How does fractional banking system work?
Everyone deposits their savings in banks.
In return we expect banks to keep our money safe and return it when we need it.
But what if I told you that banks could not fulfill their promise? At least not to everyone at the same time.
Rarely anyone withdraws all their money from the bank. It is even rarer that everyone decides to withdraw all their savings from the bank at the same time.
So, banks keep only a small fraction of savers’ deposits and lend out the rest. This is called fractional reserve banking. The fraction of money that banks need to keep is called the fractional reserve requirement, which is decided by central banks.
Banks give deposited money to borrowers and also promises to pay the deposited money to depositor at demand.
This fraud is not caught because borrowers generally do not withdraw all their money at the same time.
This is the process how banks create money. However, the process does not stop here. The borrower can spend the money or deposit it in a bank to spend later.
The bank again keeps a small reserve and loans out the newly deposited money.
This fraud can go on infinitely. I call it fraud but fractional banking is completely legal and is being followed by every country in the world.
Government even promises to pay depositors in case banks do not have sufficient reserves, this is called FDIC insurance.
Because of such a comfy arrangement banks do not have to worry if the borrowed amount will be paid back or not.
Hence, banks can be as reckless as they want and give loans to anyone who needs one. This is the reason why we have lowest interest rate ever in human history.
Drawbacks of fractional banking system
I do not want to be a party spoiler but fractional banking system has devastating long-term consequences.
Creates boom and bust cycles
Everyone feels confident and takes out loans when the economy is booming. This creates a lot of money and overheats the already hot economy.
However, the reverse happens when borrowers pay back the loan. Paying back loans destroys money, not just the borrowed sum but a lot more.
Bank runs
Banks keep small reserves and loan out the rest. They cannot redeem everyone’s money.
Other depositors get scared when banks stop servicing depositors’ withdrawals. Now they too also want their back.
This situation can soon turn nasty and violent collapsing the complete banking sector.
Moral hazard
FDIC insures deposits in case the banks are not able to return money to depositors. This stops bank runs from spreading and complete banking system from collapsing but creates moral hazards in the longer run.
Banks can be careless with depositors’ funds and give loans to their friends and risky borrowers.
Whereas bank customers only care about how cool is bank’s building and do not scrutinize how the bank operates.
Some banks failing is not a bad thing. This is how all-natural system work. In case there was no FDIC insurance and fractional banking system:
- Depositors who did not scrutinize their banks would be wiped out.
- Banks indulging in shady practices would have gone under.
- People would have learned from their mistakes and taken care the next time.
Government interference
Governments are intertwined with the banking sector because they back depositors with FDIC insurance.
Government requires banks to have banking licenses to operate. That they only give to their friends, as a result only the corrupt are able to get banking licenses and most genuine businessman are left wanting.
Inherently unstablet
Banks have to service short-term depositors who think they can withdraw their money at any time. Whereas the loans banks make will be paid back after years or even decades.
The system is inherently unstable and fragile.
Sliperry slope
Banks are creating principal amount that they loan out. However, the borrower has to pay back loan with principal as well as intrest.
The intrest amount is not being created in the system. Hence it is not possible for every borrower to pay back loan. As a result, defaults are baked into the system.
Moreover, the system has to continuously generate more money so that previous borrowers are able to pay back loans with intrest until the complete system comes down crashing like house of cards.
Inflation
The creation of new money does not come for free. It causes inflation that hits middle-income employees the most.
Full reserve banking
Under full reserve banking, banks will hold all the money that depositor deposit in their safe custody. Depositors will have to pay fees to banks for providing such services. This fee will be revenue of banks which they will use to pay their employees and provide services.
Just like any other business the banks that are able to provide the best service at the best price will gain more customers.
Lending is risky but an important part of any functional economy. However, banks will have to clearly specify when it is lending depositors money. The money given to borrowers will not be readily available to depositors.
In return for locking deposits and taking on default risk banks will share part of intrest with depositors.
In such a system government will not bail out depositors in case bank defaults.
Depositors will demand more transparency from banks. They will not prefer to deposit funds with banks that are not transparent, making such banks go bust.
Depositors will have to face the burnt in case their banks default. It will be painful but a lesson for others to take precautions when choosing a bank.
This limits bank failures to a particular branch or area unlike fractional banking which threatens complete banking sector
Other modes of gathering money to fund large projects like crowdfunding, selling equity and bonds will also be exercised by entrepreneurs looking for getting funds.
Under full reserve banking most depositors will hold two types of deposits with banks:
- Funds that bank will not loan out – will be readily available whenever the depositor wants – depositor will pay fees to bank for keeping funds safe.
- Funds that bank will loan out – these funds will not be readuily available – banks will share intrest paid by borrower with the depositor.
Full reserve banking is not inflationary as no new money is being created. Hence problems associated with unstable fractional banking system will not arise.
