with you some of the details:

  • Swiss law requires a popular referendum on any petition that receives at least 100,000 verified signatures as affirmed by the Swiss Federal Chancellery.
  • On 24 December 2015, the Federal Chancellery confirmed to finanzen.ch that it had received 110,955 valid signatures on a petition to end fractional reserve banking.
  • The effort is officially known as the Vollgeld, or “Full Money Initiative.”
  • The date for the vote has yet to be set. But given the complexities of the issue, and that Swiss law allows for counter-arguments, it will likely be a drawn out process before the official referendum date is set.

In the Heart of the Great Depression

How did this state of affairs even come about? The answer, it turns out, is shrouded in history. Specifically, it is hidden in the fog of the economics profession of the Great Depression. On 16 March 1933, a group of economists hatched an idea known as the “Chicago Plan,” Chief among these economists was one of the grandfathers of the profession, Irving Fisher. Their obsession was to identify the causes of the Great Depression and of the business cycle. Among the culprits they identified was fractional reserve banking.

In fractional reserve banking, banks keep only a small portion of the deposits they receive in their vaults and are otherwise free to lend out the rest. A typical ratio is 10:1 loans to reserves. What that means is that commercial banks share responsibility for money creation in an economy with central banks and that the credit and monetary functions of banking are intimately tied together.

Yet commercial banks have a varying and volatile appetite for money creation. The economists of the Chicago Plan thought that the business cycle was directly related to these appetites, with recessions (and the Great Depression) being among the consequences. Their solution? A 1:1 ratio of loans to reserves, with every $1 in loans backed by $1 in deposits. Despite generating a lot of interest at the time, the plan fell into obscurity. It resurfaced briefly several years later, following the US recession of 1937–1938, after which it again disappeared from history.

The Chicago Plan Revisited

In the wake of the Great Recession, many began reconsidering the Chicago Plan. But the greatest re-examination came after Jaromir Benes and Michael Kumhof — two economists at the International Monetary Fund (IMF) —  published a paper entitled “The Chicago Plan Revisited” in August 2012. Benes and Kumhof not only revisited the Chicago Plan, they tested it with modern econometric models of the economy. Before discussing the results of their modeling, what were the asserted benefits of the original Chicago Plan as set forth by Fisher in 1936?

  1. Greater control of a major source of business cycle fluctuations, including  the unpredictable expansion and contraction of banks’ credit and, consequently, the supply of banks’ created money.
  2. The complete elimination of bank runs.
  3. A dramatic reduction — if not complete elimination — of net government debt.
  4. A dramatic reduction in private debt since money creation is no longer tied to debt creation.

Certainly these are interesting contentions, and if you know anything about the financial system, then you also know that the Chicago Plan is nothing less than a radical rethink and redo of the global financial system. But will it work? According to Benes and Kumhof, the answer is an astounding and unequivocal “Yes”:

“We find strong support for all four of Fisher’s claims, with the potential for much smoother business cycles, no possibility of bank runs, a large reduction of debt levels across the economy, and a replacement of that debt by debt-free government-issued money. Furthermore, none of these benefits come at the expense of diminishing the core useful functions of a private financial system. Under the Chicago Plan private financial institutions would continue to play a key role in providing a state-of-the-art payments system, facilitating the efficient allocation of capital to its most productive uses, facilitating intertemporal smoothing by households and firms. Credit, especially socially useful credit that supports real physical investment activity, would continue to exist. What would cease to exist however is the proliferation of credit created, at the almost exclusive initiative of private institutions, for the sole purpose of creating an adequate money supply that can easily be created debt-free.”

Iceland Takes Up the Mantle

On 20 March 2015, Iceland published the results of an intensive study that explored the viability of ending fractional reserve banking. The report, commissioned by the prime minister, is entitled, “Monetary Reform: A Better Monetary System for Iceland.” In the words of the author, Frosti Sigurjonsson:

“[The report] proposes a radical structural solution to the problems we face. The feasibility of and merits of that specific solution need to be debated. But whatever the precise policies pursued, they must be grounded in the philosophy which the report proposes — the money creation is too important to be left to bankers alone.”

