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Martin Carbone

Fractional Reserve Banking is a banking system in which a fraction of the sum of (a) the bank's invested capital and (b) the deposits by the bank's customers at the bank must be kept in reserve to (a) meet routine expenditures of the bank and (b) return deposits to the depositors when the depositors want those deposits back.^{[citation needed]}

The Fractional Reserve banking system is actually simple -- but it is so counter-intuitive that it is very difficult to understand. It just does not seem possible that a bank can safely lend out ten times as much money as it has -- but that is the genius of the system.

Most of the following material is based on "A Primer On Money" a 141 page book by Wright Patman a Democratic member of the United States House of Representatives from Texas. Patman was also Chairman of the Banking Committee of the House of Representatives. In this writer's opinion Patman's book was the first clear and honest exposition of the Fractional Reserve System of banking in the United States. It clearly tells the American public that money was, and is, in fact, created by banks when they lend money to their customers. The book was written in a Question and Answer format. The book was Published in 1964 by The Government Printing Office.^[1]

When I first came across a discussion of Fractional Reserve Banking in Patman's book in 1964, I thought it was an outrageous system and some sort of a scam or rip-off designed to enrich bankers at the expense of the public by allowing the bankers to magically multiply their money. However when I closely read the laws and studied the system in about 2003 (I intended to open a bank specializing in reverse mortgages -- because no banks would make such loans in my community) I realized that the system has built in controls and safeguards that make it perfectly safe for everyone; the bank, the depositors. the borrower, the banking system, the Government and the public. The only thing wrong with the system is that aside from Patman's book, there is no honest information that explains the system fairly.

Overview

The fractional reserve method of banking originated with the goldsmiths -- the predecessors of our present bankers. It is the method of banking in use today. Briefly, it is a system whereby bankers maintain as reserves only a fraction of the amount needed to meet all the claims against them. (The vast bulk of the claims against the banks are the deposits of their customers. These are obligations which the bank must pay upon our demand.) The goldsmiths struck upon this method by noticing that the people who deposited gold with them for safekeeping only claimed a small portion of this gold at any one time. The goldsmiths realized that they could lend out a good portion of the gold left with them. They then made loans, which in fact were not of gold but warehouse receipts for gold. These receipts circulated as money. Notice, the gold—actually the certificates of ownership—being loaned by the goldsmith was not his to lend. He did not own it. In other words, the goldsmith wrote receipts to people who were not depositing gold, i.e., to borrowers. So receipts for more gold than the goldsmith actually had in his vaults were circulating. The goldsmith had only a fraction of the amount of gold needed to meet the claims against him. This is the fractional reserve system. When the banks of the United States kept their reserves in gold, their reserves amounted to only a small fraction of the amount of money they had issued, all of which was guaranteed to be redeemable in gold.

Advantages of the fractional reserve system

1. It creates real wealth and is the basic foundation for our economic system. Nobody has ever figured out a better way to create money and wealth.

2. The 10 to 1 fractional reserve ratio means that the bankers are operating with enormous leverage. For every $1 dollar they lose to bad debts, they must reduce their loans by $10. This means they must be very conservative and must be careful to only make loans that are safe. This probably keeps inflation in check -- because the created money has to be paid back. It forces borrowers to create wealth with their borrowed money -- so they can pay off the loan and the interest. If the government were able to create money without the obligation to pay it back, most people think that would probably lead to runaway inflation to the detriment of us all.

3. Under State laws, virtually anyone who is reliable and a good citizen can open a bank. You simply apply to the State and fill out some forms telling (A) why the community needs a bank where you intend to put yours, (B) that your plan is financially feasible and (C) the Federal Reserve system that you are honest and a good citizen. Once you deposit your starting capital, you have the right to operate as a bank and lend money to independent borrowers of your choice in accordance with the Federal Reserve rules.

4. Banking is a good job for people who would otherwise be trying to show their worth by subjugating others. Banking allows these people to show their worth and power by accumulating money and the things they can buy with money. Running a bank is a relatively safe outlet for alpha-male behavior.

