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A good friend of mine keeps telling me how all money is created from debt, with only a tiny fraction coming from the bank's actual reserves. Which he refers to as "Fractional Reserve Banking".

As he describes it, a bank never really loans money, instead they / the borrower create new money every time a loan is established, with only a tiny fraction of the loan money coming from the bank reserves.

If this is true(?), it doesn't seem fair to:

The borrower who has to pay interest on fiction-ally created money
People who try and save, and must compete with artificially high, loan-induced prices (i.e. houses)
Everyone who suffers from inflation.

So my question is, have you heard of "Fractional Reserve Banking"? And, is it true?

One other observation. Assuming a 20% reserve requirement. If I deposit $100 into bank A, then Bank A loans $80 (of my deposit) to Mike. Then Mike deposits $80 into Bank B, then Bank B loans $64 (of Mike's deposit). Then total loans are $144, yet total deposits are $100. And, this could keep going till nearly $400 of new money is created from the original $100. Is this correct?

edited Feb 4 at 3:47

asked Feb 4 at 2:04

unknown (google)
83●5

Welcome to the site! This is a good question about financial markets and banking theory. +1 – Chris W. Rea♦ Feb 4 at 2:52

smdpi · Accepted Answer · 2010-02-04 05:11:55Z UTC

Fractional Banking was designed to expand the money supply and cause inflation..End of story It sucks balls. From what I have read it works like this. If a bank has say 1,000,000 on deposit they can lend out 10,000,000 They need to keep 10% on deposit. So when a bank gives you a loan it is creating that money out of thin air in the form of credits. The money only exists on paper or computer. Because the system is set up this way every time a loan is made it increases the money supply. Which in turn causes inflation by devaluing the dollar. Since the federal reserve came into existence in 1913 the dollar has lost 97% of its value. Another widely unknown fact is that Federal Reserve lends the country its own money and charges interest. So the only way for the country to be out of debt is by having no money in circulation. The system by design is destined to fail. The money supply cannot expand like this and retain value. It is not possible. Google federal reserve act and see for your self.

harmanjd · Answer 2 · 2010-02-04 03:45:46Z UTC

Fractional Reserve Banking is real and is the basis of our banking system. However, it doesn't work how you've described it in the question.

This is how it works.

First depositors deposit fund to the bank.

The bank is required by law to keep a fraction of the money deposited in reserve. This is where the term fractional reserve comes from. The reserve amount varies, and I don't know what it is right now. Usually this is 10-20% I think.

So the banks can loan out up to 80% of the money they have in deposits. The reason this works is that depositors typically keep their money in the bank over long periods of time and it is rare for a bank to need to give that money back all at once.

The bank makes money on the margin of interest between what they pay depositors and what they charge people that borrow the money.

Also - via the Federal Reserve (in the US) or a national bank (common in other countries) banks can borrow and loan money to other banks. This is done at the federal reserve rate and is one way the Federal Reserve controls monetary policy. One reason banks might need to borrow money from other banks is to keep their reserve amount available.

One of the effects of reserve banking is that it is possible for the money to be loaned multiple times which seems odd, but it works.

I'll try to explain.

Let us say that in my town there is one bank - The Bank of Town.

Sally deposits $100. So if the reserve rate is 20% the bank can loan $80 of Sally's money.

Famer Joe borrows $80 from the bank to buy seed to plant. That $80 is spent at Frank's seed store.

Frank deposits that money into the bank - $80.

At this point on the banks books - they have $180 in deposits and $80 in loans.

So they can lend up to 80% of $180 - $144

So they have $64 that they can lend.

They lend $40 of it to the soda shop for a new sign.

The danger to the bank in this scenario is if Sally and Frank both decide they need their money right now and withdraw it. This is what is known as a run on the bank - large numbers of depositors pulling there money out at once. In this case the bank would have to borrow money from another bank - to cover the withdrawals until their loans get repaid.

Since the bank is still trying to make money - they typically charge more than the bank loan rate (or prime rate) in the case that this happens.

So - yes there is some danger to it. However, the bank isn't really creating money as much as it is freeing it for re-circulation.

Since the Federal Reserve system was created with the FDIC insurance program the banking system has stabilized to a large degree. The reason that banks fail now is not because of runs on the bank. The primary danger is of banks making too many bad loans. In the scenario above, if Farmer Joe and the soda shop fail to repay their loans then the bank is on the hook to the depositors for that money. A lot of analysis is done by banks on the probability of loans going bad. This is also why the credit rating system came into existence - it gives the banks a guideline for how good someone is at repaying loans.

herzmeister der welten · Answer 3 · 2010-02-13 20:37:37Z UTC

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"...banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank ‘writing a cheque on itself’. That is, banks extend credit by creating money."

Source: Bank Of England Quarterly Bulletin, p 103

answered Feb 13 at 20:37

herzmeister der welten
31●1

That's enough proof to me, that banks do indeed create new money from existing money (which they created). That is, they create money from thin air. It also seems to confirm my friend's theory that banks profit on Principal AND Interest repayments, perhaps not directly but as an industry. Not as harmanjd said "The bank makes money on the margin of interest between what they pay depositors and what they charge people that borrow the money." – unknown (google) 2 days ago

Is “Fractional Reserve” banking real?

3 Answers