Fractional Reserve Banking or Money Counterfeiting?

This week, I have decided to take apart yesterdays post into fractions, and elaborate on the several assumptions and statements that I make in it. This first of a few, in which will be taking a slightly deeper look into some issues I think people need to think about which relate to the ongoing global financial meltdown.

So the first issue I would like to discuss in detail is that of Fractional Reserve Banking. The following definition is courtesy of Art Branch Inc:

Fractional Reserve Banking refers to a banking system which requires the commercial banks to keep only portion of the money deposited with them as reserves (i.e. the reserve requirement). The bank pays interest on all deposits made by its customers and uses the deposited money to make new loans. In order to understand how fractional reserve banking works, let's look at the following example.

Somebody deposits $1,000 with Bank A. Bank A is obligated by law to keep 10% of the deposited money as a reserve, that's why the bank keeps $100 and lends out $900. Somewhere down the road the $900 loan is deposited in another chequing account (it might or might not be with the same bank). This second bank also wants to make money by giving out loans, that's why it keeps the required $90 and lends $810. Fast forward to a deposit with a fourth bank and you'll get the following:

As you can see from the table above, the banks created $2,439 based on the first $1,000 deposited. This in essence is a license to print money. The fractional reserve banking works for now, because the total amount of withdrawals is offset by deposits made at the same time. While the depositors are confident at the fractional-reserve banking system, a very small part of all deposits is withdrawn at the same time allowing the banks to handle the withdrawals through the 10% reserves. However when people's confidence in the banks is shaken, bank runs are possible, and the entire banking and financial system can collapse.

So, based on the reserve ratio principle, you can see that banks are essentially allowed to create money 'out of thin air' by keeping a small reserve on hand, and lending out the remainder of their deposits. But there is an even bigger catch at play. A lot of people wonder how banks can make so much money charging such low interest rates (in the 4% to 5% range recently). Well the answer is simple. As an example, imagine you deposit $100 in the bank, and then the bank turns around and lends out $900 based on your $100. For simplicity lets assume the interest rate is 5%. The banks earnings in this case are $45 (5% x $900). When you think about the fact that it took $100 to make $45, you realize that the banks actually earn 45% ($45/$100) on your $100 deposit, and not the advertised 5%.

The following diagram illustrates the amount of money in circulation as measured by various bank reserve requirements. As you can clearly see, the lower the reserve ratio, the higher the amount of money in circulation. Based on the previous example, you can logically deduce that lower reserve requirements result in higher bank earnings on the same $100 deposit.

As the amount of money in circulation increases, so does inflation. As such, the hidden 'tax' on everyone is in the form of increased prices (or decreased currency value). The following diagram illustrates the inverse relationship between the money supply in circulation and value of the money itself.

Getting back to the main topic of this post: through fractional reserve banking, western countries have sustained growth in their economies through booms and busts, which were arguably created by the central banks and the fractional reserve banking model. If you look at the following list, you will notice that the countries with the lowest or non-existent reserve ratios are mostly western countries. You will also notice that the countries with the highest reserve ratios are mostly developing countries. During these tough financial times, those suffering the least are the countries at the bottom of this list because of their reduced dependence on debt to finance economic growth.

In summary, I think it is quite clear that fractional reserve banking is designed by definition to be a debt-based system. The paper currencies of most if not all countries do not hold an intrinsic value based on a reserve in gold, silver or any other commodity. Instead, the currency's value is determined by the amount of money in circulation and the governments order that it must be accepted as a means of payment.

As a closing remark, now that you understand the basics of how banks 'create' money, do you really think that creating more debt and adding it to the existing mountain will really solve the problem on a long-term basis, or is it just a quick fix until one day we wake up and the banks start repossessing everything we own...


Sources and further readings:

http://www.centralbanksguide.com/fractional+reserve+banking/
(Definition and explanation of Fractional Reserve Banking)


PRO-FRACTIONAL RESERVE:
http://blog.paulmckeever.ca/2008/05/28/inflation-the-gold-standard-and-fractional-reserve-banking/
(Paul McKeever - Inflation, the Gold Standard, and Fractional Reserve Banking)

http://www.freebuck.com/articles/afekete/040420afekete.htm
(Fractional Reserve Banking Revisited)


ANTI-FRACTIONAL RESERVE:
http://www.marketoracle.co.uk/Article6989.html
(The Market Oracle - How the Fed Creates Bull and Bear Markets)

http://www.islamic-finance.com/item113_f.htm
(Don't Mention the Reserve Ratio)

http://westernstandard.ca/website/article.php?id=2884
(Banking and Morality: 100% Reserve versus “Fractional” Reserve)