What Does It All Mean?

By now you must have many questions about the ramifications of an end to fractional reserve banking. What does it all mean? There are several good sources for necessarily speculative answers (since no one has ever lived under a full reserve regime):

  • The papers from the IMF, Iceland, and Switzerland.
  • Read about the Chicago Plan and assess the potential impacts for yourself.
  • My colleague Ron Rimkus, CFA, is writing a follow-on piece to discuss the ramifications. So check back here on The Enterprising Investor.

Editor’s note: An early version of this article stated that the Vollgeld referendum would be held this year. That is not correct. A date for the referendum has yet to be set.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

 


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/william87

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

34 thoughts on “Is This the End of Fractional Reserve Banking?”

  1. Bill says:

    Why wait for the governments to end fractional reserve lending, just create 100% reserved “banking” now. Uphold.com has already created a 100% reserved cloud money platform where a variety of value options are available to ecosystem.

    1. Hi,

      Thanks for your comment, and for sharing the information about Uphold.com.

      Yours, in service,

      Jason

  2. Chuck T says:

    I can’t see the banking industry in the US allowing something like this to pass. A big payday for lobbyist if they try. It’s like trying to throw a speedbump in front of HFT’s. We all see how thats going.

    1. Hi Chuck,

      I agree with you that the hurdles to passage in the U.S. are likely insurmountable, probably the case in the UK, too. Nonetheless, a fascinating story, and I think one to watch because when a leftist country like Iceland, and a rightist country like Switzerland are discussing similar policy it begs your attention.

      With smiles,

      Jason

      1. Michael says:

        It’s not difficult to see why Iceland considered it-they were bankrupt not so long ago but Switzerland ? Hmm-one of the richest Countries in the world based on PPP. That takes a little more thinking about.

  3. Doug Barrett says:

    Is it safer, I think clearly yes. How would you do it when banks are already leveraged they way they are though. You could force banks over time to reduce their leverage to 0, but that sounds like a major depression. People would probably vote hands down for replacing their bank debt with newly printed free money from a Central Bank. Everybody gets a “Get out of Debt Jail Free Card”. The disappearance of debt would have to be inflationary, wouldn’t it? If it was at all possible, it would be time to borrow to the max.

    1. Hi Doug,

      Take a look at the IMF’s paper as they address many of these issues.

      Yours, in service,

      Jason

  4. Joseph Pijanowski says:

    Jason,

    Thank you for this post. Kids in 5th grade can tell you in general terms how a gallon of gasoline comes into existence, yet it seems that no one knows how our money comes into existence…..and this is way more important especially in the current state of our economies. Thanks for helping “clear the air”. As the smoke rises and the mirrors shatter it will become self evident that we desperately need the reforms proposed by Kumhof, Zarlenga, Yamaguci and others. These reforms are only far fetched IF WE THINK they are. Look up the NEED ACT. It was proposed twice in congress. It has already been vetted. All it needs is a little updating and get it introduced again. These reforms turn out national debt on it’s head allowing us (Government) to create the money needed to allow the power of creative LABOR to rebuild our infrastructure, fund education and healthcare while paying off our national debt. Please note: This ONLY sounds crazy if you do not understand how our current system works and how it can only drive our national debt UP….WAY UP.
    Thanks again.

    1. Hello Joseph,

      You are welcome, and thank you for your extended comment. Thank you also for highlighting the NEED Act, I will most certainly investigate further. I wrote this post, because, quite frankly I am shocked that none of the major business press has picked up this story to any degree. To me the idea that nearly opposite countries – Iceland and Switzerland – could be considering the same banking regime needs to be discussed. I first saw this story just prior to the New Year and was certain that someone would run with it and that I would be late to the publishing party. But alas, only in the blogosphere is the story getting much coverage.

      By the way, I also felt that way when the U.S. business press (except a brief blurb in one paper) did not cover the offshore tax evasion scandal that broke three years ago, and that led to resignations of politicians around the globe.

