Fractional Reserve Banking is an important concept to understand in order to get a clear picture on how the banking system in our society works and why a bank may not be such a safe place to store your money.
What is Banking?
Let’s start with a quick definition of banking before moving on, because it is essential to the discussion of any specific type of banking, such as fractional reserve banking.
Almost any definition of banking defines it something like this:
The business activity of protecting money owned by individuals or entities, and then using the money they are protecting to lend to others in order to make a profit.
So there are two elements to a typical bank. They take money in (in the form of deposits), and they lend money out (in the form of loans). It’s that simple.
Oh, and of course it needs to be mentioned that the money coming in needs to be protected and available when the depositor wants it.
Fractional Reserve Banking Definition
A good Fractional reserve banking definition would be a type of banking used throughout the modern world today that requires the amount of money on deposit, to be a fraction of the total amount that is on loan. For example, if a bank has $100 of deposits, they can loan out more than that amount because they only have to have a fraction in reserve.
Reserve in this context means the amount of money that is at the bank and ready for withdrawal at any moment.
And in America, you’ll be hard pressed to find any chartered bank that isn’t practicing fractional reserve banking.
Full Reserve Banking
To get a better understanding, let’s take a look at another type of banking, full reserve banking.
Full reserve banking requires that there is $1 in reserve for every $1 that is on deposit.
This type of banking means that it is possible for all depositors to go to the bank at the same time, request all their money and get it.
Note: this desire by all depositor to get their money at the same time doesn’t happen all that often, and is usually only a sign that the economy is failing and that trust in the financial institutions is plummeting.
But it can happen, and has happened, throughout history, and in countries all around the world. This type of behavior, when all depositors go to the bank at the same time, is called a bank run. And it’s the type of behavior that governments and banks try to avoid at all costs.
Back to Fractional Reserve Banking
So now that you understand full reserve banking, you should have a better idea of how Fractional Reserve banking works.
In the fractional reserve system, a bank can have loans of $100 for every $50 they have on deposit. Or if the fraction is even greater, the ratio of loans to deposits can be 10 to 1, which would mean a bank could have $100 in loans for every $10 in deposits.
If you understand at this point, great, you can skip down to the section on who controls the fractional reserve system. If not, let me use an illustration to make it more clear.
(Warning: this example is a bit long but hopefully educational).
Fractional Reserve Banking Example
Tank Keens was the biggest dude on the block, and there wasn’t anybody that was going to mess with Tank.
In fact, he was so big that kids started asking him to watch their lunch money for them in order to keep it safe.
Tank decided this might be profitable, so he started charging kids a small fee (usually their lunch dessert once a week) to protect their money.
This was a good deal for everyone involved. The money was safe. Kids got their food. And Tank made a nice little profit (and got bigger along the way).
This would be an example of full reserve banking. Tank doesn’t loan out money he doesn’t have on deposit. He still makes money because he charges a fee, but doesn’t use the money in his hands to make loans.
In this system if he wanted to make loans and charge interest, he would have to get kids to agree to give him money for a longer period of time – this would be a Certificate of Deposit or a CD.
Tank gets Greedy
But Tank wanted more for himself, and realized he could only hold so much lunch money at one time, so his profits were limited.
So Tank asked all the kids (depositors) to give him their lunch money for a full week in advance, so he didn’t have to deal with meeting every kid each morning.
By doing this, he was also able to have a large stockpile of money that didn’t need to be paid back all at once. With this stockpile of money, tank could start to lend.
Tank the Lender
So Tank started giving out short term loans to kids at school. If a kid wanted a loan for a big pizza at the cafeteria, he would loan them the money and charge them interest.
Tank assumed that as long as he collected on the loan within a week, he was good to go. After all, the depositor shouldn’t care what happens to the money during the week, as long as they get it when they need it.
Tank started to earn some serious money, and all the kids trusted him more and more each month. But he needed more money in deposits, so he wondered how he could get more people interested in giving him their lunch money.
Tank knew he was making more money on loans than on the protection of the money, so he decided to drop the protection fee altogether for any new kid that gave him a deposit. And it worked! New kids came by the dozens.
