Remember Silicon Valley Bank, Signature Bank, or First Republic Bank? They all collapsed earlier this year and each one had its own unique situation. However, they all crashed partly due to the way our banking system works. Since banking can be a bit mysterious to a lot of folks, we thought it might be good to dig into it a bit.
Good news: it’s your lucky day because you get an extra fact today! 😁
Here are Six Fast Facts on Fractional Reserve Banking:
- 🤔 What Is It? - It’s a system where banks aren’t required to hold 100% of the deposits their customers make. This allows banks to use that money for other things. It works because most people don’t need to access 100% of their money at any given time. Most nations use this system today.
- 💡 Example, Please - Let’s say you deposit $10,000 in a bank account that earns interest. Let’s also say that the bank is required to hold 10% of deposits, meaning they can loan out $9,000 of your money to another customer. The bank charges interest on that loan, making them profit (part of which comes back to interest in your account). The other customer gets a loan to build a business, make home improvements, whatever. Everybody wins!
- 💰 The History - The early origin of this system is unknown but generally considered to come from the Middle Ages. As more people began using banks, the banks wanted to transfer the coins from one customer to another rather than store the literal coins each customer deposited. This evolved into the idea that a deposit was an IOU, which eventually evolved into the fractional system. In the US, it was enacted into law in 1863, and then included in the Fed system in 1913.
- 👍 The Benefits - The fractional system allows banks to use customer deposits to make investments or loans to other customers, effectively creating new money that can be used to build the economy. If they had to hold 100% of all deposits, they would actually have to charge customers for things we get free today in order to stay in business.
- 👎 The Risks - Bank runs! When a large number of customers withdraw their money at the same time, the bank obviously doesn’t have enough cash to handle it. This pushes the bank into an ugly corner, and can quickly cause the bank to fail completely, and close down. In 2020, the US changed policy so that banks were required to hold 0% of deposits. What geniuses thought that was a great idea??
- ⚖️ Alternatives - There are other options, but there’s a reason they aren’t used much. There’s the full reserve concept, where banks have to hold 100% of deposits, but people aren’t fond of paying a whole lot more for services they’ve typically gotten for little or not cost. It also stunts economic growth for everyone. There’s also the use of a CBDC…but those have a whole bundle of risks, too.
🔥Bottom line: No system is without risks, but the fractional reserve system generally works very well to help encourage economic growth, which of course results in more and better Paychecks. Hopefully now you’ve got a better sense of what it is and why it’s used.
What do you think about fractional reserve banking?
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