      In any case, I am pleased that you liked the piece.

      Yours, in service,

      Jason

  5. CFA Switzerland here – thanks for picking this up!

    I’d like to correct some important factual inaccuracies first: 1) the popular referendum required by the initiative for a partial revision of the Swiss Constitution (that’s what’s happening technically) will almost certainly not be happening this year. The Federal Council and Parliament will first have to determine their recommendation and whether there will be a counter-proposal. The usual duration of this procedure is up to 3 years from the initiative’s successful inauguration.
    2) Vollgeldinitiative does not propose the same changes as would be foreseen by the Chicago Plan. According to the initiators (HT @vollgeldreform), the correct terminology in English would be positive money. The refer to a differential analysis here (http://positivemoney.org/?p=13581) and for German readers here (http://goo.gl/Ls7AqQ).

    Jason, you’re referring to Iceland and Switzerland as “nearly opposite countries”. I’m guessing you’re referring to a simplistic left-right scheme. However, both countries are quite small and have a political constitution that values direct popular involvement rather than political representation through elected institutions very highly. This is the reason why proposals that are not aligned with the established consensus of political elites have a real chance of actually passing, as we have discovered on multiple recent occasions in Switzerland. While sometimes disruptive and certainly uncomfortable for the powers-that-be, it’s not the worst system, as it keeps the political sector grounded (i.e. shoots them down occasionally).

    I am looking forward to this debate very much!

    1. Hello Chris,

      Thank you for these important contributions. First, thank you also for the clarification about the timing of a referendum, it has been devilishly difficult to get information about this issue in English, and here in the United States. Second, also thank you for indicating that there are differences between the Chicago Plan and Vollgeld. However, I did not say that the two were identical; the piece before you is one about the ending of fractional reserve banking.

      Also, I am confused by your inclusion of the Positive Money website, because it seems very different than the Vollgeld website, which is the Swiss site I linked to. For one thing, Positive Money seems last updated in 2013, whereas Vollgeld is up-to-date with the latest developments. Please clarify why you included this link. Last, Positive Money is proposing something almost exactly like the Chicago Plan, but using slightly different language. It sounds as if you thought there were significant differences, please feel free to enumerate those differences if you would like.

      Yes, I was referring to Iceland and Switzerland using a left-right framework, and still think that two countries of normally different dispositions toward the role of business discussing similar policies is interesting. Yes, there are similarities, but that is true of any two things that can be compared.

      Yours, in service,

      Jason

  6. Frank Ashe says:

    I’m surprised that the people who think fractional reserve banking is bad, are comfortable with the government issuing all the money and gaining the seignorage. We could have avoided the recessions after the financial crisis if US and European governments had created money for spending on infrastructure. But the people who dislike fractional reserve banking typically dislike this fiscal policy as well. You can’t have both.

    Well you can, but you might as well wish for a pony as well while you’re at it.

    1. Hello Frank,

      Thank you for taking the time to share your comments.

      Yours, in service,

      Jason

    2. Ross says:

      I am one of those people who see the inherit problem in fractional reserve banking, especially as currently practiced in the U.S. Our governments borrow massive amounts of money, creating inflation with the added burden of interest. At least inflation under a fractional reserve system would be interest free.

      What causes these boom and bust cycles in the first place is the disconnect between money and wealth. People forget that money is supposed to be a way of trading wealth, money is not wealth. Creating money without the backing of real wealth causes instability. To be specific, home loans were given to people who lacked the wealth to pay for the loans. There was no real wealth to back up all the money that was being created by these loans. There was no foundation.

      You say “We could have avoided the recessions after the financial crisis if US and European governments had created money for spending on infrastructure.” That is not only more of the same problem, it’s putting the cart in front of the horse. Creating money that is supposed to represent wealth before creating the wealth is what caused the financial crises to begin with. Also, creating infrastructure is of limited use. If the current infrastructure is adequate, then creating more is a misuse of labor and resources. (Labor and resources are both forms of real wealth.) All it would have done is create a temporary and false drop in unemployment, a political feather in Obama’s hat. It would have cost us all in the long run when those jobs and that fake inflation causing money ran out. Unemployment would have risen again and we would have had unneeded infrastructure that would give no return on investment.

