When you look at your bank statement and you see your balance do you think all your money is sitting there in safekeeping, well it’s not, most of its been loaned out. This practice is known as fractional reserve banking the banks only hold a fraction of their deposits as cash reserves the rest can be lent out to borrowers, while still maintaining a guarantee to pay depositors on demand.
The truth of the matter is how can banks possibly be able to guarantee paying out all depositors on demand, when the funds are not in their position, it’s just not possible, the banks just hope that everyone won’t withdraw all their money at the same time.
More than often the banks get away with this practice, as the majority of depositors will not demand their funds all at the same time and new funds are constantly being deposited with the bank which offset the ordinary day to day withdrawal of funds.
If there is a run on deposits, commonly known as a bank run, where depositors in mass decide to withdraw their money, then the bank/s may need to sell some assets or go to the credit market for more funds and/or seek emergency funding from a central bank or be taken over by the Government. If these actions are not successful then the bank will fail.
Bank runs during the great depression brought about devastating results where many banks had to close their doors, leaving a large number of depositors out of pocket. More recently Northern Rock in the UK had a bank run and many people don’t realise there are bank runs occurring across a number of Eurozone Countries where depositors are transferring funds to a safer jurisdiction.
We now live in a world of so called too big to fail banks, which basically means printing money and giving it to the banks, ultimately the citizens of the country pay for it through their currency being debased. Some countries have deposit insurance schemes, which are supposed to protect depositors but this too often requires government support; ultimately it is backed by the tax payer. When you and I make a bad investment decision we lose our money but when the banks do the same they get bailed out, so this encourages banks to take on greater risks.
When you talk about the practice of fractional reserve banking you also need to discuss what is known as the money multiplier, this is how much banks can expand the money supply through loan creation, new currency is loaned into existence. The amount that banks can loan out from their deposits is controlled by the reserve requirement.
If the reserve requirement is 10% then every $1,000 that the bank receives in deposits $100 is held as reserves and the other $900 can be lend out. But that is not where it ends eventually the $900 will be redeposited in a bank then the process continues $90 is held as reserves and $810 is lent out, if this process continues then from the original $1,000 deposited, $9,000 worth of new deposits (currency) are created and loaned out, which means the total amount of currency is now $10,000. You can start to see how this is inflationary and it’s in the banks interest to expand this process and to have everyone in debt. Savers and people on fixed incomes are the biggest loses with this system, as currencies are constantly losing value through inflation.How did this practice originate?
In the days of the Goldsmiths, people use to store their silver and gold in the Goldsmiths vaults and in return the depositors would receive a receipt acknowledging the amount held. After some time the Goldsmith realised that most depositors would not redeem their receipts all at the same time, so decided to invest some of their reserves in loans which paid interest, thus create an income from this practice. So now there would be more receipts in circulation than what they held in gold and silver, this practice worked well for the Goldsmiths, until the depositors become suspicious.
If the majority of depositors wanted to redeem their receipts at the same time, then the fraud could no longer be concealed, as the Goldsmiths could not exchange all of the receipts for silver and gold held. Many depositors would be left out of pocket and the Goldsmiths would have to close their doors and get out of town quickly.
Alternative to fractional reserve banking
A possible alternative to fractional reserve banking would be full reserve banking, where people deposit their money for safekeeping and it is not lend out. In this type of system the bank would charge a fee for this service, which does not sound that appealing, but at least you would know your money was safe and financial system as a whole would be far more stable. Governments or Central Banks would never need to bailout a bank again or need any type of deposit insurance.
If you wanted a return on your investment then you could deposit your money with a financial institution that lends the funds to a third party, that way you would receive interest for taking on greater risk.
This system would not be inflationary as banks would not be in the business of creating currency out of credit and would mean sustainable growth of the economy, certain asset classes such as houses would deflate to prices that the average citizen could afford. It would not be an easy transition to this system but what we have now does not work for the average citizen. Conclusion on fractional reserve banking
The fractional reserve banking system allows banks to create currency from credit this in itself seems wrong and unfair, why should private banks be allowed to profit from this practice, when the average citizen has to work for every dollar. And the other matter is depositors are falsely told that all their funds are available for withdrawal when they are not, in any other industry other than banking this is known as embezzlement. The only reason this practice has lasted as long as it has is that it receives protection and support from Governments and Central Banks.
This is certainly a a very interesting topic to debate and it’s time to take a good hard look at other options.