Fractional Reserve System

Author: Vivek Devarajan

Introduction

Fractional-reserve banking is the system of banking operating in nearly all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, and are at liberty to lend the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank. The country’s central bank determines the minimum amount that banks must hold in liquid assets, called the “reserve requirement” or “reserve ratio”. Most commercial banks hold more than this minimum amount as excess reserves.1

The Inherent Risk

Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that reserves will be sufficient to meet the demand for cash. The Banks take on a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. However, banks may find themselves in a shortfall situation or experience an unexpected bank run, when depositors wish to withdraw more funds than the reserves held by the bank.

The Multiplier Effect –

Initial
Deposit (Txn 1)
$1,000
Reserve
Requirement
15%
Transaction
Number
Deposits


Reserves
(Deposits x
15%)
Loan Amount
(Deposits –
Reserves)
1.$1,000$150$850
2. $850$128$723
3. $723$108$614
4.$614$92$522
5.$522$78$444
6.$444$67$377
7.$377$56$321
8.$321$49$272
9.$272$40$232
10.$232$35$197

The Transaction 2 Deposit is nothing but the Loan Amount credited by the Banks managing the Transaction 1

Total amount of money circulation at the end of the 10th transaction is the total of all the deposits (i.e. $5354 !!

Explanation of the Multiplier Effect:

With reference to the above table, $1000 is the initial deposit, deposited by a depositor (customer) of the bank.

Transaction number 1: Since the reserve requirement is 15%, the bank keeps 15% of $1000 (i.e. $150) as reserve and loans out the remaining amount ($850) to a borrower (either a retail borrower for purposes of purchasing a home, car, etc or corporate borrower). Thus $ 850 is credited to the bank account of the borrower (this could be the same bank, or a different bank)

Transaction number 2: The deposited amount this time is $850. The borrower’s bank keeps 15% of the deposited amount (i.e. $128) as reserve and loans out the remaining amount ($723) to another borrower

Transaction number 3: The deposited amount this time is $722.5. The borrower’s bank keeps 15% of the deposited amount (i.e. $108) as reserve and loans out the remaining amount ($614) to another borrower.

The above cycle repeats itself for multiple transactions. At the end of the 10th transaction, the total amount in circulation would have increased from an initial $1000 to $5354 as illustrated above.

The root cause of the problem is that each time a bank loans out money, and the loaned out money is deposited into a  bank account by the borrower, the bank receiving the deposits considers the deposit as fresh money. Hence, fresh money is created each time a bank gives out a loan.

Consequences of Fractional Reserve Banking:

  1. Poverty: The biggest trouble with the above system is that out of the total money in circulation (i.e. $5354), each and every dollar is created as a loan, which needs to be paid with interest. However, the banks create only the principal amount (i.e. $5354). They do not create the money required to pay the interest for this loan. Hence, a certain percentage of the population has to be driven to poverty, so that the remaining people have enough to pay for their loans, including the interest.
  2. Inflation: One possibility to avoid the above mentioned scenario of poverty is for more people to come forward to borrow from the banks, thereby increasing the currency in circulation. But this is only a temporary solution, as the fresh currency thereby created, would again be a loan, which would have to be paid off with interest. Also, this increase in circulating currency results in inflation of the prices of all commodities.
  3. Control of the economy by Bankers: The bankers can increase or decrease the amount of money supply, and thus create an economic boom or recession. They can also control the interest rates.
  4. Corporate domination over the commodity prices: Corporates borrow money in huge quantities compared to retail borrowers, thus they get first access to the funds from banks, which allows them to purchase whatever commodities or raw materials they need for functioning. Once the corporate borrowing creates fresh funds, the money circulation is already high, which results in inflation, by the time the common man gets to purchase any commodity.
  5. Increased stress for everyone: One may wonder why everyone is leading such a hectic life even though advancement in technology apparently makes our lives easy. This hectic life is because, as explained above, a certain percentage of the population is pushed into poverty, hence every one has to work hard to earn their share of funds required for their expenses, so that they do not fall into poverty. It is like a musical chair game, where one or two people are pushed out of the game, but everyone else is stressed out, as they do not want to be among the one or two people being pushed out.

MYTH #1: Only central banks (such as “Federal Reserve”, or “Reserve Bank of India”) can create fresh money

REALITY #1: As seen in the above example, the central bank is nowhere in the picture, in all the transactions illustrated above. It is the commercial banks who are creating fresh money in the above example

MYTH #2: Banks act as lending agencies that lend out money to borrowers from the depositor’s money

REALITY #2:  While the above statement is true for the bank that lends out the money, once the borrowed money is credited into the borrower’s  account, fresh money is created and put into circulation, as seen above. Hence, each time banks loan out money, fresh money is put into circulation.

MYTH #3: Economic booms and recessions are part of the ‘usual business cycle’ and happen due to mismatches in demand and supply.

REALITY #3: Economic booms and recessions are a result of banking policies such as increase or decrease in interest rates and lending policies. An increase in interest rate or a more stringent lending policy reduces the money supply, and results in recession, and vice versa.

MYTH #4: Poverty is created due to lack of education or job opportunities as a result of government’s policies

REALITY #4: Job opportunities are dictated by the currency in circulation that is dictated by Banking Policies

MYTH #5: The government controls the country’s economy and currency in circulation

REALITY #5: Banking policies (decided by the central banks) such as interest rates and lending norms dictate the health of the economy and the currency in circulation

MYTH #6: Central banks are government agencies that are regulated by the Governments

REALITY #6: Central banks are government agencies on paper, however, they operate independent of the government. They are regulated by the “Bank of International Settlements” which is a central bank for all the central banks of the world, and is in turn governed at a global level by international bankers.

MYTH #7: Currency in circulation is backed by gold or similar tangible assets

REALITY #7: Currency in circulation is backed by nothing, and fresh currency is created out of thin air each time banks loan out money

Quotes from famous personalities regarding modern banking practices

“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.”

Henry Ford – Founder, Ford Motor Company

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. Banking was conceived in iniquity and born in sin. Bankers own the Earth. Take it away from them, but leave them the power to create money, and with the flick of the pen they will create enough money to buy it back again.

Take this great power away from them and all great fortunes like mine will disappear, and they ought to disappear, for then this would be a better and happier world to live in. But if you want to continue to be slaves of the banks and pay the cost of your own slavery, then let bankers continue to create money and control credit.

Sir Josiah Stamp Director, Bank of England 1928-1941

I am afraid that the ordinary citizen will not like to be told that the banks can and do create and destroy money. And they who control the credit of a nation direct the policy of governments, and hold in the hollow of their hands the destiny of the people.

Reginald  McKenna, British Banker and Politician

References

  1. https://en.wikipedia.org/wiki/Fractional-reserve_banking


Suggested Reading

Can Banks Individually Create Money Out of Nothing – The Theories and the Empirical Evidence

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