Banking castles built with black magic

Lots of folks will tell you that fractional reserve banking ‘creates money’.  When I was getting my MBA this was taught as if it were some sort of anti-realist magic, the conjuring of wealth out of nothing, the creation of money through a trick of math. But the reason it looked like anti-realist magic was because of the presumption of usury.

In the absence of usurious contracts, fractional reserve banking doesn’t ‘create money’: it securitizes property.  To securitize property is just to issue title to some sort of claim against that property.  That is where every kind of currency gets any real value that it actually has: currencies entitle the bearer or owner to something other than the currency itself, and the value of that entitlement is the intrinsic value of the currency.  When a non-usurious fractional reserve loan is made, the bank issues a new demand deposit account – a claim against its balance sheet – in exchange for a collateral interest in the (new, at least to the bank) property which collateralizes the loan. It would be similar if the bank had issued new stock in exchange for its claim against the new-to-the-bank property. The main difference is that a deposit account is a different kind of security from capital stock, with a different structure of claims against the bank’s balance sheet.

A demand deposit account entitles the owner to fiat currency on demand from the bank, up to the amount of the deposit account — backed by the bank’s balance sheet, or all of the property in which the bank has a stake.  If you want to buy something you can go to the bank teller, exercise your title to some cash, and buy something with the cash that the teller gives you.  Or you can go to the merchant and electronically transfer title to a portion of your deposits to the merchant in return for the merchandise.  Most merchants these days will accept a portion of your claims against a reputable bank’s balance sheet in lieu of paper cash.

This all works fine, and does not create any wealth out of nothing, but it is of course still possible for the bank to fail [1].  If the bank does not stay liquid enough – keep enough cash and credit on hand to meet demand for fiat currency, or, said differently, maintain a balance sheet which is strong enough and of the right composition – then it won’t be able to issue all of the cash that depositors want. Prudent bankers don’t over expose their balance sheets to risk, but there is always risk involved in owning property and it always costs something simply to maintain property against the forces of entropy.

If you don’t want to take that particular risk you can instead pay the bank to keep your money in a safe deposit box, where it literally still belongs to you and is not at risk in the bank’s business operations.  But if you want the bank to look after your property without paying a fee, perhaps even earning interest, you become an investor in the bank.  A deposit account is a securitized investment just as much as capital stock, bonds, or all sorts of other more complex contracts.  And there are always inherent risks to being an investor.

When you introduce usury, though, is when the black magic appears. If the loan issued by the bank is usurious then the bank is issuing a new security against its balance sheet in return for a wink and a promise by the borrower. The bank then enters the wink-and-promise of the borrower onto its balance sheet as if it were actual property.  So in the case of banks which issue usurious loans, many of the loan ‘bricks’ in their balance sheet castles are imaginary; and in the case of collateralized full-recourse loans the ‘bricks’ are made of weaker material than they appear.

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[1] I am ignoring the whole regulatory environment and things like FDIC insurance, since my goal here is to help with conceptual understanding not to talk about every detail.  Part of the regulatory requirement is that the bank has to keep a certain amount – a certain fraction – of unproductive cash or federal reserve deposits in ‘reserve’ to meet depositor demands; thus the term ‘fractional reserve banking’.