In fact, they trusted Tank so much so, that they started using these little slips of paper from Tank, as “I Owe You’s” (I.O.U.s). In other words, they didn’t actually have to have the cash in hand, but just a slip of paper from Tank that said they were owed the money. These slips of paper became just as good as cash on the school campus.
Tank turns to Fractional Reserves
But Tank realized before too long, that he always seemed to have much more money in reserve (in his possession) than he needed.
All this money was wasted earning potential! If he could just write an IOU on a slip of paper, give it to anyone and charge them interest, he could seriously expand his business.
So he did just that. In fact, he did it so well, that at one point he figured he had about $25 out in loan for every $1 of lunch money he was given. He was now making 25x more for every $1 deposited than he had been when he first started.
This is fractional reserve banking. The amount in reserve does not fully cover the deposits that are in the bank. In the example of Tank Keens, he had a fraction, or ratio, of 25 to 1.
Unfortunately for Tank, there were a couple math wizards at the school – Jake Miltoon and Maggie Freeman. Jake and Maggie figured out that the amount of money floating around the schoolyard had increased dramatically in the past few months. And they knew that all the parents hadn’t suddenly been super generous with their hard-earned money.
No, something was wrong. Something didn’t add up. They figured out that Tank was lending out way more money than he actually had in hand (in reserve). They knew that Tank must only have a fraction of his total money in reserve. And they started wondering – what if everyone asked for their money back? What would happen? How safe is this system?
Sure enough, the word spread, and kids started to doubt the safety of their money. But even worse, the slips of paper that were IOU’s for cash became worth less and less.
You see, nobody wanted to have any of the slips of paper, so nobody was willing to exchange anything of real value for an IOU from Tank. The system came crashing in on Tank. He was a big guy, and he had a lot of money, but he owed a lot more money than he actually had.
So when all the kids came screaming, he couldn’t give them their money, and Tank was miserable.
Fortunately for Tank, just as everything was crumbling around him, a school administrator named Paul Henryson stepped in and gave him a massive injection of cash to cover all his depositors.
That is because the administration was concerned that the collapse of this new and robust school economy would hinder the growth of their school, and more importantly their salaries.
Where did the money come from, you may ask? Well, due to the large school attendance, the school just raised school fees for every student and therefore the cost was spread across all the school.
This is an example of a massive bailout by the federal government in an attempt to avoid systemic failure.
Tank ended up doing even better than before, but his critics, Jake and Maggie, continued to sound the alarm.
Unfortunately for Jake and Maggie, the system was so entrenched with the kids in school that any alternative seemed like way too much effort and risk. The kids assumed that the system had some flaws, but ultimately it must be the best system out there.
All analogies fail at some point, and I’m sure that this schoolyard story doesn’t cover everything. But hopefully you have a better idea of the idea behind fractional reserve banking.
I told the story from the perspective of Tank Keens, the banker, that wants to make as much money as possible. I think that is probably fair for most bankers in reality, but there are some things that I left out, namely regulation.
Tank could do whatever he wanted, and while some people would argue to the contrary, many would concede that there are laws and regulations that govern what a bank can and can’t do.
So, who is running this fractional reserve system and to whom do they answer?
To some degree, the fractional reserve system of banking is not managed by any single entity in America. Any chartered bank in the United States is regulated by one of the following federal authorities – Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board, or the Office of the Comptroller of the Currency.
In addition, there are other agencies that regulate credit unions and of course many banks are also governed by state organizations for any given state in which they operate.
So it may seem as though control and regulation is all across the board. For the details and the minutiae, that is correct. But for the main issues that impact everyday life of depositors around the nation, the Federal Reserve Board (aka the Fed) is the location of all the control.
The Federal Reserve Board
The Fed is made up of various board members of 12 districts around the nation, some presidentially appointed members, a group of private US member banks, and advisory councils. The Fed was created by Congress in 1913 via the enactment of the Federal Reserve Act in response to a series of financial panics that seemed to occur every decade or so.
According to Congress, the Fed was given three main objectives:
- Maximize Employment
- Stabilize Prices
- Moderate Long-Term Interest Rates
As time went on the Fed was given more and more responsibility, including bank governance and oversight, government and financial institution lending, and more.
