What is Fractional Reserve Banking?

Fractional Reserve Banking is the accounting process by which banks are entitled to create ‘new money’ out-of-nothing, leveraging on the money they have in deposit.

From that money created out-of-nothing, private banks collect interest for their exclusive benefit!

As such, the F.R.B. principle is a key factor within the current Banking system, favoring the World Debt problem and therefore Poverty!

How does the Fractional Reserve Banking process work?

By such process, banks just need to keep a portion of the deposited money as a ‘reserve’ and lend the rest, while maintaining the illusion in the depositor’s mind that his/her money is still in the bank’s vault.

How is that illusion?

Under the ‘Fractional Reserve Banking’ mechanism, account holder “A” keeps all the time the illusion that any amount that he/she had deposited is “there”, at the bank at all times.

Reality is that while account holder “A”’s balance reflects the full amount that was deposited, only a fraction of that money is kept as a reserve; the rest is used to create ‘new money’ under the form of a loan to account holder “B”.

(Let´s remember that any time a private bank generates a loan, it is creating money - see ‘How is Money Created’).

Account holder “B”’s balance now reflects that newly created money.

Why do we say that the ‘Fractional Reserve Banking’ leverages on the amount in deposit?

'Fractional Reserve Banking' leverages on the amount in deposit since banks are allowed to ‘multiply’ the said amount as many times as indicated by the ‘Fractional Reserve Ratio’ (i.e. 1:10, 1:20 and so on)

What is ‘Fractional Reserve Ratio’ (also known as ‘Required Reserve Ratio’ - RRR –, ‘Cash Reserve Ratio’ or ‘Liquidity Ratio’, expressed in %)?

‘Fractional Reserve Ratio’ is the required reserve established by the banking authorities in each country.

For example, 1:10 means that for $1 in reserve, banks can create up to $10. 1:20 means that for $1 in reserve, they can create up to $20. In terms of percentage, 1:10 means a ‘Required Reserve’ of 10% whereas 1:20 means a ‘Required Reserve’ of 5%.

From another perspective, a Fractional Reserve Ratio of 1:20 means that for $20 in deposit the bank needs to keep $1 (or 5%) in its vault and is allowed to ‘create up to $19’ at the time a loan is granted.

Let’s put it in terms of account balances:

If customer “A” deposits $20, then his/her account balance reflects the $20.

Under the Fractional Reserve Banking System, the bank is entitled to keep just $1 as a reserve and lend the rest ($19).

Customer “B” is then granted a loan in the amount of $19. So now the amount on both bank accounts totals $39! while in reality there were only $20 initially deposited.

Said in other words, customer “A” has the illusion that his/her $20 are in the bank’s vault while in reality there is only $1 left. The bank can maintain that false illusion by still recording $20 on customer “A”’s balance.

At the same time, backed up by the Fractional Reserve Banking principle, the bank is able to create ‘new money’ (in this case $19) at the time customer “B” is granted such a loan.

So, out of an initial deposit of $20, customer “A”’s account holds a balance of $20 while customer “B”’s balance is now $19.

Does the ‘money creation’ process stops there?

No, it doesn´t.

Customer “B” can take his/her $19 and pay Customer “C” (from another bank for example).

Then, out of the $19 deposited on Customer “C”’s account and under the Fractional Reserve Banking principle, Customer “C”’s bank is entitled to generate a loan on 95% of that amount (equivalent to $18.05) to customer “D” and just keep $0.95 as a reserve.

As a result, another $18.05 are created out-of-nothing.

And the process can go on and on, allowing the ‘creation’ in this example, of up 20 times the original deposit.

In other words, out of an initial amount of $20, $380 dollars can be ‘created’ out-of nothing, rendering the original amount to $400!

We could think the 'Fractional Reserve Banking' process as ‘morally acceptable’ if it was not for the fact that private banks are the ones collecting interest on $380 dollars created out-of-nothing for their own benefit!

Said in other words, it is not the Nation for instance that is collecting interest on ‘Fiat Money’ for public use instead.

Does the previous example also illustrate the fact that ‘Fractional Reserve Banking’ is merely an accounting process?

Yes, it does.

As in the example above, money ‘creation’ occurs at the accounting level. It is just entries - debits & credits – on banks’ ledgers.

Can the ‘ Required Reserve Ratio’ (RRR) be 0%?

Yes it can.

In fact, as of end of December 2011 countries like Canada, Sweden, Australia and New Zealand had for example a Required Reserve Ratio of 0% meaning ‘No Reserve Is Required’.

That is also equivalent to say that banks in those countries do not have a limit to create Money out-of-nothing!