5. Banking keeps a lot of people busy who might otherwise be causing trouble.

6. Fractional reserves provide banks with a source of funds over and above their invested capital and their customer's deposits. The banks can then lend additional money to worthwhile borrowers

7. The following advantage of the fractional reserve system was overlooked by Patman. That point should be made to establish the concept that whoever runs the money system should bear the losses for bad loans. If that were well known, we probably would not have gotten into the money problem of 2008: the bankers would have been more cautious.

8. One good but often overlooked thing about having the bankers run the system is that if they lose money on bad loans -- that money theoretically comes out of the banker’s pockets (because the bankers own the banks). If the government ran the system and owned the banks -- all losses would come out of the pockets of the taxpayers.

9. Most people do not realize that the fractional reserve system (the underlying system we use now) gives the managing or owning institution -- whether the Fed or Congress -- a system that has enormous leverage built into it. For every dollar of capital invested by the owners of the system - those owners can make loans adding up to ten times (or much more) the amount of the invested capital. In other words -- if a Federal Bank opens its doors with one million dollars of invested capital -- it has the right to lend out $10 million at whatever interest is currently in vogue

10. And they actually have much more leverage than that. If a depositor deposits another $1 million with the bank -- the bank can lend out another $10 million. It turns out that there is no limit to how much each banker or the entire system can lend out. But do not think about that now -- it adds what looks like complications

11. The upside leverage comes into play because the bank can lend out 10 times as much as it has in invested capital. If it has $1,000 in capital and lends out $10,000 at 4% interest per year -- that $400 / year is a 40% return on their invested capital of $1,000.

12. I know that sounds impossible -- but it is the way the system works.

13. The downside leverage comes into play when, for instance, a $1,000 loan goes bad -- a borrower does not pay back the loan and -- collateral can't be seized. In that case, the bank must call back $10,000 in loans and lose the income on the $10,000/ In that case the loss of a $1,000 loan costs the bank $400 / year -- or 40% every year on that bad loan.

14. Originally, it must have been thought that the enormous leverage would work to keep the Bankers prudent, conservative and cautious. It appears that this was not a conscious decision of any group. As far as I can tell, it never appeared in print as a goal of the Fractional Reserve System. Patman^{[citation needed]} points out that everyone in the know tries to keep the actual mechanism a secret -- but in any case the downside leverage built into the system, naturally and organically forced that prudent, conservative, cautious and very important behavior on the bankers -- because for every dollar of bad loans they made, they would have to call back TEN dollars of loans and they would therefor lose the interest on that 10 dollars. That loss was painful.

Disadvantages of the fractional reserve system

1. Somewhere along the line, it appears, and I believe, that three major things can and have happened that messed up the system. The system was not, and probably is not now, protected against those problems -- see (A) to (C) below.

(A) Bankers forgot the downside of the leverage and thereby took chances that were not prudent.

(B) The Government allowed, and even encouraged, (by setting up Fannie Mae and Freddie Mac) the banks to sell-off the loans they placed, thinking that would free up money and would allow the banks to make new loans. Whoever did that did not understand that the Fractional Reserve System works -- the banks do not need new money to make loans. They can prudently create whatever money is needed if they have a trustworthy lender with good collateral who has a reasonable plan to create new wealth with the money in the loan. And why should it be otherwise?

(C) The Government did not know that the inherent control built into the Fractional Reserve System was important. They simply did not understand the ramifications of the system. They did not realize that an unintended benevolent consequence (that "control" of the previous sentence) was built into the system. Unintended consequences do not always have to harmful -- lots of times (in evolution for instance) they are very valuable. Any good scientist, investigator, explorer or engineer knows this instinctively -- they are always on the alert for benevolent, unplanned results. Serendipity and fortutious accidents are very important (think of Christopher Columbus and Isaac Newton's apple). They may have led to more great discoveries than planned action.

2. The system is very counter-intuitive and difficult to understand unless the details of the system are studied carefully.

3. Hardly anyone understands how the system works. This is not a healthy situation.

4. Most of the information about the system originates with the Federal Reserve System and that information is very unreliable. In fact, it would not be a mistake to say that most of the information put out by the fed is self-serving and designed to confuse the subject of money and banking, so as to make the public very insecure about money and banking.

