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.
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
In principle, this lending out of depositors' savings as loans by the bank is good for everyone. Borrowers are provided the resources necessary to initiate new businesses or to purchase homes, home appliances, cars, etc. In the process they improve their and their families' life prospects. Meanwhile, the interest paid by the borrowers fund the bank's operations. Some of that interest on borrowing is passed on to the original depositors. This return on their savings generates incentives to deposit their savings with the bank and hence the motor for the whole process is set in motion.
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.
This perception is of course quite wrong. Obviously their money can't be in the bank if it's been loaned out. The fact of course is that most depositors, most of the time, have no reason to withdraw most of their money. Thus, the imminent disaster intrinsic to fractional reserve banking usually is averted.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
If the withdrawal demand is enough beyond a stipulated threshold, the bank could reserve the option to interrogate depositors about their financial intentions. These contractual tools allow banks to delay large sum withdrawals and thereby forestall vulnerability threats to their reserves.
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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply . As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
We can, though, at least break ground on the topic. This opens up the opportunity to review claims on both sides of the debate. Only then would one be in position to look into the deeper implications. So, to start, in basics, what is fractional reserve banking?
The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.
Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)
In principle, this lending out of depositors' savings as loans by the bank is good for everyone. Borrowers are provided the resources necessary to initiate new businesses or to purchase homes, home appliances, cars, etc. In the process they improve their and their families' life prospects. Meanwhile, the interest paid by the borrowers fund the bank's operations. Some of that interest on borrowing is passed on to the original depositors. This return on their savings generates incentives to deposit their savings with the bank and hence the motor for the whole process is set in motion.
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.
This perception is of course quite wrong. Obviously their money can't be in the bank if it's been loaned out. The fact of course is that most depositors, most of the time, have no reason to withdraw most of their money. Thus, the imminent disaster intrinsic to fractional reserve banking usually is averted.
Consequently, the banks don't lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.
Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they're actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank's fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.
If the withdrawal demand is enough beyond a stipulated threshold, the bank could reserve the option to interrogate depositors about their financial intentions. These contractual tools allow banks to delay large sum withdrawals and thereby forestall vulnerability threats to their reserves.
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.
That isn't the end of the matter, however. For, under the placid surfaces of banal banking practices, fractional reserve practices tangibly contribute to even more insidious financial dangers. Those practices contribute considerably to the ancient scourge of inflation, with its destruction of the money supply . As a consequence of the economic costs of inflation, risk of borrower default is increased, putting the entire system at heightened risk.
To understand the wider debate of what's at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.
About the Author:
Those who want to be smart about managing their money have to follow us at the Fractional Reserve Banking Review to stay on top of all the ways, new and old, that the banking system chips away at your wealth. Wallace Eddington has emerged as a major commentator on how to recognize and beat the scams of the mainstream financial system. Check out his recent controversial article on a Free Market Economy in Money .
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