What is the truth about Fractional Reserve Banking?

Economics Economics Questions
1

I have recently been exposed to fractional reserve banking and how it is a fraud on the American people. However there seems to be a lot of misinformation about about what is really going on. I would love it if someone could clarify.

From my limited understanding this is how it works. If I have $1000 dollars and want to start a bank. I go and deposit this in the Federal Reserve and now my bank can loan out 10,000 dollars with the 10 to 1 requirement. And then through fractional banking reserves, which I only need to keep 10% I loan out the rest, and through being deposited through other banks will increase the money supply to $100,000. And this is how the banks increase the money supply.

Is this how Fractional Reserve Banking works?

2

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3

Not quite. If you were the only bank, and if everyone kept their money in the bank, you could loan out $9000 (for a total of $10,000, including the depositor’s $1000), but then there wouldn’t be any other banks to expand it out to $100,000. With others in the picture, you can only lend out $900, and the other banks will expand it to $10,000 total, not $100,000. In reality, the reserve ratio is lower than 10%, but not everybody keeps all their money in the banking system, so it can’t expand quite as much as the reserve ratio alone would lead you to believe.

(See Jesus Huerta de Soto’s Money, Bank Credit, and Economic Cycles, chapter 4 et seq., for a very complete explanation)

4

I don’t think that’s how it works. A bank’s assets have to be equal to its liabilities. Your $1000 is a liability. They could keep that cash on hand (100% reserve), and thus their assets would be $1000 cash on hand, and liabilities would be the $1000 demand deposit that you have.

In fractional reserve, though, they don’t keep your cash on hand. they lend it out, up to 96% I think. 4% reserve. So they lend out $960 and keep $40 in reserve. So now their assets are $40 cash, and a loan worth $960+interest. Their liabilities are still your $1000 demand deposit. So still, their liabilities ($1000) equal their assets ($960+$40). The $40 is a “fractional” cash “reserve” of your original deposit.

If you wanted to withdraw your $1000, theoretically the bank could sell their ownership of the $960 dollar loan. Hopefully they get at least $960 for it. If they don’t, then they can’t pay you back. [:'(]

5

The reserve requirement ultimately limits how much credit can be created from any initial amount of money. Since this credit normally functions as money, it is inherently regarded as an addition to the money supply. The process can work one of two ways…

A) You deposit $1,000 in the bank. The bank owes you $1,000, and has $1,000 in cash. A borrower makes a loan of $900, which is given to him in cash. Now, the bank owes $1,000. It has $100 in cash. And it owns a loan worth $900 + interest. It’s book is balanced. The $900 in cash that you originally deposited in now in circulation. Most of it will find its way back into the banking system, creating a $900 deposit. It will loan $810 of that out. Thus, it would then have $1,900 in liabilities, $190 in cash, and $1,710 in credit assets. This can keep reoccurring infinite times, which will leave the bank with $10,000 in deposit liabilities, $1,000 in cash, and $9,000 in credit assets.

B) You deposit $1,000 in the bank. The bank owes you $1,000, and has $1,000 in cash. A borrower makes a loan of $9,000, coming in the form of crediting his bank account by $9,000. Now, the bank owes $10,000 (one $9,000 account and your $1,000 account). It has $1,000 in cash. And it owns a loan worth $9,000 + interest. Here we reach the same conclusion much quicker.

The formula is simple. Given x amount of initial money and 1/y reserve requirement, the resulting money supply will be x * y. The bank creates (x * y) - x new money.

6

this explains the problem nicely.

7

I quit reading at “never been tried in practice”.