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Fractional-Reserve Banking Is Important, And Dangerous

Fractional-Reserve Banking
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EDITOR NOTE:  If you don’t understand how the fractional reserve banking works, this article makes for a great introduction. A preview: as a bank, I lend out your money to someone else, expecting to get it back plus interest. Profit made. If I lend out more money than I have in deposit, I’ll make an even greater profit. But if my depositors ask for their money back before my debtors repay their loans, then I’m in trouble. This applies to every bank except for the central bank (lender of last resort). If they run short, they’ll just print more money, robbing you (by devaluing your money) in order to pay back its creditors. The article states this in a more elaborate and entertaining way.

The expression “elephant in the room“…

“…an important or enormous topic, question, or controversial issue that is obvious or that everyone knows about but no one mentions or wants to discuss because it makes at least some of them uncomfortable or is personally, socially, or politically embarrassing, controversial, inflammatory, or dangerous. (source

A wordy definition, yes; but it is applicable to our topic of Fractional-Reserve Banking. After reading the rest of this article, you should be able to see just how important and enormous  Fractional-Reserve Banking is; as well as how dangerous.

Lets’s start with some history.

The following is an excerpt from an earlier article of mine…

The warehouse proprietors (‘bankers’) decided they needed to find a way to increase their profits. Earning fees from their depository and safekeeping services wasn’t enough. Since most of the gold remained in storage and most transactions involved exchange or transfer of paper receipts for the gold on deposit, they decided to issue ‘loans’ of the gold/money to others and charge interest. The cumulative amounts of gold loaned out could not exceed the amount of gold held in storage. And, hopefully, not too many depositors would ask to redeem their physical gold at the same time. 

It seemed to be a workable system. But apparently the ‘bankers’ were not content. They soon started issuing more loans/receipts for gold which did not exist. Of course they saw no need to inform anyone of their actions and the receipts still stated that they were redeemable in fixed amounts of gold. And when someone wanted to take possession of their gold on a physical basis they could still do so. Up to a point. (see History Of Gold As Money)

If any of this sounds familiar to you, it should. Fractional-reserve accounting by warehouses/banks was a starting point for the credit expansion that now funds our world economy.

As we become more dependent on credit, we also become more vulnerable to events similar to that which happened twelve years ago. Another credit collapse isn’t just a possibility, nor is it only highly likely. Rather, it is inevitable.

A PRIMER ON FRACTIONAL-RESERVE BANKING

On a personal, retail level, here is an example of how fractional-reserve banking works today:

Your brother-in-law pays you the thirty thousand dollars that he borrowed three years ago. You decide to put the money in a time deposit (one year CD, etc.) at your bank. At the end of the day when your banker balances his books he finds that deposits at the bank exceed the funds which are currently loaned out/invested by an amount in excess of the ten percent US Federal Reserve requirement. And since that surplus amount is now available for new loans and additional investments, your bank’s loan committee and investment department are busily engaged in efforts to allocate those funds on a – hopefully – profitable basis. After due consideration, it loans twelve thousand dollars to Jane, who wants to buy a car and fifteen thousand dollars to a local entrepreneur.

Jane pays the twelve thousand dollars to Mr. Smith who is selling the car to her (private transaction). Jane drives away in her new car and Mr. Smith deposits the money in his bank which subsequently loans out ten thousand eight hundred dollars to a local dentist who is expanding his practice.

The local entrepreneur deposits the fifteen thousand dollars in his business account which is at the same bank that loaned him the money. Voila! The same bank which made the two loans now has fifteen thousand dollars in ‘new’ deposits of which it can lend out or invest another thirteen thousand five dollars. It promptly does so.

Where are we now? The original deposit of thirty thousand dollars has  grown to $81,300! How? By lending/investing a majority of the same money over and over again.

US Federal Reserve regulations require banks to keep on deposit an amount of money equal to ten percent of the deposits they take in (checking, savings, CDs, etc.). The remaining ninety percent can be loaned out or invested. (There are exceptions, allowances, and variations to the requirements depending on deposit type, amount, etc.  There are also ways to meet the requirement other than just holding cash reserves.)

Once the money is deposited, the process is ongoing and continually adds to the amount of dollars in the system.

TOO MANY BOBS 

Here is a story to help illustrate the risk involved in fractional-reserve banking.

