The Placid Surfaces And Torrid Depths Of Fractional Reserve Banking
The comparative virtues of fractional reserve banking have been a source of controversy. Space limits do not allow us to do the topic justice, here.
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
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.
People open bank accounts and deposit their savings there. These deposits, then, are deployed by the banks as loans to others. Such borrowers may or may not also be depositors, but this distinction is largely irrelevant to the dynamics under consideration, so, for our purposes, they'll be discussed as different people.
In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families' life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
Connecting the dots seems to suggest in fact that the banks are in a rather precarious situation, here. After all, the depositors are not investors. Most people understand that when you invest your money, it's in use: you don't have access to it while invested. However, depositors tend to regard their bank deposited savings as merely in storage. Most people seem to think of the situation as similar to having a mini-storage unit. They stash away their boxes of odds-and-ends and knick-knacks, which they neither want cluttering the house nor to throw out. The fundamental understanding, though, is that they are free to retrieve those boxes whenever it suits them. Many people seem to regard their deposited savings at the bank in the same way.
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.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source 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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply. As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
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.
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
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.
People open bank accounts and deposit their savings there. These deposits, then, are deployed by the banks as loans to others. Such borrowers may or may not also be depositors, but this distinction is largely irrelevant to the dynamics under consideration, so, for our purposes, they'll be discussed as different people.
In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families' life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
Connecting the dots seems to suggest in fact that the banks are in a rather precarious situation, here. After all, the depositors are not investors. Most people understand that when you invest your money, it's in use: you don't have access to it while invested. However, depositors tend to regard their bank deposited savings as merely in storage. Most people seem to think of the situation as similar to having a mini-storage unit. They stash away their boxes of odds-and-ends and knick-knacks, which they neither want cluttering the house nor to throw out. The fundamental understanding, though, is that they are free to retrieve those boxes whenever it suits them. Many people seem to regard their deposited savings at the bank in the same way.
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.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source 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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply. As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
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 managing their money 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 avoid the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
posted by Vittoria @ February 24, 2014
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