Fractional Reserve Banking

Money is the securitization of government debt, as demonstrated from my previous article on money creation by the Fed. This is just the beginning of the pyramid scheme. The next scheme added to debt-based currency is fractional reserve banking.


The different types of banks

Before we go over this system, we must go over banking. There are 2 types of “pure” banking institutions:

  1. Loan banking (banks loan their own capital without accepting deposits; profits are earned by loaning money out with interest)
  2. Deposit banking (banks do not loan out money but accept deposits; profits are earned by charging customers a fee for safeguarding their money)

Both of these pure banking methods individually improve the welfare of clients, have very little risk, and are non-inflationary. Mixing the 2 together (“commercial bank”) allows banks to lend out their customers’ money, and all of the sudden great risks arise, as well as inflation.


What is the fractional reserve banking system?

Now that we understand banks, we can go into how the fractional reserve banking system works. This is explained using the familiar accounting equation: Assets = Liabilities + Shareholders’ Equity. Shareholders’ equity is ignored as we are not concerned with the profits earned by the banks by charging interest.

Here’s a simple example of 100% deposit bank, which we shall call Alpha Bank:

Assets = Liabilities
$100 Reserve $100 Deposit
$0 Loan

Suppose Person A has $100. He makes a demand deposit (can be withdrawn at any time) at Alpha Bank. If a bank holds $100 on reserve, it does not loan any money out. The $100 possessed by Person A merely changes hands for the time being, from depositor (Person A) to Alpha Bank. The amount of money in circulation does not change as the $100 transfers from the depositor to the bank until he chooses to redeem his deposit.

Under a fractional reserve system, Alpha Bank only keeps a fraction of deposits on reserve, legally set at 10%:

Assets = Liabilities
$10 Reserve $100 Deposit
$90 Loan

Person A still has a claim to $100 as before, but Person B, who also banks at Alpha Bank, takes a loan out for $90. Person B now has $90 in hand that the bank has loaned him. But this $90 is not the bank’s money; it is made possible by Person A. This occurs because the bank only keeps 10% of reserves on hand, $10 of the original deposit. Only $100 exists as true money, but 2 claims totaling $190 is created on the $100. The total amount of “money” has increased from $100 to $190. The extra $90 is a money equivalent, meaning it can be converted into true money. True money can no longer be distinguished from money equivalent. The process does not end here.

Person B borrowed $90 to buy something. Suppose he buys something from Person C. Person C will then take the $90 from the sale and deposits it in Beta Bank, which multiplies the process as it also only needs to hold 10% reserves:

Assets = Liabilities
$9 Reserve $90 Deposit
$81 Loan

Person C deposits the $90 proceeds from his sale into Beta Bank, which holds 10% of that deposit on reserve, the $9, and loans the rest of it out, $81. In addition to the $190 created from the Alpha Bank, Beta Bank creates an additional $81. The total money equivalent in circulation has increased to ($190+$81=) $271.

This process repeats as each successive borrower deposits his loans into another bank. This increases that bank’s deposits, which it then holds 10% on reserve, loaning out the remaining 90% of the deposit. Theoretically, though only $100 exists as a deposit, $900 of money equivalent can be created by only having to hold 10% of that deposit on reserve. This is known as the Money Multiplier.

If the reserve ratio (R, the legally set amount that banks can hold in reserve) = 10% or 0.10, then the Money Multiplier is simply 1/R. In our example, the Money Multiplier = 1/0.10 = 10. This means that for every $100 deposited in the bank, theoretically, (10)($100) = $1,000 of money equivalent can exist. This reflects the $100 that actually exists + $900 money equivalent created by the fraction reserve banking system.

I say theoretically because not all money is deposited into banks. Individuals receiving bank loans take some of it in cash, and so do others that receive new money further down the line. In reality, the Money Multiplier in our economy with a 10% reserve ratio is somewhere around 3 rather than the theoretical limit of 10 with an R of 10%.

The banks’ reserves are held either at the Fed (electronically) or as physical cash in their vaults. This stock of money on reserve and in circulation is known as MB or Monetary Base. In our example, MB = $100, Person A’s physical cash he deposited. MB is then physical cash in circulation or demand deposits held by 100% reserves at the banks.

