Fractional Reserve Banking

I wanted to take a moment to talk about fractional reserve banking with you.

Seems to me that this is one area where you might see the term, and go “what the heck is that?” Well, it’s actually quite important in our economy. So, I wanted to take a bit of time and explain it in layman’s terms.

Banks do a lot more than transfer accumulated wealth through loans to young people like you and I seeking to buy a car or house. In fact, banks serve a vital purpose doing this.

Recently, the President and some in Congress thought it was dandy to nationalize student loans (as a ‘pay for’ for health-care reform.) Frankly, as a government, we don’t have the money to do that. This is a bad idea because it is open to political gamesmanship, and as it stands, we don’t have the necessary cash reserves on hand to finance it. It will likely be financed through borrowing, or worse yet, “quantitative easing” (i.e. printing money.) In my view, nor is it a proper role of government to get involved in lending, because politicians will start exempting certain classes of individuals from repaying their loans, thus transferring the burden to others. The recent health-care bill also takes interest earned from repayment to fund the new health-care scheme. A reassuring thought for students, I am sure, using the interest they repay from borrowed or created money to funds others’ health-care. But, I digress.

Anyways, banks earn a return on the loan they give you for a car or house and keep a portion of that interest for researching the feasibility of repayment and facilitating such a loan. They also pay interest to people who put their money in instruments like savings accounts and consumer deposits (CDs).

At some point, you may have met somebody whose name is “Goldsmith.” Similarly, like people whose names are “Brewer, Smith, and Carver” — the origin of this last name is tied to the career of the person who initially bore the name. Goldsmiths were artisans who made jewelry and items out of gold. Like any prudent person, they would protect the components of their trade (gold) in safes. In the olden days, not everyone had a safe, so people would frequently ask to store their gold with a goldsmith, who would issue a certificate redeemable for that specific item, or, if it were straight gold, that value in gold. He or she might also charge a premium for its safekeeping, but as we’ll see later, those fees likely disappeared if individuals agreed to the goldsmith’s terms of keeping it. Plus, it is worth pointing out that it was rather cost-prohibitive to either build or purchase a safe in olden days, as it is today.

People could then treat these certificates like currency, and trade them for goods or services. Goldsmiths soon realized that people tended to put their gold in their safe for long periods of time, and rarely would people all at once ask for their gold back.

Goldsmiths came to the point where they figured out that they could use the gold for other purposes, like making items for sale or lending the gold to others. They would make profit on the product they sold, or made interest on the lending of some of the gold.

Since the gold was protected in their safe, and they could lend the gold with some reasonable assurance that not all of it would be claimed at the same time, there was in effect, two types of the gold in existence. The value of that gold on paper, and the gold that goldsmiths could lend to others for interest. Naturally, this increased the value of the “money” supply.

This, of course, enabled people to generate more economic activity with the loans they received, and also led to the betterment of society as a whole through increased investment.

Of course, problems arise from this concept. What about unscrupulous goldsmiths who kept practically no reserves? What about inflation in the money supply?

In today’s banking system in the United States, two entities exist to address both of these concerns. First, the Federal Deposit Insurance Commission (FDIC) exists to guarantee deposits at banks. Banks pay a premium into a fund that exists to pay for their potential failure. The FDIC, in turn, insures your deposits up to a certain limit (which changed recently because of the economic crisis from $125k to $250k.)

The other entity exists to ensure (in theory, at least) that inflation is not rampant and, thus, a silent thief of your wealth, is the Federal Reserve. The Federal Reserve also determines the percentage at which banks have to keep certain reserves relative to their total holdings. They also lend money to banks at a fixed percentage (federal funds rate, set by the Open Market Committee) to lend to banks, and thus, individuals/businesses.

A bank may be perfectly sound, but a run could ruin it because loans (like mortgages) are not liquid to the degree where the bank could force you to repay your loan instantaneously. Banks cannot legally breach contracts like this. This is why both the FDIC, the law set by Congress, the Judicial system, and the Federal Reserve, our central bank, exist.

Through the laws of the country and the policies of both entities, a balance is meant to be struck to ensure the safety of bank deposits, their holdings, and the greater money supply, which the Federal Reserve oversees.

Just something to think about when you get your next loan, or you open up an investment instrument through a financial institution.

SOURCE: Much of the content for this blog post was adapted from Thomas Sowell’s book, Basic Economics: A Citizen’s Guide to the Economy, pages 268 and 269. This is an excellent book to purchase if you’re looking to gain a good understanding of the fundamentals of economics, or to brush up on them.

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