Fractional- Reserve Banking: The Complete Guide
The concept of money has indeed come a long way. In the beginning, we had the barter system where goods were traded. Then along came coins that were then minted and served as a means for buying supplies that were needed. The establishment of banknotes took the idea of coins and gave them a set value. Gold and silver were the standards that banknotes were set against to prove they had value. But in today's world, there is no longer the “Gold Standard.”
Money that is produced today is based on a flawed system that has been proven time and again to be unstable. The system that we have now is known as the Fractional-Reserve Banking system or FRB. The FRB is a wobbly structure that is going to crash. It may not go down tomorrow, or in five years, but it will. Which is why we need a more reliable form of currency that will allow commerce to continue on a more stable platform.
Bitcoin represents the platform the world needs to maintain a currency that has no restrictions. With Bitcoin or cryptocurrencies, there are no middlemen that will get in the way to cause instability. But you may wonder what is so wrong with the FRB system? After all, it has run smoothly enough without any major issues? Why change it?
To answer those questions, one must take a step back and look at the origins of the FRB system.
A Brief History
In 1609, the Bank of Amsterdam was established and was revered as the precursor to the modern central banks that we have today. The bank of Amsterdam is significant because they accepted banknotes and bank receipts. The bank receipt or banknote could then be exchanged for gold, silver, or other valuables which were deposited to the bank.
Banknotes were considered the standard medium of exchange between everyday people and the goldsmith or bank in which they were depositing their funds. It didn't take long for the goldsmith and banks to realize that they could issue more banknotes than what they had in their reserves. The goldsmith and bankers also discovered that people did not redeem their banknotes all at once, but rather at different times. Thus was the creation of banks and what soon became the Fractional Reserve Banking (FRB) system.
In 1668, after the creation of paper money and the successfulness of the Bank of Amsterdam, the Swedish Riksbank was established. Swedish Riksbank has been credited as the world's first central bank. It didn't take long for more countries to follow suit and set up central banks within their respective borders.
It is the central banks that control and store reserves collected from the private banks. The central banks set the reserve requirements and issue money to the smaller branches. The entire purpose of a central bank is to act as a last resort lender to smaller departments and financial institutions should a bank run take place.
What are Bank Runs?
Merely put a bank run is when everyone who has deposited money into an account, withdrawals it all at once. One of the more significant bank runs happened in the 1930s and history has labeled it the “Great Depression.”
Although despite what history has taught us, the realization is that bank runs are an inherited component of the FRB system. A great example and one that still lingers today is the fact that the US Federal Reserve is considered the central banking system for the United States. It is well-known that the US Federal Reserve’s power and authority have been extended significantly since the Great Depression and the global financial crisis that happened due to the housing bubble that rocked the world in 2008.
The US Federal Reserve
Established on December 23, 1913, the Federal Reserve had three primary objectives. The reserve was to stabilize prices, maximize employment and over-see long-term interest rates. The Federal Reserve serves both private and public institutions. The sole purpose of the Federal Reserve is to oversee private commercial banks and regulate financial institutions. It does not, however, print currency, that task is delegated by the United States Department of Treasury.
Fractional Reserve Banking: How it Works
As stated, the financial system in which we use today is the Fractional-Reserve banking system. This is a system were only a fraction of deposits are backed by cash and available for withdrawal. The purpose of FRB is to free up capital which then can be loaned out to other people as a way to grow the economy. Sounds simple enough, but there are flaws to this system.
Due to laws in place, the banks are required to have a pre-defined amount of cash on hand which is available for withdrawal to the general public. Most banks hold about 10% of every deposit that is made. A quick example would be if you were to deposit $100 into your bank, that financial institution is required by law to hold $10 of your deposit and put it on reserve.
The sad truth is that when you deposit money into your bank account, those funds are no longer your property. The money in which you bring into that institution becomes the property of the bank. However, the bank will issue the depositor an asset which we know as a deposit account.
The deposit account is a liability on the balance sheet of the financial institution. That account shows to the bank that they are legally responsible for paying it to you upon request. In the fine print, however, all banks have a clause that state that you can withdraw your funds as long as they have the requested funds to cover it. In brief, you as the depositor can collect the funds in your account down to the last cent as long as the bank has the funds to cover your request.
