Fractional Banking Unveiled: How All Banks Create Money Out of Thin Air and Why Should You Care?

Fractional Banking Unveiled: How All Banks Create Money Out of Thin Air and Why Should You Care?

Did you check your bank balance? Do you think your bank truly has all your money in your account? Or is it only showing it has all your money but in reality, doesn’t have the entire sum?

Maybe you’ll be surprised to know. Banks don’t keep the entire sum you deposit with them! This is because of a concept called fractional reserve banking.

In many ways, fractional reserve banking or FBR is the money-making engine of the modern economy. And as a young investor, gaining knowledge about the topic will help you make sound decisions on investing your money and trading your assets.

So here is everything you need to know about fractional reserve banking.

A fraction of your deposit — reserves

You usually don’t withdraw all the money you’ve in your bank, do you? You make sure you always have something left in your account. It’s the same story with everyone. In fact, people strive to increase their bank balances.

This puts banks in an advantageous position. They needn’t make available all the money deposited in them all the time.

For starters, all the deposits in a bank add up to a ginormous figure. Even a tiny fraction of the total amount deposited would be sufficient to pay for daily withdrawals. The rest banks can use it to make loans.

This fractional amount of a deposit a bank holds is called a reserve. How much reserve a bank should hold is stipulated by the Central Bank of its nation.

Big money from your super-small money

Say your employer deposits $100 into a bank account and the minimum required reserve is 10% of the deposit. So the bank needs to hold only $10 and is free to give the remaining $90 as a loan.

Now say a person takes a loan of $90 and deposits it in his bank. His bank needs to keep only $9 and is free to give away $81 as a loan to another borrower. If this borrower takes $81 as a loan and puts it into his bank his bank will hold $8.1 and lend out the rest!

Thus a simple deposit of $100 keeps multiplying over and over again and creates new money in the economy. In this case, with a reserve requirement of 10% a deposit of $100 can produce $1000 more.

This is the magic of fractional reserve banking. Banks create new money from deposits!

And this is the mechanism of money creation that led to the development of the modern world. Firms have been able to take loans to expand their business, create new jobs and produce stuff that improves the quality of daily life.

People are able to afford houses, cars and other things because of loans. Great advancements have happened in the medical field through research projects funded by loans.

All of the progress humanity has made today, FBR, loans and other investments financed it!

Fractional reserve banking on steroids

In 1971, President Nixon did something that became a turning point in the financial system. Originally the US dollar was backed by gold. Meaning, for every $35 the government had to have with it an ounce of gold. And the value of all the currencies of the world was fixed in reference to the US dollar.

But due to a series of complicated economic conditions, Nixon decided to end the gold standard. He declared that now the dollar would be backed by nothing but the word of the American government!

The result of this was that Central Banks could now print any amount of money as there was no need to back the newly created amount with a corresponding supply of gold. So banks can now get money from the Central Bank and give loans to borrowers!

But it also allows the central authorities to create as much money as they want to at any time they feel is right. Consequently, this has served to be a giant flaw in the centralised system of finance.

What’s the problem with Fractional Reserve Banking

Even though FBR is a brilliant mechanism to finance progress of the humankind, it has its shortcomings too.

Bank Runs

At the time of the Great Depression, a lot of people panicked that their banks were out of cash and stormed to the bank to withdraw all their money. This was more due to panic rather than banks being broke. But as more and more people tried to take their money out, banks ran out of funds and closed down. You can imagine all that would’ve ensued.

This is when the Central Bank of the US: the Federal Reserve, deemed that all banks should’ve a minimum amount as reserves. The Fed also came up with the concept of deposit insurance where you can claim insurance in case the bank runs out of money to pay you.

After this measure, America didn’t witness any bank runs for a long time. Unfortunately, during the 2007 financial crisis bank runs returned. On 25th Sept 2008, Washington Mutual saw a run that led to over $16 billion withdrawn. Similarly, Wachovia Bank saw a bank run of $15 billion withdrawn in just 2 weeks!

Today bank runs can still happen and can be tricky because the entire episode happens on the website of the bank. Hence, people don’t notice it. This is what makes it so dangerous.

Financial crisis

The second problem with FBR is a bigger one that can actually cause a financial crisis.

Banks can get too greedy for profits. So they make loans to people and companies without properly vetting them. As loans build up there usually comes a point at which people are unable to repay and the loans go sour.

This leads to a spot where the income for a bank stops and the bank has to declare bankruptcy. When this happens to a large number of banks it becomes a full-blown financial crisis.

Does this ring a bell? This is how the great financial breakdown of 2007 happened.

In the early 2000s banks started giving loans to anyone who walked in. Around that time the Fed enacted a relaxation in regulation which allowed banks to give housing loans to even people without a good credit history. Banks gave loans lavishly. Banks also made it possible for people to take more loans using their houses as collateral.

It was a great loan fest until one day when it all fell apart. A great number of people couldn’t repay their loans and banks were unable to bear the losses.

Over 150 banks declared bankruptcy and closed down. The stock market crashed and the investments of many people were wiped out. Thousands of people lost their jobs and it was a complete financial catastrophe. In fact, it was the worst since the Great Depression of 1929.

The crisis led to exasperation with loan-making and money creation. This forced many people to think of setting up an alternative system in which everyone has an equal say. No central authority takes decisions for everyone.

So how exactly did this happen and what is this alternative system? Head over to our next article to know more about this.