Fractional Reserve Banking Simply Explained


Guess what. Your money at the bank is not your money. A bank deposit is a loan to the bank, which should justify the fact banks only have a fraction of outstanding liabilities (receipts) in reserve. Let us examine this modern day practice of banking and the creation of what I call illusionary money. In our simplified example there is only book entry money, nowadays digital.

The process begins with the European Central Bank (ECB) that creates 10,000 euros, by the stroke of a keyboard, to buy bonds. The seller of these bonds is Paul who receives the 10,000 euros and deposits these funds at bank A. The ECB’s policy is that commercial banks are required to hold 10 % of all deposits in reserve. Meaning, bank A can lend 90 % of Paul’s money to John who needs money to buy a boat. When John borrows these 9,000 euros and receives the funds in his bank account, something remarkable has taken place. John now has 9,000 euros at his disposal, but Paul still owns 10,000 euros. Miraculously 9,000 euros has been created out of thin air! Before bank A had lend 9,000 euros to John there was only 10,000 euros in existence created by the ECB. After the loan there is 19,000 euros “in existence”, John’s 9,000 euros on top of Paul’s 10,000 euros. Bank A has created 9,000 euros through fractional reserve banking.

And it doesn’t end there. When John buys a 9,000 euro sailing yacht from Bob, Bob deposits these funds at bank B. For this bank the same rules apply, it’s only required to hold 10 % of the 9,000 euros in reserve, so it lends 8,100 euros to Michael. Another 8,100 euros is created out of thin air, now there is 27,100 euros in existence! Needless to say, Michael’s money will be deposited at a bank and multiplied by 90 % as well, and the new money will multiplied by 90 % as well – you get the picture. Eventually, out of the initial 10,000 euros created by the ECB a fresh 90,000 euros can be created by commercial banks at a required reserve ratio of 10 %.

The degree to which commercial banks can procreate money from central bank money is referred to as the money multiplier (MM), which is the inverse of the reserve requirement ratio (RRR). A smaller RRR will result in a higher MM, and vice versa, as the smaller a bank’s reserves, the more it can lend (create). Money created by a central bank is called base money and money created by commercial banks is called credit (note, on a gold standard, the gold was base money). If banks make loans they create credit and the total money supply in the economy expands, if these loans are repaid (or default) the money supply shrinks. In the next chart we can see how 10,000 units of base money procreate 90,000 units of credit through 50 stages of fractional reserve banking (RRR = 10 %).

Fractional Reserve Banking Stages, credit money, money multiplier

Note, the total money supply in the economy nowadays is compounded of less than 10 % base money and more than 90 % credit! For the sake of simplicity I’ve used a reserve requirement ratio of 10 %.

The essence of fractional reserve banking is exactly the same as what the blacksmiths did. When all customers run to a bank to get their money out, the bank has to admit it doesn’t have all the money. Banking thrives on the presumption not all money will be withdrawn from a bank at once. That is, until that happens. Millions of banks have gone bust in the past and many will in the future. The question is not if a bank can go bust, but when, as banks are by definition insolvent in holding a fraction of deposits in reserve. After the bankruptcy of investment bank Lehman Brothers in 2008 an economic depression was triggered and governments globally bailed out banks whose insolvent nature was exposed.

The fact banks are by definition insolvent is “strangely” accepted throughout society. People know banks go belly up when everybody rushes to get their money out, though they’re less aware of alternatives to storing money at the bank. This situation can be explained by the fact people are fooled by how banks operate. In high school and university students are taught banks simply facilitate in lending out money from depositors, striking a profit on the difference in interest rates. While actually banks create money to lend out, whereby a fraction of the initial deposit is held in reserve and the insolvent state is conceived. Most people that work at banks are not even aware about the fine details of credit creation. Henry Ford once said:

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

The bait for fractional reserve banking is of course interest. Why do you receive interest on a bank deposit? Basically, because you lend your money to the bank and receive interest for the risk of losing it – the golden rule is: no risk no return. Banks have to offer interest or no one would hand over their money. Then banks charge borrowers a higher interest rate than they pay on deposits and the wheel of credit starts turning round. Until the expansion of credit sends up asset bubbles that eventually pop and the house of cards comes tumbling down. The real problem starts to surface when the money supply shrinks prices and incomes decline. This makes it harder for everyone to repay debt to banks, pushing bank bankruptcies. Deflation is a huge threat for the fractional reserve system.

The most intriguing fact is that credit simply doesn’t exist. Credit is created through an accounting trick. If more than a fraction of all bank customers want to withdraw their “money”, it’s just not there. Credit only exists as book entries and in our minds. If customers have 1,000,000 euros deposited at a bank in total, they think they truly own that money, whereas in reality there is only a fraction of the 1,000,000 euros held by the bank in reserves. Yet every financial decision they make is based upon the amount of money they think they own. The lion share of their money only exists in their minds. This is what I call the money illusion, in which most of us on this planet are submerged. Will we ever awaken from this dream and will the real value of money and credit be exposed?

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