What is Fractional Reserve Banking?

by on December 15, 2010 under Banking

Fractional Reserve Banking [singlepic id=62 w=320 h=240 float=left]is the real reason why Australian banks make super profits. Through Fractional Reserve Banking the banking sector is legally allowed to expand the money supply and earn increasing interest as the the bubbles become bigger. Increased competition in banking will again lead to a lowering of lending standards in the pursuit of a bigger slice of the debt pie.

Fractional Reserve Banking is the mutation of a counterfeiting fraud started by goldsmiths way back in medieval England. Let me briefly tell you the story, it’s a fascinating one…

One medieval day a few wealthy folk came knocking on the goldsmiths door, asking if they could perhaps rent storage space in his vault to store their surplus gold coins. The goldsmith obliged, and soon earned a small side income from his vault rental business, but he wanted more. He learned that the paper receipts he had issued for depositors gold were actually trading in the marketplace as if they were real gold! After all, a claim upon gold is as good as gold itself, and pieces of paper are more convenient than heavy gold coins. This was the birth of paper money.

The goldsmith began issuing loans against his own gold in paper receipts rather than in real gold because that was becoming the new currency of choice. His interest income was the same as before however, because he was still lending against his own gold and that quantity had not really changed.

Big idea#1: “What if I begin lending against the gold that I am looking after for others? Hmm…” so the goldsmith created gold receipts, paper money, representing the amount of gold he was being paid to look after in his safe, and loaned that out at interest! So he was now earning a full income from money that was not even his! As he began to flaunt his new-found wealth, the depositors became suspicious that he was spending their gold. Of course he wasn’t, he was spending the interest earned from loaning out paper money against their gold. The physical gold was still intact in the vault. When he came clean with his depositors as to how he had increased his wealth, they demanded a share of the proceeds. So the goldsmiths income dropped from say 7% to 2% when he had to pay 5% to the depositors (for example), but this was still better than before because he was now legitimately earning 2% on other peoples money stored in his vault for safe keeping. This was the birth of banking.

Big idea #2: “So I see that people rarely come in to demand physical delivery of their gold… they place full trust in these receipts I write. Hmm… I bet I can create paper money for gold I don’t even have, and loan that out at interest! No suspicious depositors to pay, so I get the full income!” So the goldsmith began counterfeiting large sums of money, backed by nothing, and lending it out at interest. Needless to say, our friend the goldsmith became the wealthiest man in town. This was the birth of Fractional Reserve Banking.

As you can imagine, it was troublesome for the early banks when people demanded their physical gold back instead of paper receipts. There were far more receipts on issue than there was gold on deposit in the vault, so in a bank run, when everyone wanted their physical gold back, banks would frequently collapse, and many people would lose their gold. Over the years a few regulations have been added to make the system ‘safer’:

  • Central Banks were created to supposedly maintain reserves among other objectives;
  • Minimum reserve requirements were regulated.

Incidentally, Central Banks successfully lobbied us off the gold standard, so money is now backed by no unit of real value that would put a physical size limit on the money supply.

The dangerous aspect of Fractional Reserve Banking is the multiplication effect it has on the money supply, and the fact that this is all based on debt. In short, it facilitates asset bubbles and instability in the pursuit of super profits. Fractional Reserve Banking is the practice of lending out many times more money than is held on deposit.

Consider the following Fractional Reserve Banking example with parameters as follows:

  1. The minimum reserve ratio is 1:10 or 10%;
  2. An initial deposit of $100 is made at CBA;
  3. Maximum loans are issued at each step;
  4. The loan money is then deposited in another account (could be the same bank);
  5. The process continues.

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[singlepic id=67 w=416 h=578 mode=watermark float=center]

As you can see the reserve ratio of 10% allows the $100 initial deposit to multiply the money supply towards $1000! So at this ratio the fractional reserve banking system has the capacity to multiply the money supply by 10 times! This is quite close to the average reserve ratio, or capital ratio, of Australian banks today.

The initial deposit of $100 (which is incidentally based on nothing) comes into the system from the Federal Reserve (Fed) as either cash or ‘reserve money’, sometimes called ‘high powered money’, as the monetary base, forming the base upon which a succession of loans and deposits will multiply the reserve money into ‘credit money’ totalling up to $900. The banks make their interest margin on this $900 of credit money so it is in their interest to expand the money supply in this way. Withdrawing cash from the system reduces the credit money supply by 10x the amount withdrawn. That is why banks don’t like us withdrawing large amounts of cash and ultimately would like to see cash abolished. It’s one way the people can still hurt them.

This credit money is what you and I use and think of broadly as ‘money’. Credit money is what we receive in our salary or from our customers, buy our houses with, deposit into our bank accounts, and use to pay interest on our loans.

You might be wondering: “Where does the money come from to pay the interest?” Good question. After all, interest is what keeps the whole system running: without the payment of interest the banks will call in the loans, and without the receipt of interest we would deposit our money under our mattresses, both actions destroying credit money and the entire system. Well guess what, the money to pay the interest comes from the creation of more credit money! Yes, inflation. Without inflation, the creation of new money, a hidden taxation making every existing dollar worth less, the whole system would collapse.

