Fractional Reserve Banking

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I am changing my opinion on Fractional Reserve Banking -- 12/12/09

The writing on this page has been rewritten today -- 12/12/09. It will be found to contradict much of what I had written previously. I plan to change everything I have previously written to match what is written here. That does not mean I guarantee everything written here is true -- I can only offer what my thoughts tell me after a considerable amount of study of real life and the most logical information I could find.

An explanation is in order as to why I am changing my position. Where do my ideas come from? I am not formally trained as an economist. Everything I learned is based on (A) one college course in Economics at Newark College Of Engineering in 1955, (B) what I picked up over about 50 years in casually reading Forbes Magazine Weekly and The Wall Street Journal Daily for 13 years from 1973 to 1986, and (C) serious independent study of Money and Banking from about 2005 to 2009. What I have written here is my more-or-less up-to-date opinions on how our money and banking systems work. If there is a conflict between what is written here and what I have written previously -- what is here is to be considered correct -- as far as I know. In any event, follow Buddha’s dictum -- “Believe nothing, no matter where you read it, or who said it, no matter if I have said it, unless it agrees with your own reason and your own common sense.” / Buddha.

Virtually nothing that is written about money can be accepted as the absolute truth. Even the Constitution can't be believed -- what follows, in blue, at (A) & (B) in the next sentence -- is from the Constitution -- but is no longer followed. Certainly, (A) Congress does not create money and regulate the value thereof and certainly (B) the President does not sign monetary treaties with foreign countries with the advice and consent of Congress. The best we can do is observe what seems to be happening and do our best to suss out the underlying rules according to our own good sense. Even Congress does not declare War any longer -- it hasn't since 1942 and we have had any number of Wars since then.

In my opinion, The Federal Reserve lies regularly. Take the little test at << >>

In my humble opinion, the seven links found at the following link will be just about, but not quite, the equivalent of a college education in Banking for a student who reads and absorbs the essence of these laws. -- Laws, rules and regulations regarding money and banking (7 links)

Fractional Reserve Banking -- when paper money was falsely backed by gold -- an antiquated system that has evolved into paper money that is absolutely reliable and completely backed by by the laws and wealth of our nation -- by Martin R. Carbone

Fractional Reserve Banking was a banking system in which a fraction of the sum of (a) a private bank’s invested capital and (b) the deposits of gold by the private bank’s customers at the bank must be kept on hand at the bank, in gold, to (a) meet routine expenditures of the bank and (b) return deposits to the depositors when the depositors want those gold deposits back.[1] In that sense, when a private bank loaned paper money to a borrower, it guaranteed, falsely, that that paper money was backed by whatever amount of gold was written or printed on the money. That guarantee was a sham -- the bank never had more that a fraction of the gold on hand. See <<>>. We still have private banks but they now deal only in official, sanctioned, lawful money backed for all purposes by U.S. Government law.

Bear in mind that many (most?) people think the reserves are somehow still needed by the bank to “back” loans that the bank makes. That is a simple fallacy. Banks do not “back” loans -- they never have since questionable gold backed paper money was stopped. When a bank gives a customer a loan now -- it gives the customer cash or a check based on the customer having enough collateral in the form of assets or income to pay the loan back in accordance with the terms of the loan contract. The cash is also, by a legal tender law, guaranteed to be legal by an official governent action and every citizen is compelled by that law to accept that money in payment of all debts. Remember --- (1) BANKS NO LONGER BACK LOANS. THE MONEY THAT A BANK NOW GIVES WHEN MAKING A LOAN IS GUARANTEED TO BE GOOD BECAUSE IT IS MONEY THAT WAS LEGALLY MADE BY LAW UNDER THE CONSTITUTION.

Also bear in mind that many (most?) people think "Reserves" have something to do with loans made by the bank. THEY DON’T. The money for loans is created for the borrower based on the fact that the bank is acting as an agent of the government, acting to exercise the government’s sovereign right to create whatever money it needs to run the money supply in accordance with its Constitutional mandate to “coin money and regulate the value thereof”. Remember -- (2) RESERVES HAVE NOTHING TO DO WITH LOANS SINCE WE WENT OFF THE GOLD STANDARD. Isn't it kind of dumb to think we somehow have Paper Money Reserves for Paper money like we once had Gold reserves for Paper money?

The money used NOW for bank loans does not originate with the bank: it was NOT the bank’s money before it was created for the loan. The fact that the borrower pays interest on that money and apparently the bank keeps that interest does not alter the fact that the bank has none of its money “in the loan”. I have never seen the paperwork that spells out the responsibilities of (a) the government, (b) the Fed. and (c) the bank as to what happens to the interest paid by the borrower -- but I assume the bank keeps that interest even though it did not lend its money to the borrower. It seems logical to assume that the bank keeps the interest -- because in the event of a default by the borrower we know that the bank (not the Government and not the Fed.) forecloses, exercising the bank’s right to the interest due on the loan contract. We also understand that when I made interest payments on a mortgage in the past -- those payments (capital and interest) went to the bank and was kept by the bank. The capital part of those payments had been made previously, in full. to the seller of the house.

It would be more correct to say we are now using a Sovereign Money Banking System wherein all money in the system is created by the government (or its agents -- now, the Fed. and its banks).