      Read “Economics in One Lesson” by Henry Hazlitt to understand the problem of make work policies more fully.

  7. Frank Ashe says:

    BTW The IMF paper uses a DSGE model, which, by construction of their solutions, can’t have a major crisis like 2007-2009 in it.

  8. Chris Cook says:

    While I applaud the aim to replace conventional banking with a better system, this proposal is based upon misconceptions.

    In very few banking systems are reserves a constraint. The fact is that banks create credit instruments/modern money first and THEN spend (often missed) or lend this modern money at interest.

    The constraint is the cushion of bank capital – set by the Bank of International Settlements in Basel – which underpins their implicit guarantee of their loans to borrowers.

    Note that an enormous amount of credit – which underpins a great deal of retail goods and services – is created by credit card systems such as Mastercard and Visa.

    There are no deposits in these systems.

    Note also that Switzerland created in 1934 in the WIR a complementary currency/credit system which – if updated – would be an infinitely preferable approach to this regrettably flawed proposal…albeit a proposal with its heart in the rights place.

    The fact of the matter is that in a networked economy there is a need for banking-as-a-(risk management) service, but not banks-as-(risk) middlemen.

    1. Hello Chris,

      Thank you for your thoughtful comments, and suggestions. To me they contribute to the discussion meaningfully.

      Yours, in service,

      Jason

      1. Jacob says:

        We don’t live in a Fractional Reserve System. We live in an Endogenous Money system.

        Loans create deposits, and reserves are found later.

  9. Nick Egnatz says:

    http://www.monetary.org/wp-content/uploads/2013/01/HR-2990.pdf

    The above link is for the legislation put before the U.S. Congress in 2011 by Dennis Kucinich: the NEED Act (National Emergency Employment Defense Act). It is understandable, comprehensive monetary reform. The bill itself is only 12 pages and Kucinich’s two page explanation is great.

    The Three Necessary Reforms of the NEED Act
    1. The U.S. Federal Reserve System is nationalized into the Treasury Dept.
    2. Bank creation of money (fractional reserve lending) is decisively stopped.
    3. New US Money, is created and spent into existence, debt-free, in non inflation/deflationary amounts, by our government for the needs of the nation and its people. Beginning with the infrastructure repairs called for by the American Society of Civil Engineers that now amount to $3.6 trillion by 2020. This would immediately create at minimum 10 million new, good-paying jobs.

    The NEED Act has been vetted by Dr. Karou Yamaguchi as non inflationary and that includes paying off the national debt as it comes due. Kumhof and Benes, while not specifically vetting the NEED Act, did vet the Chicago Plan that the NEED Act was based on and said basically the same thing. It works.

    1. Hello Nick,

      Thank you for the additional detail on the NEED Act. At the suggestion of an earlier commenter I read through an overview of the bill several days ago. It sounds as if you are an active part of the movement to support the NEED Act, yes?

      Yours, in service,

      Jason

      1. Nick Egnatz says:

        Yes I am a strong supporter of it. Here’s a video of me talking about it at the American Monetary Institute’s 11th Annual Conference on monetary reform last fall.

        1. The pamphlet Nick Egnatz talked about, “Linking Social Justice to Monetary Reform”, is still at the alpheus web site:

          http://www.alpheus.org/linking-social-justice-to-monetary-reform/

  10. Michal Stupavsky, CFA says:

    Hello Jason,

    I would like to thank you very much for this post. I have always regarded this blog as rather mainstream overall and that’s why I applaud your effort to cover this non-mainstream subject thoroughly from all angles. It is inspiring as well to see so many value-added comments in the discussion above. Please keep on tracking these generally neglected themes.