Follow the Money
Now with FRB, things become complicated when you look at what is known as the Multiplier Effect. For example:
Janet goes to a commercial bank to deposit her lottery winnings of $1 billion into her bank account. The bank takes her deposit and is required to set aside 10% of her deposit which just so happens to be $100 million. That hundred million dollars is now set aside to be used as cash on hand for Janet, and available for withdraws either through tellers or ATMs. Janet's bank now has $900 million that they can disperse in loans to other people.
Next, we have Jeff. Jeff goes to the same bank as Janet and needs a loan for $900 million. The bank gives Jeff the $900 million. Because each bank is obligated to issue credit up to 9-10 times larger of its reserves it now has less than the amount which the bank is legally forced to pay in satisfaction of demand deposits. This just means that the money that Jeff received is actually an additional $900 million on top of the original $1 billion deposited by Janet.
Now that Jeff has his $900 million, he goes to a different financial institution and deposits it into his account there. This now makes the total amount of money from Janet's $1 billion to $1.9 billion. For each and every transaction the process repeats and is known as the Multiplier Effect.
Of course, the FRB system is much more complicated than the example above, but that's the gist of it. However one question does pop up when analyzing this example, how did the additional $900 million get created?
In one word, debt. Because the financial worlds today exist mostly through digital mediums, Janet did not actually hand the bank $1 billion in cash. Instead, the information is stored on a digital ledger that is centralized.
The bank that issued Jeff $900 million credit was done digitally. And since the original bank that is liable for Janet's a $1 billion, the second bank where Jeff deposited his $900 million is now responsible for that money as well. So you see the money was created out of nothing. Due to the way that this system works is the cause behind inflation, interest rates, and devalues currencies.
In a nutshell, the Multiplier Effect is the process of credit issuance and deposits which repeat over and over again from a single deposit. Using the example above and Janet's $1 billion deposit, the possible impact of FRB on the money supply is achieved by multiplying 10 to the deposit. Janet and her $1 billion deposit have the potential to create $10 billion of new USD into the financial system.
Inflation, Debt, and Black Swan Events
FRB ordinarily runs smoothly because depositors rarely demand their accounts to be withdrawn at any given time. When there aren't as many people requiring their funds all at once, then the chances for Bank Runs are slim. However, there is still the possibility of them happening when the financial institutions aren't stable and people panic.
Many points of views show that bank runs are inevitable hurdles to maintain a secure and stable financial system. But these views are flawed because they don't take into account the social and political consequences for such events.
It is important to state that the United States debt has been consistently increasing over the years. The money supply and debt are both correlated in their trend upwards. The reasoning behind this increase is due to the ‘new' money that is created from the FRB system.
Now, due to the FRB process, the ramifications are inflation, along with the devaluations of the dollar. It isn't the increase of services and goods, but it is debt that is causing the dollar to decrease in value. As long as more money is pumped into the economy that comes from nothing, the dollar will continue to decline.
As of right now, the United States has a debt of over $22 trillion. The cause of such a high deficit is due to funding companies, advancing the U.S. economy, generating innovation, and overspending by the government. But, with all these projects in the works, it has also caused loans to default, wealth inequality, and the increasing misconception of money and value.
Thomas Jefferson once said that if the people ever allowed the private banks to control the issue of their currency, the banks will deprive the people first by inflation, then by deflation. He went on to say how the power of such circumstances should be in the hands of the people, not the financial institutions.
This is where we are today, right now. The financial institutions around the world hold too much power over the currency. There have been news reports of governments closing down the banks to steal people's money to sustain the country. There have been issues where banks needed to be bailed out due to the defaulted loans. Then you see the problems that arise when you think about the possibility of bank runs. Countries could topple in a matter of hours if their citizens demand to withdraw their funds from their institutions.
Digital currencies like Bitcoin offer a better solution that goes hand in hand with what Thomas Jefferson proposed. Because Bitcoin isn't tied to centralized financial institutions, there is no concern for inflation. It is from electricity and hard work known as the mining process that powers cryptocurrencies like Bitcoin. It isn't created from nothing the way the FRB is structured now. Which is why cryptocurrencies should be the new form of currency.