Fractional-Reserve Banking

Fractional-Reserve Banking is a financial system in which deposit-taking financial institutions like banks, are required to keep as a reserve only a small fraction of all the money deposited with them. When an individual or business deposits their money with a commercial bank, they lend the bank their money and the bank pays them interest on the loan. The money that has been deposited with the bank is used by the bank to originate loans for its customers who need financing. The deposit account owners who have lent their money to the bank, can withdraw their money at any time, but in reality at any given time only a small fraction of the money are being withdrawn simultaneously. The fact that not all depositors will demand their money at once has great implications, and is the main reason fractional-reserve banking is possible.

Most people have no idea how fractional-reserve banking works, but if the they understood its nature the fractional reserve banking will be exposed for what it is - a grand money-robbing scam imposed on the unsuspecting society. Lets see how fractional-reserve banking works.

How does Fractional-Reserve Banking Work?

Let’s see how fractional-reserve banking works. A customer of Bank #1 deposits $100 in his chequing account. The bank keeps the required reserve of 10% ($10) and lends the rest $90 to another bank customer. The second customer spends the $90 and this money ultimately ends in another chequing account at Bank #2. The Bank #2 keeps 10% ($9) of the deposit as a reserve and lends $81 to one of its customers. If this process continues 5 times in total we’ll have the following result.

Bank #1$100$10$90
Bank #2$90$9$81
Bank #3$81$8.1$72.9
Bank #4$72.9$7.3$65.6
Bank #5$65.6$6.6$59
Bank #6$59$59$0

The initial deposit of $100 magically ballooned to $468.5, creating $368.5 out of thin air through loans. Sounds like a Ponzi scheme? I’ll leave it to you to decide. As you can see your money is not actually in the bank, after you deposit it there. The $368.5 is money created by commercial banks, and they enter the economy and expand the money supply.

Why is Fractional-Reserve Banking Possible?

The fractional reserve banking is possible, because at any given time just a very small percentage of all deposited money is withdrawn. Furthermore the withdrawals are offset by new deposits. Most people keep their money in the bank most of the time (thinking that their money is secure there), which makes it easier for the banks to repay back money deposited with it on demand.

Bank Runs

What happens if the depositors of a particular bank lose faith in the ability of the bank to repay their deposits? If this happens the depositors will try to withdraw their money from the bank at the same time, but of course the bank will not able to repay them, because it actually keeps only fraction of the deposited money as reserves. Welcome to the wonderful world of fractional-reserve banking! This unpleasant situation is referred to as a bank run, and may cause the bank to fail unless the central bank act as a lender of last resort and bail out the bank.