Fractional Reserve Banking explained in exactly 500 words

Imagine if instead of paying to park your car, you got paid for it. 

Wouldn’t you find it strange? You might assume that the parking attendant planned on renting it out while you were away. 

Yet, none of us bat an eyelid when our banks pay us to park our money in them

Guess what? They rent out most of it. It’s called Fractional Reserve Banking (FRB), and it’s synonymous with modern banking.

Here’s an example to illustrate how it works:

5 gentlemen walk into a bank and deposit $100 each into their accounts. Instead of charging them to keep their money safe and accessible, the bank pays them 2% in annual interest

The bankers are confident that not more than 10% of deposits will be withdrawn at any point. That’s just $50 out of $500 that the gentlemen have deposited. The remaining $450 will always be sitting idle. And as they (should) say - a vault filled with idle money is a banker’s workshop.

With blessings from regulators, the bankers decide to use the $450 to ‘create value for their shareholders’. They lend it out to some young ladies at a 10% interest rate.

The bank is now earning $45 per year in interest from the ladies (10% of $450), paying $10 to the gentlemen (2% of $500), and pocketing the difference of $35. The bank is laughing all the way to, well – itself.

Take a moment to consider what happened: The gentlemen think they have $500 in their accounts, and the young ladies have $450 in their purses. What started as $500 is now $950. 

If the young ladies deposit their $450 in another bank, this process will repeat itself all the way to $5000. If you’ve heard the term’ money multiplier’, this is what it refers to.

If the gentlemen attempt to withdraw more money than the bank expected them to, the bank will be unable to give it to them. When this news spreads, other depositors will rush to withdraw their money, all with the same result. This is known as a ‘bank run’.

FRB works well in the short run.

By not making it obvious to depositors that their money will be loaned out, banks create an artificially cheap source of capital for themselves to profit from while creating income for depositors and cheap credit for borrowers. 

However, this morally questionable capital-raising strategy creates problems in the long run. When loans go bad – and they do – depositors suffer. 

There isn’t an easy way out, though. Moving away from FRB will cause massive short-term pain for all stakeholders and almost definitely crash the economy. Reform is unlikely, and gradual replacement is the only option.

Overall, Fractional Reserve Banking is like smoking. Easy to start, difficult to quit, and occasionally, it’ll send the economy to the hospital.

Unfortunately, we’re already addicted. 

To stay safe, I’m holding most of my wealth in assets other than money in my savings account. 

I’d recommend doing the same.

Thanks to Kyla, Peter, Joey, Ayomide, Mikal, Christopher, Sasha, and Reuben for providing feedback on early drafts of this piece.

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