5. It can be safely assumed that many authors take information by the Fed as gospel and put that unquestioned information into their books and on their websites. Students then are exposed to that information in the classroom and generally believe what they are told. Those student than fill the internet discussion groups with that incorrect information. The result is that even people who have formally studied economics have no clue as to how the banking system really works. A good example of misleading information about "how much a given bank can lend" follows. 5.1 to 5.4 gives the written law for all banks. 5.5 gives a Wikipedia explanation which is contradictory to the law

5.1. At <<http://www.fdic.gov/regulations/laws/rules/7500-500.html#7500204.9>> -- under "§ 204.9 Reserve requirement ratios", You will find the following words "The following reserve requirement ratios are prescribed for all depository institutions ... ": You will also find a table there that shows a bank with any amount of "transaction accounts" up to $44.4 Million, is required to have only 3% of that $44.4 Million as "Reserves". In other words, a bank in that category can lend out 33.3 times as much money as it has in reserves.

5.2 Definition of : "Transaction account" -- At "Definitions. (same URL as 5.1 above) § 204.2(e) Transaction account means a deposit or account from which the depositor or account holder is permitted to make transfers or withdrawals by negotiable or transferable instrument, payment order of withdrawal, telephone transfer, or other similar device for the purpose of making payments or transfers to third persons or others or from which the depositor may make third party payments at an automated teller machine ("ATM") or a remote service unit, or other electronic device, including by debit card, but the term does not include savings deposits or accounts described in § 204.2(d)(2) even though such accounts permit third party transfers.

5.3 Together, 5.1 and 5.2 above means that any bank with transaction accounts up to $44.4 Million can lend out up to 33 times its Reserves.

5.4 Because a bank's invested capital can also serve as a reserve, any bank up to that $44.4 Million in transaction accounts can lend 33 times the amount of its invested capital. In summary, on the day any bank opens, it can lend out 33 times its invested capital.

5.5 The following is from Wikipedia in their attempt to explain how "multiple banks" ... "practice fractional reserve banking" which has a "cumulative effect of money creation by banks" ... It is from: <<http://en.wikipedia.org/wiki/Fractional_reserve_banking>> Note that Wikipedia's explanation comes from Reference #12 and #13 which both originated as Federal Reserve publications

5.6 This sentence from reference 13 "If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit." is obviously a direct contradiction to the following remark by President Obama in a recent speech at Gerorgetown University "the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses ..." .

5.7 The sentence from reference 13 is also in direct conflict with the conclusion at 5.4 above, which is absolutely authoritative because it comes directly from the law.

6. I can find no authoritative or official mention of what I consider to be the fact that the Federal Reserve system, as enacted, is set up in such a way so as to rely on bankers being very cautious when making loans. There are no explicit words to that effect anywhere in the law as far as I know -- but the obvious result of the Federal Reserve mechanism shows that bankers must be cautious -- or they will wind up going bankrupt. There is enormous leverage built into the system and the result of that leverage is that losses are magnified by the system. Any intelligent banker must know this when he signs up to operate under the Federal Reserve system -- it is fairly obvious. This is an important reason why the Federal Reserve system can work and has worked for years. If however that point is not clearly re-stated -- over time the bankers may forget that they are under enormous pressure to be conservative and they may take chances that have the potential to cause them great financial harm. In fact, I think the present (2008) money and credit problems in the U.S. are a direct result of bad loans and those bad loans are a direct result of the bankers simply not being careful when making loans.

6. The Central Bank lends money to the Government of the United States and collects interest on that debt. Many see that as an unnecessary expense of the Government.

7. Many people also claim the Constitution demands Congress directly supervise and control the creation of our money. The Constitution says “ Congress shall have the power to coin money and regulate the value thereof”. In 1913, Congress transferred the management of the banking system to the Federal Reserve System which is privately owned and operated corporation or group of coporations. That transfer may very well be unconstitutional. Until the point is argued definitively in court by a competent team of lawyers, in my opinion, that point will not be settled

8. In my opinion -- if you do not understand the words in this text-block, you can't understand Fractional Reserve Banking. On the other hand -- if I am wrong on this -- I do not understand Fractional Reserve Banking. That is a possibility.

References

1. ↑ "A Primer on Money", by Wright Patman, 1964