Fractional Reserve Banking
The precursor to modern day banking was a crime when it first began over a thousand years ago. Today, fractional reserve banking is preferred worldwide.
Fractional Reserve Banking requires a bank to only keep a fraction of its capital on hand to back deposits. Unfortunately, we know from the history of our great depression that there is no effective way of managing a fractional reserve banking system when the loans created using that system begin to fail.
To understand Fractional Reserve Banking, you must first learn about the four kinds of money. Once you have done that, come back here.
Under the National Bank Act of 1863, the reserve ratio (fractional reserve requirement) was 25%. Under the 1913 Federal Reserve Act, it was reduced to 18%. By 1917 it was further reduced to 13% and today stands at 10%, although during the current crisis, many banks in America are closer to 7%. It is even lower elsewhere in the world.
What does this mean? A 10% reserve requirement means that for every $10 of deposits a bank has, it can loan $9. If the borrower then deposits the $9 in a bank, that bank can lend out all but 10% or $8.10 and so on. So the banking system can turn the original $10 deposit into $100 ($10 + $9 + $8.1 + $7.29 + ... = $100) at a 10% reserve requirement. That's $90 that is created out of thin air. The banks don't have it to loan. Nobody has it to loan. The lower the reserve ratio, the more money can be created from nothing. It is a franchise allowed by government for banks to create money.
"No one has a natural right to the trade of money lender, but he that has money to lend." ~ Thomas Jefferson
Bankers love Fractional Reserve Banking because they receive interest on money that does not exist. It is very profitable. Of course, it doesn't take a lot of thought to realize that it is also very risky. You will not be surprised to learn that banks get around the problem of very risky loans with the guarantee of bailouts from Congress through the mechanism of debt monetization through the Fed. Further, the government has established guarantees through the FDIC (Federal Deposit Insurance Corporation) to give comfort to small account holders in order to prevent runs on banks when consumers perceive the presence of too much risk.
When a bank is all loaned up, it can get more reserves in one of four ways. It can increase deposits, it can use bank profits, it can sell bank stock or it can borrow money from the Federal Reserve (go to the "discount window"). Typically, a bank will use commercial loans as collateral for the money it borrows from the Fed. But remember, those commercial loans were largely made with money the bank didn't have in the first place. When it borrows from the Fed, the bank has more reserves, which it can loan out at a 10% reserve requirement which creates more loans that it can use as collateral to borrow more money from the Fed (see above).
Banks are more likely to make large, risky loans and be satisfied with a low reserve ratio because they know Congress is there to bail them out. This is a major purpose of the Federal Reserve Act of 1913 and it works just as planned. Congress and the Fed have made loans to:
- Risky companies (Penn Central - later Amtrak, Lockheed, Chrysler)
- Risky banks (Unity Bank and Trust, Commonwealth Bank of Detroit, First Pennsylvania Bank, Continental Illinois Bank, Bank of Oklahoma)
- Risky governments (New York City, Panama, Mexico - 3 times, Russia, Brazil, Argentina)
The fact that fractional reserve banking is a problem is evidenced by a recent meeting in Switzerland that was held to increase the reserve ratio worldwide. The purpose was to "...prevent a repeat of the recent financial crisis," and financial markets responded the next day with a favorable increase in bank stock values. Clearly, markets and bankers know the score. Fractional reserve banking is extremely risky. Additionally, if you are interested in more information about bailouts, see this and this.
This is a subject much debated by economists, but better alternatives to a "fiat money through central banking" monetary system do exist. One is a return to a gold standard, 100% or otherwise. Another is a commodity basket standard. Another is some variation of a "Free Banking" system. With free banking, banks set their own reserve ratios and decide what will back their currency and citizens use a particular bank based on their personal willingness to accept the risk profile that bank offers. All these options eliminate a central bank that monetizes debt for bailouts and government spending. Regardless, that topic can be postponed. Rather, we are interested in removing the ability of Congress to steal from the citizens for any reason, regardless of how noble. Once this is done, the discussion of what monetary system is best will follow naturally.