Can Fractional Reserve Banking Develop On Top Of Bitcoin?

Fractional reserve banking refers to banks lending out a fraction of the deposits they have available on demand to depositors. A depositor who places a sum of money in a demand deposit does so under the understanding that they are able to withdraw all of that sum at any time they wish. But a fractional reserve bank will nonetheless lend out a fraction of that deposit. If the depositor demands their deposit back, the bank will have to provide him with money from other depositors. It is always possible that a larger fraction of deposits will be demanded for withdrawal than what the bank has available, and in that case, the bank is considered 'illiquid': it has assets to meet all its liabilities, but its assets are in the form of loans to others which the bank cannot liquidate for cash to redeem depositors. This lack of liquidity causes a bank run, wherein depositors rush to the bank to try to get their deposits out first.

Maturity transformation is a banking practice similar to fractional reserve banking, wherein a bank relies on continuously taking out short-term loans to finance long-term lending. A maturity transforming bank would make a ten year loan without having savers placing money at the bank for an agreed upon duration of ten years. It would make the ten year loan while relying on always having short-term lenders providing it with enough liquidity to roll over the debt. Similar to fractional reserve banking, a maturity mismatching bank is also under threat of a bank run if it runs into any difficulty in finding short-term borrowers.

Fractional reserve banking is a highly contentious topic among sound money economists. Because the global monetary and financial system has been under the control of the government-enforced monopolies of central banks for the past century, this debate was largely an academic one. Governments made fractional reserve banking legal and used their monopoly over the issuance of currency to protect banks that engaged in it. As a result, it was impossible to know whether such a fractional reserve system would develop in a free market. However, the budding development of an alternative and completely free market monetary and financial system on top of Bitcoin has resurrected this debate and is giving it a heretofore unprecedented significance in the real world. It is my contention that a fractional reserve system is not sustainable under a Bitcoin Standard. While there is nothing to stop individuals from engaging in fractional reserve lending in a free market bitcoin financial system, such activities would be doomed to failure, with a heavy cost to everyone involved. Even if central banks and governments were to adopt Bitcoin as a global currency, its distributed nature, digital settlement, and transparency make fractional reserve arrangements that thrived with government money (and even gold) untenable.

In The Bitcoin Standard, I quote the late Hal Finney discussing how Bitcoin can scale. With great foresight, Finney identified the inherent limitations of Bitcoin on-chain scaling, which still escape many Bitcoin fans and has led to doomed forks of Bitcoin that attempt it:

Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases.

Finney then discusses how such a banking system could accommodate fractional reserve banks, and how it would be stable, inflation-resistant, and self-regulating:

Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others.

George Selgin has worked out the theory of competitive free banking in detail, and he argues that such a system would be stable, inflation resistant and self-regulating. I believe this will be the ultimate fate of Bitcoin, to be the "high-powered money" that serves as a reserve currency for banks that issue their own digital cash. Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as . . . well, as Bitcoin based purchases are today.

While I find myself in agreement with Finney on the idea of Bitcoin on-chain transactions evolving to settle net transfers between financial institutions, I must disagree with him on the likelihood of fractional reserve banking developing. Before we dive into whether such a system can survive, I want to begin by examining whether there's a need for it to emerge in the first place.