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...
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were 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.
Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.
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.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
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.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were 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.
Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.
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.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
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.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
About the Author:
Those who want to be well-informed about personal finance management need to stay tuned to 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 recognize and avoid the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
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