The Placid Surfaces And Torrid Depths Of Fractional Reserve Banking
The comparative virtues of fractional reserve banking have been a source of controversy. Space limits do not allow us to do the topic justice, here.
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
On first blush, this arrangement seems good for all parties. Borrowers can access funds to launch businesses or buy high price items, improving the quality of life for themselves and their families. The interest paid by borrowers fund bank operations. Additionally, a portion of that interest is passed on to depositors: this return on savings incentivizes them to deposit their savings at the bank and thereby fuels the entire system.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
The observant reader may have noted that the banks seem to be in something of a precarious situation in all of this. They're making more promises than they can keep. Consider the depositors, who, after all, are not investors. When you invest in something, you understand that your money is tied up - you can't spend it while it's invested. Depositors though consider their savings being stored at the bank. Some actually regard the arrangement as analogous to renting a mini-storage unit: they stash boxes of knick-knacks and keepsakes they can't bring themselves to trash. The boxes though are always there to be retrieved when they want them. Most depositors think this about the money they've deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
On first blush, this arrangement seems good for all parties. Borrowers can access funds to launch businesses or buy high price items, improving the quality of life for themselves and their families. The interest paid by borrowers fund bank operations. Additionally, a portion of that interest is passed on to depositors: this return on savings incentivizes them to deposit their savings at the bank and thereby fuels the entire system.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
The observant reader may have noted that the banks seem to be in something of a precarious situation in all of this. They're making more promises than they can keep. Consider the depositors, who, after all, are not investors. When you invest in something, you understand that your money is tied up - you can't spend it while it's invested. Depositors though consider their savings being stored at the bank. Some actually regard the arrangement as analogous to renting a mini-storage unit: they stash boxes of knick-knacks and keepsakes they can't bring themselves to trash. The boxes though are always there to be retrieved when they want them. Most depositors think this about the money they've deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
About the Author:
Those who want to be well-informed about personal finance management need to stay tuned to the Fractional Reserve Banking Review to keep tabs on all the ways, new and old, that the banking system chips away at your wealth. Wallace Eddington has emerged as a leading voice on how to detect and avoid the scams of the mainstream financial system. Check out his recent provocative article on a Free Market Economy in Money .
Posts
