There is a lot of misconception about fractional-reserve banking. I've spent hours reading articles, forums, and rants as people argue back and forth about how things really work.
For such a fundamental part of society, it's frightening that there is so much ambiguity about it.
Here's my current understanding of fractional-reserve banking and how it affects our lives (if you think it's wrong, let me know).
What is it?
- Fancy name for something super simple.
- Banks are only required to hold a fraction of the credit they loan out.
- The fraction is typically 10% (can loan 90%).
- So if a bank has $100,000 in "cash", it can loan out $90,000 of that.
- When banks give loans under fractional reserve banking systems, they create money for new loans in the form of deposits.
(Note: this makes things more confusing and is not an accurate reflection of reality, says Bank of England and many other banking experts). Skip at your own will.
- Jim has $100,000 under his pillow, but burglaries are on the rise.
- He deposits his $100K with Bank A.
- Jane wants a business loan to grow her business.
- Bank A says "cool" and loans out $90,000 of it (a fraction) to Jane.
- So while we started with $100,000 in cash, we now have $190,000 of "money" in the economy ($100K with Jim and $90K with Jane).
Money supply vs Wealth
- When you think about money, you probably think about dollar bills 💸 you're sort of right.
- Rather than thinking of money, think of wealth and money supply.
- Wealth – the amount of net value in the world.
- Paper money – is a promise from the Central Reserve Bank for some real money.
- Money supply – the amount of gross "money" available for transactions in the economy.
- In the case above, while there was $190,000 of total money supply, there was still only $100,000 of wealth ($190K deposits - $90K debt).
- Under fractional-reserve banking, banks have the power to create money supply (to a certain point) but not wealth (actual money).
The textbook examples suck
The examples that you find in all economic textbooks and websites sucks. It does not reflect how things really work. In reality:
- There is the Central Reserve Bank who is top dog 🐕
- He only interacts with official banks 🏦
- Every bank gives out as many loans as they possibly can 💸
- When they give out $1M worth of loans, they borrow 10% (the reserve minimum) from the Central Reserve Bank or another bank at a lower interest rate then they are charging you.
- Hence the bank's profit is the difference between the Reserve Bank's interest rate they are borrowing at, and the interest rate it charges to consumers.
- Or alternatively, they sell your loan to someone else for a short-term profit.
The big risks
Fractional-reserve banking is like a perpetual motion machine. Banks give out loans and cover them with other loans. People pay back loans with bigger loans. While banks secure loans with assets, these can fall in value, making the loan worthless.
Hence, when a major part of the system crumbles, it can all come crashing down.
- The obvious risk with fractional-reserve banking is that money supply (money + credit) is always significantly greater than "real" money.
- Hence, it's well established that it's impossible for every promise the bank makes (credit) to ever be fulfilled at the same time.
- It is impossible for everyone to take out their money at the same time, as the bank only has a fraction of all credit as money.
- This is called a "bank-run", but is theoretically covered by the Central Reserve Bank, who will print/loan/bail out banks in the case that this happens.