THE FEDERAL RESERVE Fractional Reserve Lending (Banking 101)

Financial Sense Online ^ | 29 Nov 2005 | Douglas Gnazzo

[Travis McGee]

Don't worry, folks will be along shortly to assure us that "It's different this time."

Of course, they can never give an historical example of ever-expanding fiat money systems coming to a good end.

[Fighting Irish]

I'm confused.

Too many big words.

[Alberta's Child]

I'm not so sure this is such a big deal. Of course banks don't keep "reserves" in their vaults to cover any more than a tiny fraction of the outstanding deposits. That's basically what a bank is -- an institution where borrowers and lenders can exchange money without ever dealing directly with each other.

The scene from Frank Capra's "It's a Wonderful Life" in which George Bailey uses his honeymoon funds to help the family-owned building/loan company weather a run on cash deposits is particularly instructive. When one of the customers tries to withdraw a huge sum of money, Bailey points out: "We don't have that kind of cash here -- we'll fill out a form for you, and you can get your cash next week when the bank down the street opens."

When the customer protested, Bailey explained it quite clearly: "Your money is in the mortgage on Fred's house, and the mortgage on Bert's house, etc. You want us to call all of these loans from people who can't pay them in full -- just so you can get more cash than you need for a week?"

[Petronski]

[hubbubhubbub]

LOL. Everything's all right. It's just like the movies.

[Alberta's Child]

Banks cannot fulfill all of their contracts if demand occurred at the same time.

Neither can their customers, since the banks could technically respond to a run on cash deposits by calling all of their outstanding loans simultaneously. I don't know too many people who are capable of paying off the entire balance on their 30-year mortgage on short notice.

[american spirit]

I've heard that's why our prison population is so large....when someone becomes incarcerated bonds are created on that person.......not sure who gets the $ though.

[Lloyd227]

"I've heard that's why our prison population is so large....when someone becomes incarcerated bonds are created on that person......."

Huh?

This is a joke on the bail bonding industry right? :-)

[little jeremiah]

I am interested in this subject but due to natural lack of smarts and no education I can't for the life of me read the whole thing and grasp its import.

If you or any other smart person here wouldn't mind summarizing the main points, I'd appreciate it. Don't bother if you don't want to, I don't have any money anyway. Academic interest, and how it affects/will affect TIG. (Things In General.)

[babble-on]

its horsehockey, don't bother.

[Radix]

I didn't read it all, but basically, banks are allowed to lend money that they do not actually have. That is the reserve business.

Banks are only required to have a percentage of what they loan, but not all of it. In other words, you can borrow $100,00.00 from a bank that might only actually have $90,000.00 or even less on hand. That is the insurance stuff too somewhere.

The Fed can change that percentage based on events or current circumstances. If the Fed changes that percentage upward, banks have less to lend. If the Fed lowers the rate, banks have more to lend.

Gosh, I still have my finance management text book somewhere. I think I aced that course but it was a long time ago, and I definitely hated the subject.

[Turbopilot]

I'm not sure what the author feels so conspiratorial about. Nothing he wrote about is new, secret, or particularly complicated. Any 200-level econ textbook will present this same information much more directly and clearly.

[Pylot]

The bottom line of the fractional reserve banking system is that as long as the money supply expands at the rate of the interest being charged, everything is ok.

But the expansion is based on consumption.

When the consumption trend slows or even goes negative, there is big trouble.

The fractional reserve banking system is a form of theft.

Imagine, and this will be difficult but try to imagine that the number of dollars in circulation were limited to a finite number of dollars. What would happen then is that the money would, over time, buy more and more. The value of the money as measured in things, would go up.

That is an honest system. Its also impossible to steal from the common man with that system. So the fractional reserve system was created.

And just to put a point on it, citing the example from a wonderful life above, its not your money that was used for freds mortgage. Its conjured up money created at a multiple of ten times or more what you have on deposit that was used to pay freds mortgage.

If its really your money, you should be able to put your hands on all of it at any time you want. But that can not be done. Its why FDR declared "bank holidays". We will see this phenomenon again in the next ten years.

[ArrogantBustard]

Too many meaningless catch-phrases about 'magic' and 'wizards'.

The author may well be right, but his writing style (or lack thereof) wrecks his essay. It comes across as inflammatory rhetoric for the true believers, rather than as a factual presentation to be taken seriously.

[Skywalk]

I'm not sure if quoting John Kenneth Galbraith is such a good thing anyways.

But basically it's a plea to go back to gold/silver/precious metals reserves.

To an extent, while I'm coming to understand the arguments AGAINST going back to a standard, I also think having some backing wouldn't be a terrible development.

[little jeremiah]

You're sure about that?

[Toddsterpatriot]

The Treasury sells bonds to the public. The bonds the public does not buy, the Treasury deposits with the Federal Reserve.

Does anyone know of a time when the Treasury was unable to sell all the bonds it offered for sale? Does anyone have an example of the Federal Reserve buying bonds during an auction?

Which means that 90% of the money supply is non-existent, nothing more than a fleeting illusion.

Why is this bad?

[Turbopilot]

The main points I could discern are:

-The U.S. Treasury prints money
-They "sell" it to the Federal Reserve, a quasi-public banking institution, in exchange for Treasury bills, which are the debt instrument of the United States Government
-The Federal Reserve buys and sells many Treasury bills on the open market daily in order to keep the bills at the target interest rate
-The Federal Reserve also sells Federal Reserve Notes (dollar bills) to other banks
-Banks do not have to have 100% of deposited money on hand; they have to hold some fraction (10% for most types of deposits) and can lend the rest to others
-Fractional reserves increase the money supply (by a factor of 1/reserve rate) by lending deposited funds out, which are then typically deposited in other banks by the borrower, which banks can then lend those deposited funds out, and so on
-This is all a secret conspiracy, and you should stock up on gold and move to your compound as soon as you can put on your tinfoil hat

Points 1-6 are readily learned from a college economics textbook, and are the foundations of the U.S. money and banking system. Point 7 is believed by moonbats who think the U.S. banking system is a plot by the Illuminati/UN/international Jewry/etc. to establish a one-world government, black helicopters and all.

[Turbopilot]

But basically it's a plea to go back to gold/silver/precious metals reserves.

That part is understandable, and I too can see the arguments on both sides. But whether currency is backed with gold or government debt has nothing to do with the fractional reserve system, which 1) is not a conspiracy, or secret in any way and 2) is required for functional banking. I like being able to do things like buying a car and a house, and getting a little return on my savings.