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.
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The fundamental details of fractional reserve banking practice is simply enough stated. The tricky part is that such a simple statement leaves many people not fully appreciating the broader implications. First things, first, though: what is it?
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were 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.
Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.
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.
This perception is of course quite wrong. Obviously their money can't be in the bank if it's been loaned out. The fact of course is that most depositors, most of the time, have no reason to withdraw most of their money. Thus, the imminent disaster intrinsic to fractional reserve banking usually is averted.
The banks of course don't lend out all the deposits. Instead, they reserve a fraction to meet withdrawal demands as they occur daily. This of course is the origination of the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
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.
Usually, though, in the course of routine banking life, such measures are unnecessary. The banks' ability to anticipate reserve levels sufficient to cover expected withdrawals is generally effective enough to keep most people adequately contented with the arrangement.
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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply . As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
With these basics under your belt, you might want to turn to this article on the pros and cons (and con jobs) of fractional reserve banking for a deeper understanding of what's at stake.
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The fundamental details of fractional reserve banking practice is simply enough stated. The tricky part is that such a simple statement leaves many people not fully appreciating the broader implications. First things, first, though: what is it?
Depositors place their savings into an account with a bank. The bank then uses those deposits to make loans to others - who may or may not also be depositors. (If they are, semantically accurate description can create complications with diminishing returns in insight. So, for purposes here, we'll just talk as though depositors and borrowers were 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.
Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.
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.
This perception is of course quite wrong. Obviously their money can't be in the bank if it's been loaned out. The fact of course is that most depositors, most of the time, have no reason to withdraw most of their money. Thus, the imminent disaster intrinsic to fractional reserve banking usually is averted.
The banks of course don't lend out all the deposits. Instead, they reserve a fraction to meet withdrawal demands as they occur daily. This of course is the origination of the term fractional reserve banking.
Usually, this system works efficiently enough. It is true that many depositors don't realize when creating accounts that the small print in their contracts deny them withdrawal on demand. Often they have to at least endure a waiting period for withdrawals beyond a certain size.
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.
Usually, though, in the course of routine banking life, such measures are unnecessary. The banks' ability to anticipate reserve levels sufficient to cover expected withdrawals is generally effective enough to keep most people adequately contented with the arrangement.
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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply . As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
With these basics under your belt, you might want to turn to this article on the pros and cons (and con jobs) of fractional reserve banking for a deeper understanding of what's at stake.
About the Author:
Those who want to be smart 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 major commentator on how to recognize and beat the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
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