I mostly agree with Breeze and peterb. There’s nothing inherently wrong with fractional reserve banking and it has one enormous advantage over non-fractional reserve banking: lower interest rates. Look at the interest rate spreads between mortgages and government debt in countries where there is no or limited fractional reserve banking – they’re through the roof. Why? A thought experiment to explain part of the reason. Let’s say I want to start a bank and earn 10% on my equity. Fractional reserve banking allows me to lever up my equity, thereby lowering the necessary spread between my cost of borrowing (deposits) and lending (loans). Holding return on assets constant, my return on equity increases with leverage. So, let’s say I can lever 10-1, earn 1% on assets and achieve a 10% ROE. Now, let’s eliminate fractional reserve banking and now I have to fund entirely with equity. Now I have to earn a 10% ROA. If my cost of deposits is 3% and operating costs are 2%, then I have to charge 15% on my loans to make it worth my while. Anybody want 15% mortgages? Then eliminate fractional reserve lending and your wish shall be granted in short order.
Personally, I don’t have a problem with 20% down mortgages. Recall, that without the 0%, 5%, 10%, etc.-down mortgages, we never would have had the bubble in the first place, so the 20% down mortgages wouldn’t currently be in jeaopardy. That is, if we had stuck to 20% down over the last 8 years we wouldn’t be in this mess in the first place.
