The Truth About Fractional Reserve Banking (2024)

What is Fractional Reserve Banking?

Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash or reserves held by the bank. Banks create money by lending out a larger amount of money than they actually have in reserves. For example, if a bank has $1,000 in deposits, it may only hold $100 in cash reserves and lend out the remaining $900. This is known as the reserve ratio, which is the percentage of deposits that banks are required to hold in reserve and in this example it's a 10% reserve ratio. Fractional reserve banking allows banks to create credit and expand the money supply. When a bank makes a loan, it increases the borrower's account balance, which in turn increases the total amount of money in circulation

In Canada the reserve requirement is 0% meaning if you deposit $1000 the bank can then lend out the entire $1000 which can be an issue that I will cover shortly. Each country has their own reserve ratios ranging from 0% in Canada and the United States all the way up to 44% in Argentina.

The History

Fractional reserve banking has a long and complex history, dating back to ancient civilizations. However, the modern system of fractional reserve banking as we know it today emerged in Europe in the 17th century.

During this time, goldsmiths in London began to offer deposit accounts to their clients, who could deposit their gold and receive a paper receipt in exchange. These receipts were essentially the first banknotes, and they quickly became a convenient way for people to carry out transactions without having to carry large amounts of physical gold.

As the use of banknotes became more widespread, goldsmiths realized that they could lend out some of the gold that was deposited with them, while still maintaining sufficient reserves to meet customer withdrawal requests. This practice became known as fractional reserve banking, as banks held only a fraction of their customers' deposits in reserve, while lending out the rest.

Over time, fractional reserve banking became more institutionalized, and central banks began to play a role in regulating and supervising the banking system. In the United States, for example, the Federal Reserve System was established in 1913 to regulate the banking system and stabilize the economy.

Today, fractional reserve banking is the dominant banking system in most countries around the world.

The Big Disadvantages of Fractional Reserve Banking

Fractional reserve banking is a system that has both advantages and disadvantages. Some people argue that fractional reserve banking is bad for a number of reasons, including:

1. Risk of bank runs: Fractional reserve banking exposes banks to the risk of bank runs. If a large number of depositors want to withdraw their money at the same time, the bank may not have enough cash reserves to meet the demand, which can lead to a bank failure.
2. Inflation: Fractional reserve banking can also contribute to inflation by increasing the money supply. When banks create credit, they increase the amount of money in circulation, which can lead to higher prices for goods and services. Something we have experienced greatly these past couple of years. An increase in money supply only results in a higher level of liquidity, but it does not make the economy wealthier at all.
3. Moral hazard: Some critics argue that fractional reserve banking creates a moral hazard by allowing banks to take on more risk than they otherwise would, knowing that the government or depositors (you and I) may bail them out in the event of a crisis.
4. Unequal distribution of wealth: Fractional reserve banking can also contribute to the unequal distribution of wealth by enabling banks to charge interest on loans, which can result in a transfer of wealth from borrowers to lenders. The banks profit billions of dollars each year but never from their own money it is always from us, the depositors. However, why don't we see any of the billions of dollars of profit? It is similar to a business partner, you front all the money but your partner takes all the profit. Not the greatest business plan.

It's important to note that fractional reserve banking also has benefits, such as enabling banks to provide loans and credit to individuals and businesses, and helping to facilitate economic growth and development. In my opinion the effectiveness of fractional reserve banking depends on a range of factors, including the regulatory environment, the stability of the banking system, and the overall health of the economy. During downtimes in the economy like we are seeing in the past few years fractional reserve banking has shown its faults as we've seen the impacts of inflation from the cause of increasing the money supply. Us as bank depositors get to clean up the mess from other peoples decisions and that shouldn't be the case, we should be in control of our money and make the decisions we want to make because it is our money! But we are also to blame because we are letting this happen to us, we are not taking control and finding alternative ways to store our money without losing access to the money when we need it and having it continuingly grow for us. There are alternative ways we just have to look for them.

I appreciate you for taking the time to read the article and I hope you learned something along the way. If you have any questions or comments please email me at [email protected] or message me on LinkedIn!