Let me show you how it works in this example using fairly standard numbers:

The banks charge 7% on loans and pay 5% on deposits. Inflation runs at 3%, the rate of expansion of the money supply.

So the money available to the population at any one time is:

5% + 3% = 8%

To pay an interest bill of 7%!

Therefore we have a 1% margin between our income and our costs. At all times our financial system is only ever 1% away from recession.

If you haven’t worked it out yet, our credit money system is a house of cards. This house of cards nature was evident in the GFC. As much as it pains me to say it, Kevin Rudd’s deposit guarantee was the smartest thing we could possibly do given the short time frame. That was all he needed to do. This move alone is what saved Australia in the GFC. There is plenty to say here and I might need to save it for another article.

There is another limit on the quantity of credit money other than the reserve ratio. This is the physical limit of the debt society can afford to service. This is the ‘sweet spot’ for which all banks aim. Maximum interest revenue with minimal defaults. If this limit is surpassed you have an imminent correction in the financial system. The introduction of strong competition into the banking sector will naturally lead down this path as small, less experienced lenders inevitably play the sub-prime balancing act in an attempt to grab a bigger slice of the overall credit money pie.

When you consider that reserve money created or destroyed by the Fed has up to a 10x effect on the size of our credit money system, and that the wholesale interest cost of money is directly set by adjusting the cash rate, you can begin to grasp the staggering power central banks like the Fed have. When you realise that central banks are owned by private shareholders, not elected governments, then you begin to realise we are not as ‘free’ or ‘lucky’ as the government would have you believe.

Quick Fact: The approximate composition of our money supply is:

Reserve Money = 10% (2% cash, 8% Fed money), and Credit Money = 90%.

If you would like to learn more about the history of money or our credit money system in an entertaining video format, take a look at Money As Debt.

 

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8 Comments for this entry

  • Pete

    A lot of this article is reintroducing topics covered in numerous books about the US fractional reserve system, which has a reserve ratio of 1:10. What I’m having trouble finding from a reputable source is the official Australian reserve ratio. I’ve read sources that say 1:10, others 1:100, and others still that state there isn’t an official ratio – that it’s entirely up to the banks and their need for self-preservation not to exceed a sensible ratio. A moot point in the end, because this system relies on perpetual growth, which is not possible to sustain with finite physical resources. Still, I’d like to know for sure.

    • Chad Elliott

      Hi Pete,

      Thankyou for your comment. I’ll give you a quote from a book called “What I didn’t Learn at School but Wish I Had” by Jamie McIntyre. On page 31 it states “Since 1984, trading banks have been able to loan out 18.3 times the money they have on deposit, and savings banks and building societies up to 32.8 times.”

      I have also seen the figure 32.8 many years ago in an official financial institution document but have since lost it.

      From memory the big 4 operate at reserve ratios between 1:7 and 1:11 depending on conditions, so I decided 10 works for the explanation. They clearly have room to expand the money supply if they so decide.

      Hope that helps and I will update you if I see more concrete evidence.

      CE

  • Bob

    This website has too many words and not enough pictures. Do you have any pictures of fractional reserve banking?

  • Brett

    Great article, found it googling for “australia bank reserve ratio”. Thanks for writing it Chad! I suggest you include the fact that banks CHARGE compound interest on loans but DON’T PAY it on deposits?

    Comment to Bob; you’re like most of us who don’t get it, but persist and you’ll be amazed, gobsmacked and furious. It’s taken me years to educate myself in politics, finAcne (the blemish on this planet) and banking.

    Bob’s response underlines why banks can continue this practice, since regular people don’t have the fiscal sophistication to understand they’re being ripped off in broad daylight, and WITH their government’s blessing.

    Bring on finance in schools I say!

    • Stev

      There are some fascinating ptoins in time on this article however I don’t know if I see all of them heart to heart. There is some validity however I will take maintain opinion till I look into it further. Good article , thanks and we would like more! Added to FeedBurner as well

  • Rory

    O.K. This is only my point of view, because there is no legal sancte that would ever/could ever or had dealt with such a meltdown.If the US ever did collapse beyond any comprehension we know about .The $ could indeed become worthless .Countries that , lets say, were owed trillions of dollars, could ask to have collateral give against the loan but it is so unlikely, it is not worth considering. The US would be forced to sell/lease out viable assets .oil reserves,oil resources, gold etc. Railways and of course Land e.g. Alaska.At this stage, you own property would in effect be worthless, market collapse.You would owe money to the mortgage lenders, but it is likely that company would have collapsed as well. What third party would want to take on/buy these debts outstanding, when repayment was going to be unlikely ..I would imagine, if this dire positon did every happen, you would have a huge civil unrest and it wouldbe every man for himself and a brand new order would have to grow from the ashes, which would take years. Imagine what happens after a nuclear explosion . Keep smiling though

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