The comparative virtues of fractional reserve banking have been a source of controversy. Space limits do not allow us to do the topic justice, here.
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
The fundamental details of fractional reserve banking practice is simply enough stated. The tricky part is that such a simple statement leaves many people not fully appreciating the broader implications. First things, first, though: what is it?
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were different people.)
In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families' life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
The observant reader may have noted that the banks seem to be in something of a precarious situation in all of this. They're making more promises than they can keep. Consider the depositors, who, after all, are not investors. When you invest in something, you understand that your money is tied up - you can't spend it while it's invested. Depositors though consider their savings being stored at the bank. Some actually regard the arrangement as analogous to renting a mini-storage unit: they stash boxes of knick-knacks and keepsakes they can't bring themselves to trash. The boxes though are always there to be retrieved when they want them. Most depositors think this about the money they've deposited in the bank.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
The banks of course don't lend out all the deposits. Instead, they reserve a fraction to meet withdrawal demands as they occur daily. This of course is the origination of the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
Additionally, if their withdraw demands are over a certain threshold, the bank often reserves the right to interrogate them about their intentions regarding their own money. These are tools used by the banks to forestall the danger of withdrawals that exceed or make vulnerable the reserves they've kept on hand.
Most of the time, though, there is no need to resort to such draconian measures. The banks do decent jobs of anticipating the level of reserves necessary to cover the withdrawals and everyone goes about their business more or less contently.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
Even that though is not the end of the danger. Under its apparently serene surface, fractional reserve banking plays an even more insidious role through its contribution to the inflationary destruction of the money supply . And that naturally increases the likelihood of borrowers defaulting on repayment and putting the entire system at even greater risk.
With these basics under your belt, you might want to turn to this article on the pros and cons (and con jobs) of fractional reserve banking for a deeper understanding of what's at stake.
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
The fundamental details of fractional reserve banking practice is simply enough stated. The tricky part is that such a simple statement leaves many people not fully appreciating the broader implications. First things, first, though: what is it?
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were different people.)
In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families' life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
The observant reader may have noted that the banks seem to be in something of a precarious situation in all of this. They're making more promises than they can keep. Consider the depositors, who, after all, are not investors. When you invest in something, you understand that your money is tied up - you can't spend it while it's invested. Depositors though consider their savings being stored at the bank. Some actually regard the arrangement as analogous to renting a mini-storage unit: they stash boxes of knick-knacks and keepsakes they can't bring themselves to trash. The boxes though are always there to be retrieved when they want them. Most depositors think this about the money they've deposited in the bank.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
The banks of course don't lend out all the deposits. Instead, they reserve a fraction to meet withdrawal demands as they occur daily. This of course is the origination of the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
Additionally, if their withdraw demands are over a certain threshold, the bank often reserves the right to interrogate them about their intentions regarding their own money. These are tools used by the banks to forestall the danger of withdrawals that exceed or make vulnerable the reserves they've kept on hand.
Most of the time, though, there is no need to resort to such draconian measures. The banks do decent jobs of anticipating the level of reserves necessary to cover the withdrawals and everyone goes about their business more or less contently.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
Even that though is not the end of the danger. Under its apparently serene surface, fractional reserve banking plays an even more insidious role through its contribution to the inflationary destruction of the money supply . And that naturally increases the likelihood of borrowers defaulting on repayment and putting the entire system at even greater risk.
With these basics under your belt, you might want to turn to this article on the pros and cons (and con jobs) of fractional reserve banking for a deeper understanding of what's at stake.
About the Author:
Those who want to be smart about managing their money have to follow us at the Fractional Reserve Banking Review to stay on top of all the ways, new and old, that the banking system chips away at your wealth. Wallace Eddington has emerged as a major commentator on how to recognize and avoid the scams of the mainstream financial system. Check out his recent provocative article on a Free Market Economy in Money .
