The fractional reserve banking system
As I have said before, understanding monetary policy and how money works is important in order to get a firm grasp of how the economy of any nation works. In my post, “What is money?,” I briefly explained how the government printing large supplies of money can be disastrous. Believe it or not, it is not only the government that creates the money we use.
The United States currently uses the fractional reserve banking system, which means that banks are allowed to lend more money than they actually have. This too leads to the creation of money (it is estimated that 95% of the current money supply was created through fractional reserve banking.) This system is contrary to the popular belief that the bank keeps all of one’s money with them in their safes. In fact, if every single person went to the bank to withdraw their money, there would be what is called a “bank run”, and the bank would not have enough cash to pay out to everyone. Such an occurrence would lead to the collapse of the bank. This is exactly what happened recently with the now failed IndyMac bank. A similar thing also happened to failed Washington Mutual, the largest bank failure in history, when too many depositors withdrew funds electronically, in what is known as a “silent run.”
So how does the system allow banks to do this? When a bank receives central bank money (money that is created by the Federal Reserve,) it is required to keep a certain amount of it in reserves, but is free to loan the rest out. The loaned out money can then of course be deposited somewhere else, where the next bank (or the same bank if it was deposited there again) will keep what is needed for the reserve requirement and then loan out the rest. Remember, that when these loans are being made, the accounts of the original depositors still stay the same, which means that virtual money, in the form of loans, is being created. How much money can be lent and hence created out of thin air depends on what is known as the money multiplier, a ratio of 1/r, where r is the reserve requirement. The reserve requirement changes from time to time, but at current levels it is far from 1:1 (which would be full reserve banking- when banks can only lend the money that they actually have.) This is why the banks don’t have all of the money that its depositors have put in it.
The money that is created by fractional reserve banking is in the form of debt, since it is made when loans are created. That money that is loaned out is completely new money, as the account of the depositors still stays the same. Loans play an important role in the growth of modern economies as they spur growth, but the current system is too inflation prone. This is because if the amount of money created through this system (along with what the government prints) surpasses the amount of economic growth experienced, we experience inflation and again, we, the people suffer because of it.
Because fractional reserve banking requires exponential economic growth to avoid inflation (since the monetary supply grows exponentially under it,) inflation is very likely because as soon as the economy stops growing exponentially, we will see the currency inflate. It is a sad reality and something that we really need to look at again. Our monetary system is broken and we need to rethink fractional reserve banking and printing money above the level of economic growth. The loss in the strength of a dollar in recent decades is not something that simply happened, a large part was (and still is) caused by the current system and it can really be avoided.
7 Comments »
Jan 12 2009 at 12:27 pm
[...] The fractional reserve banking system | Miraj Patel [...]
Feb 01 2009 at 2:05 pm
[...] The United States currently uses the fractional reserve banking system, which means that banks are allowed to lend more money than they actually have. This too leads to the creation of money (it is estimated that 95% of the current money supply was created through fractional reserve banking.) This system is contrary to the popular belief that the bank keeps all of one’s money with them in their safes. In fact, if every single person went to the bank to withdraw their money, there would be what is called a “bank run”, and the bank would not have enough cash to pay out to everyone. Such an occurrence would lead to the collapse of the bank. This is exactly what happened recently with the now failed IndyMac bank. A similar thing also happened to failed Washington Mutual, the largest bank failure in history, when too many depositors withdrew funds electronically, in what is known as a “silent run.” mirajpatel [...]
Feb 05 2009 at 1:32 pm
Miraj
Great commentary on the banking system. Your first line is absolutely correct….more people desperately need to be educated on the monetary system in general. First, they need to understand how the Fed and in turn banks create money out of thin air. Thanks for your thoughts and I’ll keep reading!
Feb 05 2009 at 11:38 pm
Thanks Luke, I look forward to reading more of your comments
Feb 23 2009 at 5:11 pm
[...] government has also had many regulations on the markets that added to the crisis. The unsustainable fractional reserve requirements are playing a big part right now with the bank failures because so many banks are facing the risk [...]
Mar 17 2009 at 12:24 pm
[...] in two ways: having its hand in how much money is printed and by being the driving force behind the fractional reserve banking system. In theory, the Federal Reserve would use its control over the monetary supply in order to keep [...]
Mar 17 2009 at 8:35 pm
Hi Miraj,
Thank you talking about this. This is a very important topic.
It very well explained in the following video: http://video.google.com/videoplay?docid=-9050474362583451279
Cheers, PF