Fractional Reserve Banking

What Is Fractional Reserve Banking?

Fractional reserve banking is a system in which only a fraction of bank deposits is available for withdrawal. Banks only need to keep a specific amount of cash on hand and can create loans from your deposit money. The theory is that fractional reserves expand the economy by freeing capital for lending.

How does Fractional Reserve Banking work in practice?

When you open an account at a bank, in the contract, you agree to allow that bank to use a percentage of your deposits as loans to other bank customers. You still have access to all of your money if required. Still, the bank must access funds elsewhere if you need to remove your money. The system works because most savers will not wish to withdraw all their funds simultaneously. However, this has happened in the past and is called a 'Run On The Bank.' One prime example is Northern Rock in the UK, which changed its status in 2008 from a Building Society to a bank—queues of savers formed outside the bank to withdraw their money. The British government had to step in and guarantee the funds.

When you deposit money, your bank can lend 90% to other customers. For instance, say you deposited $100, $90 could be lent to someone else who will pay interest to the bank. In return, your $100 should receive interest as an incentive to save. However, banks frequently fail to pass on interest payments to savers, as we have witnessed over the last decade.

Central banks set interest rates based on economic circumstances to fulfil their dual mandate of achieving a 2% inflation rate and maximising employment.

Banks can borrow money from other independent banks, rather than from central banks, if required to fund loans, meet withdrawals, pay debts, or fulfil other obligations.

Fractional Reserve Banking Process

Fractional Reserve banking creates money out of thin air; tangible assets, such as gold, do not back the funds.

When you deposit that $100, your bank might lend 90% to other customers and pay that $90 into bank accounts in their names. Now the system allows the bank to loan 90% of the $90 in the new customers' accounts to other borrowers again. For clarity, 90% of $90 = $81 lent to other borrowers. And the cycle starts again; 90% of $81, or $72.90, can also be loaned to new borrowers and deposited into their bank accounts. The bank can loan 90% of $72.90 ($65.61) to new borrowers again. The cycle continues until $100 has created over $900 in loans.

Each loan creates an income stream (Interest) for the loan term. The income is an asset on the bank's balance sheet, and the debt is sold to investors to generate additional capital for the bank if needed.

The system enables the bank to lend 90% of the deposited amount and generate wealth from the interest paid by the borrower. The borrower earns money by producing goods or services (known as "sweat equity"), which pays the interest on the loan.

Fractional Reserve Banking & Other Banking Systems

If you scour the internet, you will find all sorts of different opinions concerning Fractional Reserve Banking and other methods.

There is no doubt that Fractional Reserve Banking can help create wealth if the funds are invested in the right areas, such as building infrastructure, roads, railways, and factories that produce goods that generate wealth. Unfortunately, governments can easily borrow money to spend on non-wealth-creating activities, such as welfare, which increases the tax burden on citizens. Most Western countries spend more money than they receive in tax revenue and top this up with borrowing; this would be seen as living beyond one's means in a domestic household. Governments pay massive annual interest to service their debt. For example, the USA's interest in the region is $663 billion per annum for 2023, rising to $745 billion in 2024, an enormous number when compared to its defence budget of $816 billion. Inflation devalues debt, but is this level of spending sustainable in the long term? Food for thought.

If the banking system required banks to hold 100% of the deposited money, lending would be restricted, stifling growth. A system backed by gold is also prone to this problem. Fractional Reserve Banking, when used correctly, can enable a country to expand its money supply to meet the demand for growth.

Conclusion

The banking system is a complex area with many opinions worthy of consideration. The current system is likely to change as governments and taxpayers require assistance in servicing the rising interest payments.

The current Fractional Reserve Banking System allows banks to create money to lend out of thin air and then charge interest. Taxpayers pay the interest on government debt, and after their income has been taxed, they pay interest on loans and mortgages.

I have never seen a poor banker; if banks fail, governments frequently bail them out. Would the system be more cost-efficient if governments owned national banks and the high interest paid by taxpayers were used to repay the national debt, rather than rewarding bankers and their shareholders? Again, food for thought!