This should be a familiar scenario: you go to your bank to make a deposit, hand the cash over to the teller and walk out thinking that your money is safe in the building. But actually, not all your money goes straight into a secure vault, not even half.
If you didn’t know this, you’re not the only one. A study found that 26 percent of people believe banks are required to hold 100 percent of customer deposits in reserves.
So, where does it go, and why? What are the risks involved? Here’s what you need to know about fractional reserve banking.
What is fractional reserve banking?
All commercial banks around the world engage in a process called fractional reserve banking to increase their money supply. They do this by only keeping a small portion (10 percent) of the money that is deposited by account holders in the actual bank building. For example, if you deposit $100, the bank only sets aside $10 in physical cash to be withdrawn in the future.
But what happens to the rest of the money? Banks use it to offer loans to other individuals and companies. They then profit from these loans by charging higher interest on them than the interest given to the people who deposit money. Essentially, fractional reserve banking is a way for banks to create money that didn’t exist before.
When did fractional reserve banking start?
Fractional reserve banking could date as far back as the Middle Ages. But the process as we know it today started in the 17th century, with the first central bank in the world (Riksbank, in Sweden). It was implemented to stimulate the economy and expand customer deposits, rather than simply hoard money in a vault.
The concept was swiftly adopted by other central banks, including in the United States in 1791.
What risks does fractional reserve banking pose?
There are questionable ethics involved in fractional reserve banking. Imagine if you were a counterfeiter, printing fake money and putting it into circulation. If you were caught, you would be arrested and sent to prison. Banks, however, are encouraged to create new money.
Creating money increases the monetary supply, and if this growth isn’t controlled, the value of a currency can be diluted. This is known as ‘inflation,’ and can cause general prices in a country to rise. In the United States, the expanding money supply over the years has likely influenced dramatic drops in the dollar’s purchasing power.
Fractional reserve banking also works on the assumption that people won’t demand all their deposits back at one time. The steady stream of money being put into banks, versus the low volume of money being withdrawn, allows fractional reserve banking to work. Still, history has shown us that there are occasions when people do request all their money to be returned (known as a ‘bank run‘), and the outcomes have been severe.
Following the 1929 Wall Street Crash, account holders in the United States tried to withdraw their money from banks due to rising concerns about the security of their finances. The rush led to the closure of 1,300 American banks by 1930. A more recent example is that of the Washington Mutual Bank during the 2008 financial crisis. Customers withdrew $16.7 billion from the bank in just 10 days, forcing Washington Mutual to declare bankruptcy, and the Federal Deposit Insurance Corp. to pay $9.8 million to people whose accounts fell into ‘inactive’ status.
If banks don’t have sufficient cash on hand to meet the demand for withdrawals, they could be forced to ask anyone to whom they have loaned money to make full repayments. People typically cannot afford full repayments in one go, which would force them to sell collateral like their homes or cars. Businesses with loans may have to disrupt production or let staff go to make repayments. Whatever the scenario, banks suddenly calling in loans causes serious damage to the larger economy.
Time for alternatives?
It’s easy to view banks’ internal workings as mundane, but they can have a significant impact on your finances and livelihood. Fractional reserve banking has both micro and macro implications for society, and if not controlled responsibility, can have grave consequences.
In a world where the value of money is rooted in a trust-based system, generating new money in this way will always be a high risk. It’s necessary to consider alternative options for banks to sustain themselves financially without jeopardizing other people’s money. Moreover, it may be time to explore alternatives to the banking system as we know it altogether.