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The Risks Associated With Fractional Reserve Banking

By Edited Nov 13, 2013 1 1


Fractional reserve banking, is a banking method practised in the United States and in many places around the world. Fractional reserve banking, is the practise were a bank deposit is only fractionally backed. This means that when someone deposits money in the bank, only a fraction of that money is actually held in the bank in the form of cash. The rest of the money is loaned out or tied up in some asset.  When you deposit money in the bank, the bank guarantees that money. It is the banks job to protect the money put in the bank. When the bank loans a fraction of that money out or ties it up in some illiquid asset, your full deposit is not backed up. This can cause issues, as it has done in the past. In this article, I will outline the risks of a fractional reserve banking system.


Fractional reserve banking has been around for a very long time.  The first banks started in Greece, and they did not have the fractional reserve system. In fact most of these banks, did not even lend money. People put there money in the bank to keep it safe. They paid a fee for the bank to store their money.  As time went on, banks started lending out their money deposits, this was helpful in creating new business opportunities and economic prosperity. Since people were lending money, they were contributing to society by helping people build and grow their businesses. This was very helpful, but it also caused some issues. Since the banks did not have 100% of their depositors money, in certain instances, they had trouble giving people their money. During the great depression this happened. Since banks had loaned the majority of their deposits out, they did not have enough money to pay everyone. On October 29th 1929 the stock market in America crashed. People panicked and started withdrawing their money from the banks. The banks were flooded with people demanding their money, and the banks just didn't have it. Many people lost everything and due to this system, thousands died of starvation. More recently in 2008, large banks such as Lehman Brothers failed when the market crashed. All there money was tied up in assets that lost their value and Lehman Brothers was stuck with worthless assets. They failed and cost many people their jobs and even more people, their money.

      Fractional reserve banking, makes people feel richer. Because the banks, only keep a percentage of the money on hand and loan the rest out, more and more people feel like they have money when in reality it doesnt exist. Here is a easy way to look at it.

Person 1 puts 100 dollars in bank 1. Bank 1 keeps 10 dollars and loans 90 dollars to person b, person b buys a car from person 3 and person 3 puts the money in bank 2.Bank  2 will lend the money out and this will happen again. Here is how everyone feels richer. Person 1 has 100 dollars, so he feels like he has 100 dollars, person 2 bought a car and gave person 3, 90 dollars. Person 3 feels like he has 90 dollars. 100 dollars ended up feeling to people like 190 dollars. This process of lending money out happens over and over again. This can make 1 dollar feel like 1 million in a way. The cause of this wealth effect is fractional reserve. If the bank kept all 100 dollars of person 1 money in the bank, than there would only be 100 dollars felt in the economy, but once the bank lends the mony out, everything gets out of whack. There is only 100 dollars in actual money, yet everyone combined feels like that 100 dollars is 190. This is happening at a huge scale. Money is being lended out and relended over and over again. This is causing  institutions and people to loose money.

Today when banks fail, the consumers are for the most part protected, due to the FDIC insurance policy, if a bank fails and cannot give depositors their money, the government will step in and give people their money back. This policy has caused some banks to be reckless and make bad investments. This is another one of the many issues with the banking system in America. If the government ensures that people will not lose there money, than the bank will spend it  knowing that no matter what happens, they have a safety net below them. In reality, it is not in the best interest of a bank to spend money recklessly, but it does happen. FDIC in my opinion does more good than harm, it protects the consumers from loss and can even protect the bank. Having a safety net gives people a peace of mind and it allows them to deposit money without worrying. When money is deposited and lent out, the whole economy prospers and grows.


The Big Issue

The big issue with fractional reserve banking is the fact that the percentage, of deposits banks are required to keep is to low. I have no issue with the concept of fractional reserve banking, in fact I think it's a great system, but the requirements for banks are way to low. Currently banks are required to keep 10% of deposits in cash so that they can keep in case people ask to withdraw their money. I feel that this percentage should be around 20-40%. This will make the banking system safer as a whole. Less banks will fail, and people will feel better about putting their money in the bank. It is unlikely that more than 20% of people will take there money out at once, but it can and has happened. It is better to be safe when dealing with peoples money. If banks start collapsing, than the whole world could be brought into a recession. Banks will not make as much money if the reserve requirements went up since, cash doesn't make money, but it will make them safer entities, and that in my opinion is more important. Banks were created to help create prosperity and development, they should not be made just to make money. They provide an important job in society and should be used and managed with care.

Khan Academy Fractional Reserve Banking Video



Oct 5, 2012 7:23am
A couple of profound statements being made here. As you stated the government creates an incentive for risk for the banks by backing or "insuring" the people's money in the event of a bank collapse.

This same concept can be found in other areas where the government (although it has good intentions) insures pension funds through the Pension Benefit Guaranty Corp and insures mortgages through FreddieMac and FannieMae.
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