Placid on the surface, but churning with controversy and risk in its depths, fractional serve banking practices have been the object of great debate. It won't be possible to do justice to the nuances of that debate, here.
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
The basics are not especially challenging to express. Often, though, merely expressing them leaves their implications unexplored. A few sentences provide those basics.
People open bank accounts and deposit their savings there. These deposits, then, are deployed by the banks as loans to others. Such borrowers may or may not also be depositors, but this distinction is largely irrelevant to the dynamics under consideration, so, for our purposes, they'll be discussed as 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.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
Connecting the dots seems to suggest in fact that the banks are in a rather precarious situation, here. After all, the depositors are not investors. Most people understand that when you invest your money, it's in use: you don't have access to it while invested. However, depositors tend to regard their bank deposited savings as merely in storage. Most people seem to think of the situation as similar to having a mini-storage unit. They stash away their boxes of odds-and-ends and knick-knacks, which they neither want cluttering the house nor to throw out. The fundamental understanding, though, is that they are free to retrieve those boxes whenever it suits them. Many people seem to regard their deposited savings at the bank in the same way.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source of the term fractional reserve banking.
Most of the time, this approach serves its purposes. Admittedly, such efficacy may well be largely based on depositors' ignorance of how the system works and what it entails. For instance, few read the small print of their banking contracts, where they agree to the bank denying withdrawal on demand. The best case scenario may be being forced to wait a bank-stipulated period to make withdrawals beyond a certain value.
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.
Most of the time, though, there is no need to resort to such draconian measures. The banks do decent jobs of anticipating the level of reserves necessary to cover the withdrawals and everyone goes about their business more or less contently.
Are we to conclude from this, though, that fractional reserve banking is without controversy or risk? Not at all: critics insist in fact that such banking practices pose constant threats of disaster. This is not only true for any individual bank, either: the interconnection of our globalized banking system means such risks threaten the integrity of the entire world's economy.
Even that though is not the end of the danger. Under its apparently serene surface, fractional reserve banking plays an even more insidious role through its contribution to the inflationary destruction of the money supply . And that naturally increases the likelihood of borrowers defaulting on repayment and putting the entire system at even greater risk.
For a fuller appreciation of the wider controversy over fractional reserve banking, and what's at stake, check out this elaborating article on the practices' pros and cons (and con jobs) .
What can be done though is to provide an evocative introduction and tasty sample to whet your appetite. A brief review of the claims from either side gets us started and lays the groundwork for a more thorough examination.
The basics are not especially challenging to express. Often, though, merely expressing them leaves their implications unexplored. A few sentences provide those basics.
People open bank accounts and deposit their savings there. These deposits, then, are deployed by the banks as loans to others. Such borrowers may or may not also be depositors, but this distinction is largely irrelevant to the dynamics under consideration, so, for our purposes, they'll be discussed as 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.
On paper, this sounds like a win-win-win prospect. The reality though is a little messier than that.
Connecting the dots seems to suggest in fact that the banks are in a rather precarious situation, here. After all, the depositors are not investors. Most people understand that when you invest your money, it's in use: you don't have access to it while invested. However, depositors tend to regard their bank deposited savings as merely in storage. Most people seem to think of the situation as similar to having a mini-storage unit. They stash away their boxes of odds-and-ends and knick-knacks, which they neither want cluttering the house nor to throw out. The fundamental understanding, though, is that they are free to retrieve those boxes whenever it suits them. Many people seem to regard their deposited savings at the bank in the same way.
If we've understood the description of fractional reserve banking practices from above, though, obviously, their money isn't in the bank. It has been loaned out to borrowers. And, it can't be two places at the same time - right? Still, this slightly awkward situation works well enough in the general course of affairs. This is because most depositors, most of the time, have no reason to withdraw most of their money.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source of the term fractional reserve banking.
Most of the time, this approach serves its purposes. Admittedly, such efficacy may well be largely based on depositors' ignorance of how the system works and what it entails. For instance, few read the small print of their banking contracts, where they agree to the bank denying withdrawal on demand. The best case scenario may be being forced to wait a bank-stipulated period to make withdrawals beyond a certain value.
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.
Most of the time, though, there is no need to resort to such draconian measures. The banks do decent jobs of anticipating the level of reserves necessary to cover the withdrawals and everyone goes about their business more or less contently.
Are we to conclude from this, though, that fractional reserve banking is without controversy or risk? Not at all: critics insist in fact that such banking practices pose constant threats of disaster. This is not only true for any individual bank, either: the interconnection of our globalized banking system means such risks threaten the integrity of the entire world's economy.
Even that though is not the end of the danger. Under its apparently serene surface, fractional reserve banking plays an even more insidious role through its contribution to the inflationary destruction of the money supply . And that naturally increases the likelihood of borrowers defaulting on repayment and putting the entire system at even greater risk.
For a fuller appreciation of the wider controversy over fractional reserve banking, and what's at stake, check out this elaborating article on the practices' pros and cons (and con jobs) .
About the Author:
Those who want to be well-informed about personal finance management have to follow us at 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 recognize and avoid the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
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