The Sovereign Money Banking System is actually simple -- but it is so counter-intuitive that it is very difficult to understand. It certainly does not seem possible that (a) the bank can lend money that it never had and (b) the banks have an endless amount of money to draw from that it can lend or spend into the economy. The fact that the private bank keeps all the interest seems at first glance to be somehow excessive, and perhaps it is, but the bank seems to be the entity responsible to the Fed. and to the Government that the loan is paid back by the borrower. The bank is responsible for making sure that the borrower is responsible and the borrower's plan to use the money is legitimate and sensible. Neither the Fed nor the Government seems to bear a loss if a borrower does not pay back a loan -- simply because the borrower has no contractual obligation to the Fed. or the Government. It is possible that I am wrong on this and the bank has a contract or agreement with the Fed or the Government that the bank will share all profit and loss on loans the bank makes on money created for a loan it makes. I have never heard or read of such a contract or agreement so I think I am justified in believing no such contract or agreement exists (I have read through most of the law at -- Laws, rules and regulations regarding money and banking -- 7 links)

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. This is not a metaphor or a figure of speech -- the bank literally creates the money -- the money did not exist in any other account before the bank created the money specifically for that loan. The idea is that the borrower will take that money and create wealth with it. When the borrower pays the loan back, I am assuming the loan money is removed from the banking system -- but whatever wealth was generated stays in the economy for the benefit of us all. I have never seen the books kept by the bank or the Federal Reserve -- but it is logical that it is a simple matter to take the loan money out of the system once it is paid back. Taking the money out of the system would eliminate the possibility of that money contributing to inflation.

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. And even Patman's book has lots of errors that Patman picked up from Federal Reserve Publications. Remember -- you can't believe anything the Fed. writes. They are habitual liars. It turns out that the United States is so wealthy that all the stealing and lies can't really hurt our economy. Ultimately, the Plutocrats and Bureaucrats that run this country need the common Worker Bees to do all the work -- so those "crats" can't take everything for their own.


The fractional reserve method of banking originated with the goldsmiths -- the predecessors of our present bankers. It is not the method of banking in use today. Briefly, it was a system whereby bankers maintained as reserves of gold only a fraction of the amount needed to meet all the claims for gold against them. (The vast bulk of the claims against the banks were and still are are the deposits of their customers. These are obligations which the bank must pay upon our demand.) The goldsmiths struck upon this fractional method by noticing that the people who deposited gold with them for safekeeping only claimed (redeemed) 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 (and collect interest on those loans) and they would not get caught with a shortage of gold.

Subsequently the goldsmiths switched to making loans which in fact were not of (a) gold but were of (b) 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 the gold that was supposedly backing the gold receipts. 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 Goldsmith Fractional Reserve System and its present-day offshoot, The Sovereign Money Banking System

1. Both create 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 goldsmith's 10 to 1 fractional reserve ratio meant that the goldsmith bankers were operating with enormous leverage. For every $1 dollar they lost to bad debts, they had to reduce their loans by $10. This means they must have been very conservative and must have been careful to only make loans that are safe. This probably kept inflation in check. Because the created money has to be paid back. It forced borrowers to create wealth with their borrowed money -- so they could 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. Since we have essentially abandoned "reserves" in modern banking (we still use the word "reserves" -- but it no longer has any power or reason for being -- it has no meaningful, enforceable force of law. It is, we think an obsolete sterile force of antiquity). Our present system would work as well if the required-reserve ratio was anywhere from zero % to 100% -- in fact, it is zero for banks with deposits up to about $10 million. See --PART 204—RESERVE REQUIREMENTS OF DEPOSITORY INSTITUTIONS (REGULATION D) <<>>

4. 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.

5. 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.

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

7. Sovereign Money Banking provides banks with a source of funds over and above their invested capital and their customer’s deposits. The banks can then lend that additional money to worthwhile borrowers

8. 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.

9. 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.

10. Most people do not realize that the Sovereign Money Banking 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. Banks essentially have no limit on how much money they can lend and that can OBVIOUSLY lead to terrible problems if the lending is mismanaged.

11. I know that sounds impossible -- but it is the way the system works as far as I can figure.

12. 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.

13. 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 Fractional Reserve 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 therefore lose the interest on that 10 dollars. That loss was painful.

Disadvantages of the fractional reserve system as it evolved into a Sovereign Money Banking System

1. Somewhere along the line, it appears, and I believe, that four 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 (D) below.

(A) Bankers forgot the downside of the system's 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 how the Sovereign Money Banking System works -- the banks do not now need existing 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 downside leverage 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 “leverage” 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 fortuitous accidents are very important (think of Christopher Columbus and Isaac Newton’s apple). They may have led to more great discoveries than planned action.

(D) Laws became anachronistic. Primarily because Congress writes the laws and Congress does not understand how the Money and Banking System works. That is because the people running the Fed. don't tell Congress what is going on -- and the Fed. is not audited by a reliable independent agency

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

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

4. Most of the information about the systems originate 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 <<>> -- 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 link 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: <<>> Note that Wikipedia’s explanation comes from Reference #12 and #13 which both originated as Federal Reserve publications. I consider that explanation to be total nonsense.

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 Georgetown 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.

5.8 Check out << >> where we attack wikipedia directly and the Fed, indirectly.

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 corporations. 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. Call me on it if I am wrong.

end ------------ by Martin R. Carbone -------- updated 12/12/09 --------------------
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