What if I told you that the money you deposited into your bank account was carried straight out the back door and placed in the coffers of someone or an institution that you had never met, that you had never heard of or had jurisdiction to handle your money? Would you be cool with it?
The fact is that:
- Due to fractional reserve banking, your bank is probably actually giving a lot of your money to third parties without your knowledge or consent
- You may not be cool with it
Findings from our research Perceptions and Understanding of Money – 2020 indicate that a significant number of Americans do not know how fractional reserve banking works. More than a quarter of respondents believed that banks should keep the exact amount of customer deposits in their reserves at all times.
While others are generally aware that banks can re-lend or reinvest your money, they may not know to what extent banks are doing that.
If you plan to continue using the US banking system, you have no control over where your money goes after you deposit it. But you may want to at least have a general idea of where your money is going thanks to fractional reserve banking. Then read on.
Explain Fractional Reserve Banking
The Federal Reserve Bank of Atlanta (subtly) traces the roots of fractional reserve banking back to an unnamed goldsmith in ancient times. The story goes that while holding onto his clients’ gold supplies, the goldsmith eventually realized that he could make a tidy sum by re-lending the gold. As long as he returned the gold to his stores before the customer realized it was gone, no harm could be done.
Now replace gold in the above story with your bank deposits and the goldsmith with your bank of choice. Here you have a simple explanation of how fractional backup banking works.
The mechanism that allows fractional reserve banking is the reserve requirement established by the Federal Reserve Board of Governors. The reserve requirement is the percentage of customer deposits that a bank must keep on hand.
According to the Fed Board of Governorsthe reserve requirement for banks was reduced to zero effective March 15, 2020. This basically means that your bank can lend or invest 100% of the money that you and other customers give them. Fed Chairman Jerome Powell indicated that the non-existent reserve requirement could continue to exist for the foreseeable future.
Why fractional backup banking exists
Several reasons are given for the existence of fractional reserve banking. They include that:
- Banks that lend and invest customer deposits enable the banks to make a profit and run their business
- Money that is ‘created’ by loans and investments by banks increases the money supply
- By increasing the money supply and stimulating the flow of credit from banks to other institutions and individuals, fractional reserve banking ‘makes the economy grow’
Fractional reserve banking is one of the many tools the Federal Reserve uses to manipulate the money supply and thus the relative value of the US dollar. In times of stagnant economic activity, the Fed can lower the reserve rate to encourage more credit and, the theory goes, stimulate economic activity. In times of inflation, it can do the opposite.
The idea that borrowing money while proving that the money is in your bank account is a ‘growing’ money supply can be confusing or even hollow.– there are certainly such criticisms.
When there is a run on a bank, as can be the case in times of financial panic, the dangers of fractional reserve banking become abundantly clear. The money just isn’t there when customers want it.
The idea that customers cannot theoretically withdraw their money en masse at any point is just one of the criticisms of fractional reserve banking.
Criticisms of fractional reserve banking
At a simple level, fractional reserve banking exposes customers to risks they would probably rather not face. As a bank customer, if you wanted to get more returns than the modest bank interest rates, you would have put your money in the stock market or some other investment vehicle with a higher return.
For many, the advantage of banks is reliability. When you deposit your money in a bank, the popular thought may be:
- The bank should keep your hard-earned money in a safe that is much more secure than anything you can access
- The bank must guarantee that you can access your money when you need it, without excuse or exception
Under fractional reserve banking, it may instead be true that:
- Your money is not held at all by the bank where you deposited it, let alone in a safe
- If enough important customers ask to withdraw their money at the same time, there may not be enough money in the bank’s suture to guarantee access to your money
This can happen if there is, for example a bank run that causes an economic depression. Or maybe as banks have lent large chunks of customers’ deposits to borrowers who should not have been eligible for a mortgage under any circumstances.
History has painfully demonstrated the risks of having too few assets and too many assets tied up in unguaranteed (or downright risky) investments. These risks are, in a nutshell, those of the fractional reserve banking system.
The history of fractional reserve banking is one of extreme ups and downs. A zero reserve requirement theoretically allows banks to maximize their revenues, but boom times can cause widespread financial slaughter at an individual and societal level. It can even leave customers with little to no cash to show for their bank deposits.
The extreme tides of the US fractional reserve banking system are enough to sew the seeds of suspicion, and those seeds could be the impetus for once-burnt victims of the fractional reserve system to move to new asset protection means like cryptocurrency.
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