Bob has ten thousand dollars that he doesn’t know what to do with so he gives it to his best friend, Sam, for safekeeping. Bob tells Sam that he does not expect to need the money anytime soon, but he may want to get some of it from time to time. And, of course, if the unexpected happens (it always does) he may need to have access to more – or all – of it.

Since Sam is a specialist in financial matters and has considerable investment expertise he decides to invest four thousand dollars of Bob’s money in US Treasury notes. Sam also loans five thousand dollars to a friend of his who is a homebuilder. Sam will earn interest on the construction loan in addition to a modest return on the US Treasury notes he purchased. Not bad. Especially since he does not have to pay Bob more than a pittance for ‘watching’ his money for him. Maybe Bob should pay Sam something for the good job he is doing (think negative interest rates).

Sam has decided to keep one thousand dollars of Bob’s money available in case it is needed. Good thing, too. After one week, Bob asks Sam for one thousand dollars of his money back in order to take care of some ‘unexpected’ expenses. Sam promptly pays Bob his one thousand dollars.

Sam now feels that the likelihood of Bob needing more of his money anytime soon is a remote possibility. Hence, he pledges the US Treasury notes as collateral and borrows four thousand dollars. He keeps one thousand in cash and loans another three thousand dollars to his friend, the home builder.

Bob sees the success the builder and others are having and decides that he wants to invest his remaining nine thousand dollars in real estate. So he goes to see Sam.

Sam only has one thousand dollars of Bob’s money available and gives it to him right away. He tells Bob that he will have the rest of his money shortly.

Sam calls his builder friend right away. The builder tells Sam that a couple his homes have not sold yet and the money to repay Sam isn’t available until the homes are sold.

Sam could sell the four thousand dollars in US Treasury Notes in order to access part of the money needed to pay Bob. But the proceeds would have to be used first to pay off the loan for which they are pledged as collateral. Since the loan amount is nearly identical to the market value of the US Treasury notes, no additional funds would be available.

Bob, meanwhile, decides that he won’t start investing in real estate as he had planned. Therefore, he won’t need the rest of his money right now.

Except that when his wife gets home from work, he learns that one of their kids needs braces on her teeth. Also, the interest rate reset on their home mortgage has taken effect.  The new monthly payment will increase by several hundred dollars. He decides that he might need to draw from his money (that Sam has charge of) after all.

When he calls on Sam the next day, Bob is shocked to find out that his money is not available. And Sam doesn’t know when it will be available.

Do you see the risk in fractional-reserve banking? If too many Bobs want their money at the same time or can’t make their mortgage payments, what do you think will happen?

CREDIT ADDICTION STARTS WITH US TREASURY

All of the credit expansion explained in the illustrations above is after the fact. The original credit expansion starts with the United States Treasury.

You may have heard the term “robbing Peter to pay Paul”. Among other things, the meaning is “to take from one person or thing to give to another, especially when it results in the elimination of one debt by incurring another. ” (source)

This is how US Treasury debt is paid. New Treasury securities are issued to pay off those that have matured.

The total debt continues to grow because it is never paid off; only replaced with more debt. In addition, new debt offerings must be large enough to pay interest on existing debt and continue to fund day-to-day operations of the government.

Referring to fractional-reserve banking, fund manager and investor Bill Gross said:

“It still mystifies me…how a banking system can create money out of thin air, but it does. By rough estimates, banks and their shadows have turned $3 trillion of “base” credit into $65 trillion + of “unreserved” credit in the United States alone…”  

Mr. Gross’s quote above is from several years ago. The numbers today are so much larger as to be nearly unimaginable. And the risk of systemic financial crisis looms ever greater.

Fractional-reserve banking is ongoing.  It is at the core of the Federal Reserve’s efforts to expand the supply of money and credit. Hence, the number of US dollars continues to increase and their value continues to erode.  Their value at any given time is always suspect.  How can we possibly know what a dollar is worth when there is an unlimited supply and no constancy?

What is truly amazing is the extent to which our banking system can hold itself together.  And, to whatever extent the Fed’s efforts have kept the system from imploding, it is noteworthy that we continue to look to and depend on the perpetrator of the crime to rescue us. Even worse, the solution(s) offered are the very same actions that led to the current predicament.  Spend more and borrow more.

Originally posted on Kelsey Williams Gold

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