Fractional Reserve Banking

Fractional Reserve banking is the practice where banks loan out more credit money than they have on deposit. A simple statement. But you may ask how does it really work?

Now many people believe that a bank needs deposits before it can loan money. This is based on the erroneous believe that banks need the reserves before they can make a loan. This is totaly wrong. The banks and the FED would love for you to believe this. But it is false. The loans come first, not the reserves.

Banks are capital restrained they are never, never reserve restained.Why are banks not reserve sestrained? Because the Federal Reserve as the central bank provides the system with enough reserves as a way to manipulate the interest rate as it'smonetary policy.

Or in other words as Professor Scott Fullwiler has pointed out [1]:

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed's stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

The nitty gritty is a fabrication but still useful to understand one key point

This is what you have probably been taught in school. When a bank gets a deposit it has to keep a certain fraction in reserve to satisfy withdrawals. Hence the name fractional reserve banking. So let's take a specific example and "follow the money".

To make things easy we are going to fix the reserve rate at 10%. That means that 10% of a deposit must remain in the bank. The other 90% can be lent out. This money that is lent is spent and then deposited into a bank. For simplicity we will say that it is deposited into a different bank. In fact it can be deposited in the same bank or in a few different banks. Here is a table of what happens to a $1000 deposit of "real money" in starting in ACME bank.

Bank

Amount deposited

Amount loaned out

Amount left

Interest charge

(simple 10%)

 

 

 

 

 

 

Acme

$1,000.00

$900.00

$100.00

$90.00

 

B

$900.00

$810.00

$90.00

$81.00

 

C

$810.00

$729.00

$81.00

$72.90

 

D

$729.00

$656.10

$72.90

$65.61

 

E

$656.10

$590.49

$65.61

$59.05

 

F

$590.49

$531.44

$59.05

$53.14

 

G

$531.44

$478.30

$53.14

$47.83

 

H

$478.30

$430.47

$47.83

$43.05

 

J

$430.47

$387.42

$43.05

$38.74

 

K

$387.42

$348.68

$38.74

$34.87

 

L

$348.68

$313.81

$34.87

$31.38

 

M

$313.81

$282.43

$31.38

$28.24

 

N

$282.43

$254.19

$28.24

$25.42

 

P

$254.19

$228.77

$25.42

$22.88

 

R

$228.77

$205.89

$22.88

$20.59

 

S

$205.89

$185.30

$20.59

$18.53

 

T

$185.30

$166.77

$18.53

$16.68

 

U

$166.77

$150.09

$16.68

$15.01

 

V

$150.09

$135.09

$15.01

$13.51

 

W

$135.09

$121.58

$13.51

$12.16

 

X

$121.58

$109.42

$12.16

$10.94

 

Y

$109.42

$98.48

$10.94

$9.85

 

Z

$98.48

$88.63

$9.85

$8.86

 

AA

$88.63

$79.77

$8.86

$7.98

 

BB

$79.77

$71.79

$7.98

$7.18

 

CC

$71.79

$64.61

$7.18

$6.46

 

DD

$64.61

$58.15

$6.46

$5.81

 

EE

$58.15

$52.33

$5.81

$5.23

 

FF

$52.33

$47.10

$5.23

$4.71

 

GG

$47.10

$42.39

$4.71

$4.24

 

HH

$42.39

$38.15

$4.24

$3.82

 

JJ

$38.15

$34.34

$3.82

$3.43

 

KK

$34.34

$30.90

$3.43

$3.09

 

LL

$30.90

$27.81

$3.09

$2.78

 

MM

$27.81

$25.03

$2.78

$2.50

 

NN

$25.03

$22.53

$2.50

$2.25

 

PP

$22.53

$20.28

$2.25

$2.03

 

RR

$20.28

$18.25

$2.03

$1.82

 

SS

$18.25

$16.42

$1.82

$1.64

 

TT

$16.42

$14.78

$1.64

$1.48

 

UU

$14.78

$13.30

$1.48

$1.33

 

VV

$13.30

$11.97

$1.33

$1.20

 

WW

$11.97

$10.78

$1.20

$1.08

 

XX

$10.78

$9.70

$1.08

$0.97

 

YY

$9.70

$8.73

$0.97

$0.87

 

ZZ

$8.73

 

 

 

 

 

 

 

 

 

 

 

$9,921.45

Total deposits

 

$892.14

Total interest

 

 

$8,921.45

Total loans

 

 

 

 

 

$991.27

Total reserves

 

 

 

$1,000.00 Total reserves + last amount deposited

As you can see from the table the amount of money loaned out asymptotically approaches $9,000, while the money on deposit asymptotically approaches $10,000. The new money ($9,000) loaned out is never really created it is virtual money. If you want to play with the numbers in the table yourself it can be downloaded as an Excel spreadsheet.

The banking community has agreed that money is fungible. That means that you can't tell the difference between the new virtual money created through loans. It is like there was only one bank and the money loaned out came right back to the same bank to be loaned out again. The banking community treats all banks as one large bank for the purpose of fractional reserve banking.

This allows is a shortcut. A single borrower does not have to go through all these steps to get a loan that is larger than the available deposits at one bank. The bank can loan out 900% of its deposits (for a 10% reserve rate). So a person can go to ACME bank, which has the $1,000, deposit and borrow $9,000.

When the loan is paid back the virtual money is destroyed leaving the original $1,000 real money. This is how the money supply is expanded and contracted.

The interest can only be paid with new debt

But wait! The bank is paid interest on the money that is loaned out. Let's look at that table again. For simplicity the bank is charging 10% simple interest. So it gets back 110% of what it loaned out. In total there is $892.14 of interest money, which has to be paid back to the bank. Where does this money come from? The bank (or banks) never created the interest money. This interest money can either be real money or more credit money. If there wasn't enough real money created to cover this interest money then another loan has to be taken out to create the credit money to pay the interest. This starts a cycle of having to constantly create more credit money to pay the interest.

[ 1 ] New Economic Perspectives, Don't Fear the Rise in the Fed's Reserve Balances http://neweconomicperspectives.blogspot.com/2009/06/dont-fear-rise-in-feds-reserve-balances.html