There are many claims on different sides of the debate over fractional reserve banking. Doing the debate justice would require a book. And even then...
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
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 are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
In principle, this lending out of depositors' savings as loans by the bank is good for everyone. Borrowers are provided the resources necessary to initiate new businesses or to purchase homes, home appliances, cars, etc. In the process they improve their and their families' life prospects. Meanwhile, the interest paid by the borrowers fund the bank's operations. Some of that interest on borrowing is passed on to the original depositors. This return on their savings generates incentives to deposit their savings with the bank and hence the motor for the whole process is set in motion.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
On the face of it, the banks seem to be putting themselves in a precarious situation. After all, the depositors are not investors. Most regard their money as merely being stored at the bank: a bit like renting a mini-storage unit to stash away those boxes of keepsakes they can't bring themselves to trash. They can go fetch those boxes, though, any time they want. So, most expect with their money deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since 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.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
If the withdrawal demand is enough beyond a stipulated threshold, the bank could reserve the option to interrogate depositors about their financial intentions. These contractual tools allow banks to delay large sum withdrawals and thereby forestall vulnerability threats to their reserves.
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.
Does this mean though that fractional reserve banking is uncontroversial or unproblematic? Far from it, claims many critics. In fact, it presents a constant threat of catastrophe for the bank and, given the interconnection of today's globalized banking system, even for the world economy.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
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.
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
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 are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
In principle, this lending out of depositors' savings as loans by the bank is good for everyone. Borrowers are provided the resources necessary to initiate new businesses or to purchase homes, home appliances, cars, etc. In the process they improve their and their families' life prospects. Meanwhile, the interest paid by the borrowers fund the bank's operations. Some of that interest on borrowing is passed on to the original depositors. This return on their savings generates incentives to deposit their savings with the bank and hence the motor for the whole process is set in motion.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
On the face of it, the banks seem to be putting themselves in a precarious situation. After all, the depositors are not investors. Most regard their money as merely being stored at the bank: a bit like renting a mini-storage unit to stash away those boxes of keepsakes they can't bring themselves to trash. They can go fetch those boxes, though, any time they want. So, most expect with their money deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since 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.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
If the withdrawal demand is enough beyond a stipulated threshold, the bank could reserve the option to interrogate depositors about their financial intentions. These contractual tools allow banks to delay large sum withdrawals and thereby forestall vulnerability threats to their reserves.
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.
Does this mean though that fractional reserve banking is uncontroversial or unproblematic? Far from it, claims many critics. In fact, it presents a constant threat of catastrophe for the bank and, given the interconnection of today's globalized banking system, even for the world economy.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
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 personal finance management 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 leading voice on how to detect and beat the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
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