Fractional-reserve banking in Bitcoins - nothing prevents it!

[mpfrank]

So, I've noticed that many people like to think of Bitcoins as a solution to the way that central banks today can inflate the money supply of fiat currencies...

However, it seems to me that the powers-that-be could use the very same methods to effectively inflate Bitcoins, as follows...

Suppose that someday, Bitcoins become widely accepted, enough that most commercial banks start offering their customers demand-deposit accounts denominated in Bitcoins.  (Just as with paper money, the value-add could be, "We'll keep your coins safe from theft in a secure electronic vault, and plus you'll earn interest on them.")

However, just like with paper dollars and coins today, banks would not necessarily have to hold onto enough actual Bitcoins to pay out on 100% of their deposit accounts - just a percentage of them, like 10%.  The rest could be loaned back out.

This is how the banking system (all the way up to the Federal Reserve) works today, and by doing so, it effectively increases the money supply - if a bank has X amount of deposits, they keep X/10 amount in their vaults, and loan out the other 90%.  Both the depositor and the loan recipient think they have the money - so there is (a perception at least) that there is more money than before.  (This is called fractional-reserve banking, and it is (or has been) the basis of credit-fueled economic growth, increasingly so through the hundreds of years since its invention by the Medicis...)

Anyway, as the loaned amounts are re-deposited at other banks, the cycle repeats itself, and as a result, the effective money supply can increase many-fold above and beyond the supply of "base" physical (or in this case, virtual) currency.  This higher-order money supply would then include not only actual Bitcoins, but Bitcoin-denominated demand-deposit accounts and loan accounts at banks -

Obviously, such a system would be vulnerable to a "run on the bank", and institutions like FDIC could insure individual banks against such eventualities... while failing to prevent systemic risks (such as the near-collapse of the banking system that happened in 2008).

But, I see no reason why this same entire edifice of fractional-reserve banking, with all its inherent risks, could not or would not be rebuilt on a foundation of Bitcoins, assuming they became popular.

So in other words, this community will have put in all this huge effort to build up a new "inflation-proof" currency, only to find that it still ends up being prone to inflation as a result of central bank/government manipulation anyway, as the banking system (with its shady accounting practices) multiplies the effective money supply way out of proportion to the underlying asset...  (At least by up to about a factor of F, if the reserve requirement is 1/F.)

Any thoughts?

[FooDSt4mP]

They can't inflate the base supply like they can with fiat currencies.  Not perfect, but much better.

[Findeton]

Yes, you can have Fractional-reserve banking in Bitcoins.  I don't see it happening in the near future, though.

[Grant]

You can start a fractional reserve or even a zero-capital-reserve bank anytime. In secondlife there used to be many zero-capital-reserve banks, when they "failed" depositors lost their money (and their 30-70% annual interest gains) but the currency didn't inflate any more nor any less due to those failures.

The biggest one was a zero-reserve bank, he started it without ANY capital at all.
http://www.wired.com/gaming/virtualworlds/news/2007/08/virtual_bank

The systemic risk that got created was that other people copied his idea and started their "fractional or zero reserve-banks", part of the problem was they put their depositors money in the Ginko Bank or other similar banks to earn interest. Then when a few of them collapsed, the rest collapsed. However there was noone printing massive amounts of new money to rescue depositors, therefore no inflation was caused due to these "failures".

[FooDSt4mP]

You can start a fractional reserve or even a zero-capital-reserve bank anytime. In secondlife there used to be many zero-capital-reserve banks, when they "failed" depositors lost their money (and their 30-70% annual interest gains) but the currency didn't inflate any more nor any less due to those failures.

The biggest one was a zero-reserve bank, he started it without ANY capital at all.
http://www.wired.com/gaming/virtualworlds/news/2007/08/virtual_bank

The systemic risk that got created was that other people copied his idea and started their "fractional or zero reserve-banks", part of the problem was they put their depositors money in the Ginko Bank or other similar banks to earn interest. Then when a few of them collapsed, the rest collapsed. However there was noone printing massive amounts of new money to rescue depositors, therefore no inflation was caused due to these "failures".

Indeed.  That's the other main point.  There is no way to save such an institution when it fails. It might work a few times, but people will learn.

[mpfrank]

Lots of insightful answers, thanks!!

[hugolp]

There is nothing wrong with fractional reserve banking. The problem is when you have fractional resrve banking + central bank (or similar regulations). Then you get all the problems. But fractional reserve banking alone is not a problem, and its even positive because it helps the allocation of capital and stabilicies the swings due to changes in the demand for money.

I recommend this blog as an starting point to learn why free banking (fractional reserve WITHOUT a central bank) is positive: http://www.freebanking.org/ Also, this article by George Selgin: http://www.independent.org/publications/tir/article.asp?a=774

This is how the banking system (all the way up to the Federal Reserve) works today, and by doing so, it effectively increases the money supply - if a bank has X amount of deposits, they keep X/10 amount in their vaults, and loan out the other 90%.  Both the depositor and the loan recipient think they have the money - so there is (a perception at least) that there is more money than before.  (This is called fractional-reserve banking, and it is (or has been) the basis of credit-fueled economic growth, increasingly so through the hundreds of years since its invention by the Medicis...)

Anyway, as the loaned amounts are re-deposited at other banks, the cycle repeats itself, and as a result, the effective money supply can increase many-fold above and beyond the supply of "base" physical (or in this case, virtual) currency.  This higher-order money supply would then include not only actual Bitcoins, but Bitcoin-denominated demand-deposit accounts and loan accounts at banks -

No. It depends on the system. Under a free banking system (fractional reserve WITHOUT a central bank) the banks tend to only accept gold (or in this case bitcoins) as base money, they dont accept notes of other banks.

