When you make a deposit at a bank today, unfortunately the money does not actually sit securely in a special personal account for you. Although banks to continue to charge various monthly, annual, and per-service fees to their clients, in point of fact the bulk of their income is produced by taking the money you have deposited and loaning it to other customers. This practice is known as fractional reserve banking.
– About Fractional Reserve Banking –
The rise of fractional reserve banking is a consequence of the way in which people tend to use banks. Since the first goldsmiths began taking deposits of gold for security, the money system has grown increasingly symbolic and abstract, based on financial trust rather than on solid value. We encounter this fact every day when we pay for something with bank notes or bills – which, barring the force of law and confidence in a nation’s central bank, would be worth no more than the scraps of paper or plastic they are printed on. The same is true when we pay with a credit card or a debit card, and have confidence that our bank will promptly transfer money to the merchant’s bank, without even using paper notes to solidify the transaction.
At banks, however, a different process is at work. Banks realize that, in normal circumstances, only a relatively small proportion of their clients will want to access a substantial fraction of their savings at any one time. This means that, to cover the day’s withdrawals, a bank only has to have a relatively small fraction of the total deposits on hand. Initially, goldsmiths and early banks held gold so that it would be secure. However, banks soon realized that most of their deposits simply sat in the vault, unused. The obvious solution, from the banks’ perspective, was to lend out that money at interest, increasing bank profits at only minimal risk.
In the simple model of fractional reserve banking (reality is more complex because slightly more money must be held back), a bank takes a deposit from one client, holds back 10% of it as a reserve, and then loans out the remainder to another client. For example, if you were to deposit a $1000 paycheck, the bank would keep $100 in reserve to cover your withdrawals, and lend out $900 to another client who wants to buy a car. If the loan money itself returns to the bank in the form of a deposit (say, by the car dealer), then 10% of it will be held back again in reserve, and then the remaining $810 will be loaned out again. The process can continue until all of the initial deposit has been transferred to reserves.
This is, essentially, what happens when you make a deposit at a bank. The bank holds back enough money to cover regulatory requirements and the likelihood of future withdrawals, and then loans out the rest of the money to other clients. If, the next day, you decide to withdraw your money, the bank will cover that withdrawal out of the reserve money it has held back, both yours and that from other accounts if necessary.
– Reserve Ratios and Deposit Insurance –
This system allows banks to generate high profits, but there is an obvious problem. The bank continues to claim on your monthly statements that you have a deposit of $1000 – and, legally, the bank has to make good on that if you demand it back as a withdrawal. Yet the money is not all there any longer. In fact, another client’s account balance is showing, say, $900, but all of that “money” was created by loaning out your deposit. In just the first iteration of the process described above, the bank has declared that it has $1900 worth of accounts on its books, but in actuality it has only $1000 in real money. In any other industry, this sort of bookeeping would probably be called fraud.
So long as a bank seems relatively healthy, people are usually willing to tolerate this process even if they fully realize what is going on (and especially if they do not, as the majority of individual consumers do not). However, there is always a risk that an unexpectedly large number of people will demand their money at an inconvenient time. If word gets out that the bank cannot cover these withdrawals, even more people may rush to their branch to try and withdraw money. The result is a so-called “bank run,” and usually results in the collapse of the bank. Historically, in the 19th century, bank runs were relatively common crises. Today they are extremely rare but not unheard of: for example, a bank run destroyed the British bank Northern Rock (formerly NRK; now government-owned) in September 2007.
In the 19th and 20th centuries, governments instituted several reforms to attempt to prevent bank runs from occurring. The first was the creation of rules requiring private banks to deposit 10% of their assets with the central bank – like the Bank of Canada, the Bank of England, or the U.S. Federal Reserve. This so-called reserve ratio ensures that there is always at least a minimal check on the extent to which banks can loan out depositors’ money to other clients, and that there is always at least a minimal amount of money on hand to meet its obligations. If the reserve ratio were not present, banks could literally lend out all of their depositors’ money without holding anything back at all, although this would be exceedingly foolish.
The second standard protection created by Western companies was deposit insurance. Deposit insurance guarantees that if a bank collapses, the insurer will cover the losses of individual customers, usually up to a fixed limit (like $100,000 or $200,0000). Deposit insurance is usually backed by the government for even greater security; for instance, the U.S. Federal Deposit Insurance Corporation (FDIC) and the Canadian Deposit Insurance Corporation (CDIC) are both government-owned companies. Deposit insurance discourages bank runs because people can be confident that they will (eventually) get their money back, even if the bank goes bankrupt.