What happens to your money in a Bank: Fractional Reserve Banking.
So, you work hard at your job, get a salary and then what do you do with it? Obviously, you will spend some and put the rest in the Bank. Then what? You might think nothing happens as it shows the same amount in your account and you can use it, but a lot of amazing things happen to your money that you might not be aware of. To understand this, we have to understand the concept of Fractional Reserve Banking.
What is Fractional Reserve Banking?
Fractional Reserve Banking is keeping a fraction of money deposited as reserve and lending out the remaining to other people or businesses etc. Simply told the bank holds a fraction of your money and loans the rest.
Let understand this with an example:
There are three friends A, B and C. These three go out to make a new town (named ABC) on their own. A has 1000 Rupees, B and C don’t have any money. So, there is only Rs.1000 in the whole town.
B decides to become the banker and A deposits his Rs.1000 in Bank B. According to fractional reserve banking, Bank B has to keep 10% of deposits in reserve and rest can be loaned out. Remember the Bank B gives interest to A on his deposit. So, Bank B can loan out 90% of 1000 =Rs.900. And A has Rs.1000 in his account which he can withdraw (take out of Bank B) according to his wish.
C decides to start a new restaurant in the town. For that, he takes a loan of Rs.500 from Bank. C has to give interest on the loan to the bank.
So now A has Rs.1000 in his bank account and C has Rs. 500 with him. So, there is more money in the town than before (Rs.1500). Wait, what? How is this possible? It seems like the bank is making money out of thin air.
And let us take this example even further. C hires D to work at the restaurant and so D moves to town ABC. C pays D a salary of Rs.100 for his work. D now deposits this Rs.100 in the Bank. Now the bank keeps 10% of 100 = Rs.10 in reserve and loans out Rs.90. E moves to town ABC, takes a loan of Rs.90 and starts his store. By this time F moves to the town and starts another bank. So, E keeps his Rs.90 in Bank F. And now Bank F can loan out 90% of 90= Rs.81. G takes a loan of Rs.81 from bank F.
Now the whole town has a lot more money than before (and more services like restaurant and store) A has 1000, C has 400, D has 100 E has 90 and G has 81 Rupees.
Also, we now have two banks with each of them earning interest from loans and giving out interest on the deposit. The rate of interest for loans is greater than interest on deposit so that the banks make a profit.
We also know that A will go to C’s restaurant any pay him and C will put that in his bank and all other such transactions place all over the town. But in the end, it will end up in some bank and then the process of lending out and creating more money starts again. Note that money always ends up in a bank.
From where did the initial Rs.1000 come?
The Central Bank of each country prints currency or money. The Central Bank is controlled completely or partly by the Government in most countries. Also, the percent of fractional reserve is decided by the government and Central Banks. That we had taken as 10% in the example. Note that by controlling the rate of reserve the Central Banks can control the supply of money and rate of loans in the country.
So, the Central Bank print that physical money or make electronic money, and then they can give this money to people doing government jobs, people selling stuff to government also Central Banks gives loans to the private banks. This way the “new” money is created and brought into circulation.
What if people who had deposited their money want it all back?
This is a very important question to ask. When a large number of people simultaneously try to withdraw all their money it might be because they have lost faith in the bank and think that the bank will default(fail).
This is called a Bank Run and you understand the reason behind the name. If people withdraw a lot of money the bank might not have enough cash in its reserves as we know it only keeps a fraction of the money.
To pay the people the banks sells it’s assets quickly and may become insolvent(bankrupt). Bank runs have happened a lot of times in the past. In the Great Depression(the 1930s) multiple bank runs occurred simultaneously leading to world-wide banking crises. After the Great Depression government introduced a fractional reserve system and not to loan out all of the money and some money is protected as before all the money of depositors was loaned out.
When a bank defaults and is unable to pay the people their money the Central Bank has rules that safeguard a certain amount of money for each account. That is whatever happens to the bank this amount is ensured by Central Bank per bank account in the country. This is because the Central Bank can make more money(currency). Note that they are not creating wealth but currency (money). For example, gold, iron, etc can be wealth as they have some value but the currency is just paper it is just a medium of exchange it has no intrinsic value.
Understanding Fractional Reserve Banking at a world-wide scale
As you have read in the example which started with Rs.1000 and three people became a thriving economy with two banks and a lot of people and more money than before. Similarly, in the world, there are a lot of banks, a lot of people depositing their money, and a lot of people taking loans from the bank. The volume of exchanges, deposits, and borrowing is too high in the world to imagine. But we can see a simplified version.
Let us say the government makes 100 currency and loans to bank A and bank A loans 90% of it to a person who deposits it at bank B. Note that we have used the fact that all money ends up at a bank after loan or transaction. We can use the sum of an infinite series to find money created.
Pros and Cons of Fractional Reserve Banking
“Give a man a gun, he can rob a bank. Give a man a bank, he can rob the world”
Fractional Reserve Banking might seem like a very complex pyramid scheme as banks take your money and give it someone else and so on. And there are a lot of critics of this system. Because banks have controls of your money so what if they put your money in a very risky loan or investment. The banks have control of your money but they must behave responsibly but why should they as if a risky investment fails the bank is rescued by the Central Bank.
We can also argue that you as an individual do not know about investing or finance so banks can use their expertise and technology to put that money to good use and raising the world-wide economic benefit and giving you certain interest on your money. As seen by us in the example above the bank led to growth in the town. More money was there for exchange and the money supply increased leading to economic growth in the town.
You might think that your money is not safe in the bank but by fractional reserve banking at least a part of it is always safe and better than what happened in the Great Depression where people lost their whole life’s savings.
Banking is a business so they will not just store your money for free. So they give you interest on deposited money and loan out your money to get interest. Some banks with 100% reserves take a fee to store the money but the money is 100% safe. This is used by ultra-rich people who want it to be safe as the amount insured by the government is very less compared to their money.
In conclusion, Fractional Reserve Banking can boost the economy if the banks act responsibly with people’s money and also if the government puts good regulations to ensure it and safeguard the public and prevent a crisis.