The money equivalents created by banks, that is, each additional dollar beyond the original $100 deposit in our example + MB, is known as M1. $9 are created for every $1 that actually exists in the bank’s reserves due to the 10% reserve ratio. M1 in our example would be $271 after the 2 bank loans are made. With a 10% reserve ratio, M1 = MB + the 90% new money created. M1 then is MB + demand deposits made at banks.

Not all bank deposits are demand deposits. There are also time deposits, meaning money is deposited but it cannot be withdrawn until after a length of time has elapsed. Banks like time deposits better than demand deposits because they know that the deposit will be on reserve for a fixed period of time; they don’t have to worry that the depositor will redeem their deposit until a certain time. This allows them to lend out 100% of the deposit during this time. M2 is the stock of M1 + time deposits, savings deposits, and other market mutual funds. M2 is known as “near money” as it can be converted to money after a short period of time. M2 then is larger than M1.

In our example, time deposits would function as follows:

Assets = Liabilities
$0 Reserve $90 Deposit
$90 Loan

Let’s say Beta Bank receives a time deposit from Person C. The time deposit “locks” in the deposit for a period of time, during which, no reserves have to be held by the bank. The bank can then lend the entirety of the deposit out. Instead of being able to create an additional $81 off of the $90 deposit (as before), it can now create an additional $90. This is why M2 is the larger than M1.

As we can see, each successive M includes the previous M amount + additional money created by fractional reserve banking. This means that MB < M1 < M2. Due to this system, the stocks of MB, M1, and M2 form an inverse pyramid. MB is the bottom, M1 above that, and M2 at the top.

The various M measurements can be expressed with the following diagram:

Screen Shot 2015-02-19 at 11.37.34 PM

MB forms the base. A 10% reserve ratio allows 90% of money equivalents to be created, expanding money in circulation as shown by M1. Time deposits allow even more money equivalents to be created, as expressed by M2. The amount of true money + money equivalents = M2, which all holders accept as money.

This is similarly expressed over time:

Screen Shot 2015-02-21 at 4.24.39 PM

 

From the FRED data, the real Money Multiplier for U.S. money is somewhere around (12,000/4,000=) 3. Though only about $4 trillion of money exists as physical cash or as reserves, there are really $12 trillion in circulation existing equivalent to money.


Dangers

Fractional reserve banking contains some obvious dangers. Because the deposits held by the bank are only a fraction of what is actually loaned out, not all demands for redemption by depositors can be redeemed immediately. When depositors rush to the bank to withdraw their money, it is called a bank run. A bank run simply means that the bank has too few reserves to meet current demands for customers that wish to redeem their credits with the bank in physical cash.

If the banks run this danger, why lend out more money than actually deposited? They do this because the more money they lend out, the more interest they can earn on the loan, and hence more profits. The truth is that only a fraction of people demand their deposits at the same time under normal circumstances, therefore banks can get away with keeping only a fraction of their deposits on hand to fulfill redemption.

The banks then walk a tightrope, trying to lend as much out as possible while simultaneously remaining capable of meeting the current demand for deposit withdrawals. If the bank holds the confidence of its clients, bank runs are avoided. But once confidence is squandered, a bank run can ruin the bank. As the bank only holds a fraction of all deposits on reserve, some people will obviously not be able to redeem their deposit from the bank during a bank run.

But the government is creative. It then comes up with the idea of a “bank holiday”, where banking services are suspended by decree. The holiday isn’t for the depositors, but for the banks that are relieved of upholding their contractual obligations with depositors. If the bank still cannot meet redemption obligations when the holiday ends, it becomes insolvent.

But the government is creative. It next comes up with the idea of a “bank bailout”, where banks are given emergency loans. This bailout isn’t for the depositors, but for the banks so that they can remain solvent after failing its contractual obligations. Who knows how far the creativity of government will extend?

The other danger is inflation, which is caused by banks lending out more money than kept in their reserves. Thus, more money is lent out than actually exists. Money equivalents are created and become indistinguishable from money as all money equivalents have claims to the same pool of true money. When claims to real assets have increased while real assets themselves have not, that is price inflation. There is no theoretical limit to inflation with fractional reserve banking (imagine R = 0) as long as the bank maintains an image of security in the minds of depositors.