Fractional Reserve Banking
Did you know banks lend out many times more money than they actually have? Find out how banks make money.
Elizabeth Carlassare
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Fractional Reserve Banking
Last week, we took a look at the world’s reserve currency. In today’s episode, I want to talk about how banks work.
How Banks Make Money
Banks make money by making loans. Depositors put money into the bank and the bank turns around and lends the money out to a borrower. The interest rate the bank charges a borrower is higher than the interest rate it pays on deposits. Banks make money off this difference, which is called the “spread.”
Banks Lend Many Times More Than They Have
But that’s just the beginning. The amount of money that a bank can lend is actually much, much greater than the deposits in the bank. Banks lend out many times more money than they actually have. How much they can lend out depends on the reserve requirement set by the Federal Reserve.
In the United States, reserve requirements are typically 10% of the total value of the checking accounts at the bank. A small reserve requirement magnifies the amount of money banks make from lending money.
Think about it this way: If your bank has a 10% reserve requirement and you deposit $1000 in your checking account, the bank must keep 10% or $100, but it’s free to lend out $900 at interest. The person who borrows that $900 will spend it and it will usually be deposited into another bank. Then that bank will do the same thing. It will keep 10% or $90 and then it’s free to lend out the rest at interest, which is $900 minus the $90, or $810. This process is repeated again and again, and is called “fractional reserve banking.” Each time the bank receives a deposit, it keeps 10% as reserves and can lend out the rest at interest.
After this process has been repeated as many times as possible, that $1000 you originally deposited in your bank can actually be turned into as much as $10,000 in the overall money supply. You can calculate the $10,000 by dividing your initial $1,000 deposit by 10%.
In this way, the total money supply in the economy increases when banks make loans. But, when the money supply increases, the consequence is inflation. Fractional reserve banking leads to inflation.
What if There’s a Run on the Banks?
Because banks operate on slim reserve requirements, they would have an immediate and serious problem if their customers were to all demand their money back at the same time. This is what led to the thousands of bank failures during the Great Depression. In response to this crisis, the U.S. government created the FDIC in 1933, which insures the deposits in banks that purchase FDIC insurance. I did two podcast episodes on FDIC insurance several weeks ago (episodes 34 and 35), and you can listen to them to learn more about how this insurance works.
The Birth of Fractional Reserve Banking
So how did fractional reserve banking come to be? To get the answer, we need to go all the way back to the 16th century and the time of the goldsmiths.
Goldsmiths were the first bankers. Goldsmiths would store a person’s gold and keep it safe for a fee. They would provide the owner of the stored gold a receipt to indicate the amount of gold they had stored. The owner of the gold could redeem his receipt for gold at any time. Eventually the receipts themselves were used as money rather than the gold itself.
When the goldsmiths realized that they could lend out more receipts than the gold they were actually storing, fractional reserve banking was born. As long as the goldsmiths kept enough gold to redeem those receipts that were presented for payment, the system worked.
The Federal Reserve Act of 1913
Fast forward to 1913. In this year, the Federal Reserve Act was passed, which created the central banking system and the Federal Reserve note as a single paper currency in the United States. The Federal Reserve Act established parameters for the reserve requirements for U.S. banks.
You can learn more about fractional reserve banking and the Federal Reserve by visiting the links at the bottom of this page. Next week, I’ll explain how banks use dollars and anti-dollars like gold, then we’ll take a look at the gold standard to understand how the dollar is valued as it is. Finally, once we’ve done that, I’ll give you some strategies to invest in gold.
Today, I’m giving away the book What Has Government Done to Our Money by Murray Rothbard. This book provides an explanation of fractional reserve banking and how money and currency work in the United States. And the winner is Erich S. Congratulations, Eric, and be sure to check your e-mail for instructions.
Cha-ching! That’s all for now, courtesy of Money Girl, your guide to a richer life.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.
If you’d like to request a topic or share a money tip of your own, e-mail it to money@quickanddirtytips.comcreate new email. Money Girl is part of the Quick and Dirty Tips network. Be sure to check out the other great shows like Modern Manners Guy. This week he’s talking about how to plan a dinner party.
Thanks for listening!
Related Links:
- The Federal Reserve Act of 1913
- Money, Banking, and The Federal Reserve
- The Money Masters
Bank image courtesy of Shutterstock