The proponents of the Fed will point out that the Fed has managed to limit the number of banking crises since it was founded to just two – the Great Depression 1930-33, and the Great Recession 2007-09. While those that criticize the roll of the Fed will state that it has far too much power and is ultimately not beholden to the people of a democratic nation.
Ultimately this is where all the big money decisions are made. Do interest rates go up? Do they go down? Do they stay the same? How much money does a bank have to have in reserve? How much money does it cost for a bank to borrow money from another bank? These questions are answered by the Fed.
And don’t think for a second that the Fed is a non-profit institution. Far from it – in fact, you could safely say that the Fed is the most successful for-profit organization on the planet. In 2015 the Fed reported it had made a record of $98.7 billion in profits. Yes, that is billion with a b.
Having said all that, I’m going to avoid the Fed debate for this article, and instead talk about those that profit the most from our current banking system.
Who Profits From the Fractional Reserve Banking System?
The main benefit of fractional reserve banking to an economy as a whole, is the velocity of money. In other words, this system helps keep money moving from one individual or entity to another. The movement of money (velocity of money) is needed for a healthy and robust economy.
During the most recent financial crises, the Fed changed the reserve requirements for member banks, and in so doing, increased the availability of funds. For those that believe in the Fed and this monetary system, they will say that things could have been much worse than they were.
So, in general, we may say that the entire economy benefits from this system, because it helps keep money moving.
Who Specifically Benefits?
But there are also some specific people that benefit from the fractional reserve system as well. Those that have access to money first, or early, can profit from this system due to the lag in inflation that happens when money is created.
Okay, I just threw out some new terms and concepts and we’re going to have to step back to unpack them. Stay with me here.
When a bank is able to lend out money that it does not have on deposit, it is essentially creating money out of thin air.
When money is created, in a typical financial system, prices go up (inflation) because more people have money to spend and the goods and services have remained steady.
But here is the catch, prices don’t go up right away, they take time to react to the increased money supply.
So those that have access to the new money first have more money to spend when the prices are still low (prior to rising).
So, who has first access to this money?
The BANKS. It may seem obvious now, but the reality is that the banks are those that benefit from the increased money supply because they have access to the money first.
Who is Most Likely to be Harmed by the Fractional Reserve System?
We discussed earlier that the banks benefit from fractional reserve banking by being the first to access the new money that is created by their fractional lending. So who loses? Those that are last to access the money lose in this system.
In other words, SAVERS, i.e. those that save.
WINNERS = BANKS; LOSERS = SAVERS
If you do not contribute to the velocity of money, if you hold on to your money and want to see it grow slowly in a savings account, inflation will eat away at your profits year after year.
Think about the above example – money has been created because the bank is now lending out money it did not have on deposit. This increased money supply contributes to inflation over time.
If you have money saved, your money will eventually be able to buy less and less goods and services. So savers are penalized in this system because their future dollars are going to be worth much less than they are today.
Some may argue that good savers don’t actually help the economy because they don’t move their money around.
That may be true, but they also typically don’t default on their loans, live beyond their means, and ultimately require a bailout to stay solvent.
I’m sure you can see the two sides of the argument.
What Can You Do About it?
The banks in the United States, and around the world, are not going to change from a fractional reserve banking system anytime soon. They are making too much money, and our world economy is too dependent on it to change quickly.
But for those that don’t like contributing to the system, or feel like it’s fraudulent or immoral, you can fund your purchases without approaching a typical banker. You may still want to use an independent bank for convenience sake, but for those big purchases that require financing, why not find an alternative to a big bank?
Alternative to Fractional Reserve Banking
A cash value life insurance policy can eventually become a tool for financing any and all your family and business purchases.
In fact, if you use the best whole life insurance company and fund it properly, you can pay yourself interest instead of some big corporate bank.
But using life insurance to finance your purchases via the infinite banking concept® is a topic for another article altogether. We strongly recommend you research the pros and cons of infinite banking and make your own decision.
Just be aware that the big banks that operate on the fractional reserve system and are governed by the Fed, don’t need anymore of your hard earned money. You have the ability to choose alternative forms of financing that increase your own bottom line, not theirs.