That was the case of the UK as well, where the RRR ‘did not have a minimum value’ (implying that it could be 0%)

What is a usual ‘Required Fractional Reserve Ratio’ (RRR)?

It varies from country to country and changes over time.

For instance, as of end of December 2011 the Eurozone had an RRR of 1%, while that in the US varied from 0 to 10% (depending on the account liability type).

Under the ‘Fractional Reserve Banking’ system are banks interested in capturing money as deposits?

Yes, as in the example above, banks leverage on the money in deposit to create ‘new money’, also called ‘Fiat Money’.

Where does the Fractional Reserve Banking idea come from?

It can be traced back to the XVII and XVIII centuries (see ‘The History of Banking’). Goldsmiths of that time were the central characters of the story.

How is it so that the goldsmiths were key characters in the emergence of the Fractional Reserve Banking system?

At the end of XVII century, in the territory that we currently know as the UK, the monarchy was acting as the ‘banker’, controlling the flow of gold and silver coins. Yet it lost credibility after King Charles I appropriated a significant amount of money from the Royal Mint (£ 200,000). That incident happened in 1640.

Seeing that their fortunes were not safe with the monarch, merchants turned to the goldsmiths as safe-keepers; in return goldsmiths started to extend deposit receipts to the merchants. Those receipts became very popular due to their effectiveness as a means of payment.

Goldsmiths also realized that nearly all of the coins that were left under their care remained untouched in their vaults. That fact, combined with deposit receipts popularity and the increased demand for credit, made goldsmiths think that they could start ‘lending money’ under the form of paper receipts. That was the beginning of a new form of ‘money’, backed up with coins which by the way were not theirs.

Furthermore, goldsmiths came up with the idea that it was possible for them to ‘lend more money’ under the form of paper receipts, than the actual coins they had in hand. And just to be ‘safe’, they thought in the need to maintain a fraction of the said coins as a reserve. That was the origin of the Fractional Reserve Banking system.

Were goldsmiths’ paper receipts the origin of the ‘Money as Debt’ and ‘Legal Tender’ concepts as we know today?

Yes, that’s right.

Goldsmiths’ paper receipts, generated at the time loans were granted, were the beginning of ‘Money as Debt’ as we know today. At the same time, those receipts acted as promissory notes payable on demand ‘to the bearer’. That was indeed the beginning of the ‘Legal Tender’ concept as well.

Were goldsmiths charging interest on paper-receipt-based loans, despite the fact that those paper receipts were not fully backed up with gold or silver coins and that those coins were not theirs?

Yes, they were.

Despite the fact that the coins on hand were not theirs and that only a fraction of the ‘money’ lent under the form of paper receipts was backed up by those coins, goldsmiths were charging interest. Such interest was a great source of profit and skyrocketed their wealth.

In today’s world, does it mean that people’s account balances are not 100% backed up by actual money deposited in banks’ vaults?

Yes, that is correct.

Our current Banking system is based on the acceptance by banking regulators and governments that only a fraction of people’s money needs to be kept as a reserve and available for potential withdrawals. At the same time it is based on general public’s trust that whenever anybody would go to his/her bank to claim his/her money back he/she will get it.

Yes, but what happen if all of sudden a greater than usual amount of account holders in a country decides to claim its money back at the same time?

Such event would trigger a banking crisis since money in the banks would not be sufficient to respond to such withdrawal demands. This is in fact the scenario of any banking crisis; see as examples the ‘Great Depression-1929’ and the ‘2008 Global Economic Crisis’.

In summary, Fractional Reserve Banking is the accounting process by which banks are entitled to create ‘new money’ out-of-nothing ('Fiat Money'), leveraging on the money they have in deposit.

The net effect is that in the world there is always more money on people’s account balances than ‘physical money’ in banks’ vaults to back those balances up.

Private banks can create ‘Fiat Money’ (out-of-nothing) as much as they are allowed by the Fractional Reserve Ratio, and collect interest on such a money for their own benefit!

If we assume (just for a moment) that 'Money' is equivalent to 'Wealth' then by creating 'Money' out-of-nothing, private banks are creating 'Wealth' out-of-nothing. They even expand such 'Wealth' exponentially based on the interest they collect on the said 'Money' created out-of-nothing.

Does it make sense then ... :

--> ... to allow private banks to collect interest for their exclusive benefit, on money created out-of-nothing based on the Fractional Reserve Banking principle?

--> ... to permit the existence of such a principle that is favoring the World Debt problem and therefore Poverty?

Return To The Top Of This Page

Return from 'Fractional Reserve Banking' to 'Money As Debt'

Return from 'Fractional Reserve Banking' to 'How to Fight Poverty'