    Best,
    Michal

    1. Hi Michael,

      Thank you for sharing your thoughts here. One of our difficulties in ensuring that you can find the content you want on The Enterprising Investor is that we do not have ‘channels’ that you can subscribe to, or that you can navigate to. We are working on fixing that, because we actually pride ourselves on covering non-mainstream materials. For example, the series I wrote about intuition is not something I have seen covered anywhere else. In any case, I am pleased that you liked this piece : ) It is an issue that we promise to continue to follow.

      Yours, in service,

      Jason

  11. Ending fractional reserve banking would cause the money supply to shrink as loans no longer generated electronic money. But the central bank could reflate the money supply by generating new money and directly giving it to the government to spend into circulation with the effect of lowering existing taxes.

    However, ending FRB by itself would only result in banks creating near money alternatives to continue their business model of transforming short term debt into long term loans. So ending fractional reserve banking would have to be part of a larger reform ending the practice of maturity transformation within the entire financial shadow banking industry.

    1. Hello Lorenzo,

      Thank you for taking the time to share your thoughts about the piece, and for your interest in The Enterprising Investor.

      Yours, in service,

      Jason

  12. paul says:

    Altho’ I studied bookkeeping and later, some accounting & economics, in my post secondary education, I wouldn’t regard my background on par with all the CFA types commenting. I will say I came here to verify fractional banking was still in effect, because I’m on my 2nd pass through an ebook in pdf, I downloaded free, from a site that piqued my interest, http://www.getoutofdebtfree.org/wiki/images/8/89/Mary-croft.pdf, and the pdf has been not only illuminating (tho I already knew much of what she discusses re the banksters, etc), but found myself chuckling out loud at this maven’s testimony of her journey. I can identify with her “maverick” tendencies.

  13. Chris Clark says:

    I am an engineer and have been aware of this for quite a while and I think the comments above are excellent. I completely agree that the FRB system has to go if humanity is going to make it but the concern I have is that it seems to me that FRB is an effect of the a more fundamental issue within human nature itself and it mirrors the FRB effect which is mathmatically a pyramid hiearchal structure. I refer to it as hiearchal domination as it relateds to the source energy creating it. Seems to me that it is a very old survival mechanism in many animals that has been around for a very long time way before money. FRB is just a distortion of this as human concensusnous evolved. It is reaching an evolutionary dead end for humans but how do you get the few who full well know this and control all the weapons, media and whatever that have ensalved most of humanity with this ethos to make this evolutionary shift? Its possible there are things at work way beyond FRB that is causing this distortion to stay in place. The above described mechanics are right on but the controlling energy in play executing the current state of affairs is another whole story in my observation.

  14. Dennis Richardson says:

    How can monetary truth come out of Switzerland? The Rothschild family has their money and their gold there. Does economic truth actually reside in that country that has manipulated or debased currency for centuries since in the modern era it began in Venice with the Doge.

    1. Hello Dennis,

      Thanks for taking the time to comment, I appreciate it.

      Yours, in service,

      Jason

  15. Andrew Smith says:

    Hi, not sure if it’s still possible to make comments on this section, but since Vollgeld is still very topical, I assume a comment would be relevant.

    I read the Benes and Kumhof paper and wonder about one of the key assertions they make: that often credit is created “for the sole purpose of creating an adequate money supply” (p.7) They lump mortgages, consumer loans and working capital loans into this category – that is, they assert borrowers take out these loans for the sole purpose of creating bank deposits (money) with which to effect payments by way of inter- or intra-bank transfers. On this basis, the authors argue that these loans can be paid-out with no economic impact, since the deposits are no longer necessary, as there will be enough treasury credit to provide all the liquidity needed.

    I have problems with this assertion as there is a strong economic incentive not to take out a loan for the sake of simply creating a deposit: the interest rate charged on the loan is much higher (around 2%) than the interest paid on the deposit. That’s a high price to pay for liquidity. I would aver that such loans are indeed taken out for the credit they provide, and not just the liquidity they provide.

    The authors contend (Fig.3, p 66) that such loans (Manufacture Deposits and Constrained Household Deposits) amount to 80% of gdp. Surely the large bulk of these should be re-classified as investment loans.

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