Accepting notes of other banks as base money only happens when there are regulations, like we have now, that protect the banks (FDIC, central banking) and allow them to overexpand the supply of money, creating debt and inflation.

Obviously, such a system would be vulnerable to a "run on the bank", and institutions like FDIC could insure individual banks against such eventualities... while failing to prevent systemic risks (such as the near-collapse of the banking system that happened in 2008).

Actually, history shows that free banking system (fractional reserve without a central bank) are remarkably stable and wihtout too many bank runs. The banks know that there is no one to protect them and are forced to behave because of fear of going bankrupt. Fear and greed always balancing each other. If you take the fear away with a central bank, fdic, and other regulations then banks start to misbehave and you have things like the 2008 collapse you mentioned.

But, I see no reason why this same entire edifice of fractional-reserve banking, with all its inherent risks, could not or would not be rebuilt on a foundation of Bitcoins, assuming they became popular.

So in other words, this community will have put in all this huge effort to build up a new "inflation-proof" currency, only to find that it still ends up being prone to inflation as a result of central bank/government manipulation anyway, as the banking system (with its shady accounting practices) multiplies the effective money supply way out of proportion to the underlying asset...  (At least by up to about a factor of F, if the reserve requirement is 1/F.)

Fractional reserve alone is not inflationary. Once banks reach the zone of equilibrium they mantain the reserve ratio in a range, thus the money supply remains stable, only reacting to changes to the demand for money (this is a positive effect of fractional reserve).

[killer2021]

Actually there is lots that prevents fractional reserve banking. Its called not putting all your money in the bitcoin bank and no FDIC. The end result is that if too many people pull their money from the bitcoin bank then you have an old fashioned bank run. These bank runs will severely limit the size and trust of any fractional reserve bitcoin banks.

[qualia8]

I'd love to see fractional reserve banking.  As long as people understand the REAL risk associated with default, bank runs, etc., they will charge absurd interest rates to the banks to make deposits.  To avoid all risk, you should just hang onto your BTC yourself.  The banks, in turn, to pay your deposit interest must charge extremely high interest rates to borrowers, keep lots of capital on hand, etc.  In other words, both lender and borrower would be more cautious.  And no TBTF.  If there's a wave of defaults and a bank run, everyone involved loses and the money supply returns to its former level.  Mattress stuffers win big.

[FreeMoney]

The thing that 'stops' fractional reserve backing is called 'going out of business'. The problem is that banks who would fail are magically saved with our money instead of failing and allowing more responsible banks to win customers. It's to the point now that you have to participate in the way overboard fractional reserve plus insurance scheme to get permission to operate at all.

Now to be clear, with BItcoin, you can have unbacked balances at a Bitcoin bank denominated in Bitcoin, but you can't actually have the extra Bitcoins in your client at the same time like you can in a dollar bank. The base money is strictly limited with Bitcoin, but not with the dollar. If dollar banks have to give people their dollars simultaneously they are printed.

[bitcoin.monger]

Fractional reserve banking is impossible within the Bitcoin system. Please read the software manual again 
Unlike fiat currencies, one cannot "deposit" a bitcoin that does not exist 

[bitcoin.monger]

Let me clarify. You (Alice) can write a check (you got from your credit card company) tomorrow for $100 and give it to your buddy (Bob) who can deposit it and later use the money to pay his mortgage.
No $100 dollar bill has changed hads from Alice to Bob to mortgage servicing company.

Bitcoin scenario:
Alice wants to send 100 BTC to Bob and Bob wants to pay his mortgage.
Alice HAS to have the 100BTC she wants to send to Bob. Unless the 100BTC are in her wallet (well, this is a complicated conversation) she cannot send it to Bob, who cannot pay his mortgage with it.
There are no bitcoins made of thin air like the fictitious USD printed by the banks...

[bitcoin.monger]

Unless the pseudonymous character of Bitcoin si completely destroyed, it would be impossible to have fractional reserve 2.0 happen here 

[bitcoin.monger]

Simply because there's no bank helped by "men with guns" to enforce debt obligations denominated in BTC (yet  )
However, you may have noticed that many users support government regulation of Bitcoin, so time may prove you right 

[Adam]

Fractional reserve banking is impossible within the Bitcoin system. Please read the software manual again  
Unlike fiat currencies, one cannot "deposit" a bitcoin that does not exist  

You had to post nonsense four times in a row in the same thread?  Of course fractional reserve currency works for bitcoins.  I deposit 100 BTC in bitcoin bank.  My balance in the bank will show up as 100 BTC, but those specific coins can be lent to someone else.  No coins were created in this transaction.  I have a claim for 100 BTCs with the bank, but no actual bitcoins, because they were lent to someone else.

[bitcoin.monger]

I apologize if it's nonsense to you.

[bitcoin.monger]

Would you care to explain how a bitcoin bank can lend a hundred bitcoins it does not have?
Some details on how the block chain might look would also help...

[Adam]

Would you care to explain how a bitcoin bank can lend a hundred bitcoins it does not have?
Some details on how the block chain might look would also help...

Are you trolling or just retarded? 

• I have 100 BTC
• I deposit this with the bank, now the bank has it
• The bank takes these BTC and loans them to someone else so now this third party has them

[Vinnie]

In addition to what Adam said, the bank would likely be issuing a bitcoin backed note or secondary digital currency. So they would either issue the loan in the form of BTC and pay their original depositor his withdrawals in bitcoin backed notes, or issue the loan in the form of bitcoin backed notes and pay the original depositor in his original BTC.

[bitcoin.monger]

Adam, thank you for your opinion on my IQ!
Retarded as I am, please explain how the bank (which one?) can "deposit" BTC100 in the block chain if said bank does not own BTC 100 to clear the transaction.

Thank you in advance for your explanation!