There are many claims on different sides of the debate over fractional reserve banking. Doing the debate justice would require a book. And even then...
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
The basics are not especially challenging to express. Often, though, merely expressing them leaves their implications unexplored. A few sentences provide those basics.
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.)
On first blush, this arrangement seems good for all parties. Borrowers can access funds to launch businesses or buy high price items, improving the quality of life for themselves and their families. The interest paid by borrowers fund bank operations. Additionally, a portion of that interest is passed on to depositors: this return on savings incentivizes them to deposit their savings at the bank and thereby fuels the entire system.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
On the face of it, the banks seem to be putting themselves in a precarious situation. After all, the depositors are not investors. Most regard their money as merely being stored at the bank: a bit like renting a mini-storage unit to stash away those boxes of keepsakes they can't bring themselves to trash. They can go fetch those boxes, though, any time they want. So, most expect with their money deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source of 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.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
Does this mean though that fractional reserve banking is uncontroversial or unproblematic? Far from it, claims many critics. In fact, it presents a constant threat of catastrophe for the bank and, given the interconnection of today's globalized banking system, even for the world economy.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
For a fuller appreciation of the wider controversy over fractional reserve banking, and what's at stake, check out this elaborating article on the practices' pros and cons (and con jobs) .
All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?
The basics are not especially challenging to express. Often, though, merely expressing them leaves their implications unexplored. A few sentences provide those basics.
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.)
On first blush, this arrangement seems good for all parties. Borrowers can access funds to launch businesses or buy high price items, improving the quality of life for themselves and their families. The interest paid by borrowers fund bank operations. Additionally, a portion of that interest is passed on to depositors: this return on savings incentivizes them to deposit their savings at the bank and thereby fuels the entire system.
You can see why defenders of fractional reserve banking depict this as a win-win-win arrangement. The critics, though, point out that the reality is a good deal messier than this win-win-win language suggests.
On the face of it, the banks seem to be putting themselves in a precarious situation. After all, the depositors are not investors. Most regard their money as merely being stored at the bank: a bit like renting a mini-storage unit to stash away those boxes of keepsakes they can't bring themselves to trash. They can go fetch those boxes, though, any time they want. So, most expect with their money deposited in the bank.
Technically, of course, though, their money isn't actually in the bank; it's been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.
To meet the demands of depositors who do want to withdraw some portion of money, banks reserve a fraction of total deposits. This is then the source of 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.
Furthermore, beyond a certain threshold, the bank may exercise a prerogative to interrogate them about the financial intentions behind their withdraw demands. These contractual instruments enable banks to avoid the dangers posed by withdrawal demands that put their reserves at risk.
On the average banking day, though, there's no great need for resorting to such small print machinations. Day to day, banks effectively anticipate necessary reserves for meeting withdrawal demands. Consequently, most everyone can go about their business with reasonable satisfaction.
Does this mean though that fractional reserve banking is uncontroversial or unproblematic? Far from it, claims many critics. In fact, it presents a constant threat of catastrophe for the bank and, given the interconnection of today's globalized banking system, even for the world economy.
And that's not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today's fractional reserve banking practices.
For a fuller appreciation of the wider controversy over fractional reserve banking, and what's at stake, check out this elaborating article on the practices' pros and cons (and con jobs) .
About the Author:
Those who want to be well-informed about personal finance management 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 leading voice on how to detect and beat the scams of the mainstream financial system. Check out his recent provocative article on a Free Market Economy in Money .
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