Fractional Reserve Banking

How do banks work, anyway? As a kid, I still remember the day my parents took me down to open my first bank account. I wanted to deposit a silver dollar my grandpa had given me, but I quickly learned that the money I deposited was not kept in a vault so I could get the same currency back later. I could get a silver dollar back, but probably not the one I deposited.

Although I didn't know it at the time, that was because banks operate using what's called the fractional reserve system. This means they don't put the exact currency you hand to them into a vault for safekeeping, they just keep a percentage of the total amount deposited by all bank customers. They can then loan out the rest and earn interest on your cash.

As it turns out, they can actually earn interest on your cash several times over...legally. Here's how the fractional reserve system works. You may be shocked.

When the economy was based on gold, goldsmiths could act as depositories for their customers' gold. If a customer deposited two gold coins, they would receive two certificates that could be exchanged for two gold coins. These were called "reserve notes."

Take a dollar bill out of your wallet and you'll see the words "Federal Reserve Note" on it. This is how they came into being. The dollar in your wallet used to be a piece of paper representing an actual dollar's worth of gold. Now, since the dollar is not backed by anything but the "full faith and credit of the United States," times have changed.

This is why the value of the dollar floats according to the whims and policies of the Federal Reserve. When there are more dollars in circulation chasing the same amount of good and services, we get inflation because the dollar is actually worth less—it takes more of them to buy the same item today than it did yesterday. When the Fed prints money (also known as Quantitative Easing), it is essentially a policy of intentionally devaluing the dollar. This is why investing in gold has become a hot topic of conversation whenever the Fed turns to QE—because gold has traditionally been a safe haven "currency" to store and transact wealth.

Once it became common practice to carry around reserve notes instead of the "real thing," gold depositories realized that most customers did not redeem their entire gold deposit all at once. They only withdrew what they needed at the time to buy food and farm supplies. This meant that most of the money on deposit just sat in their vaults collecting dust.

Over time, they devised a way to put that money to work. Instead of getting paid by the person depositing the gold, they could actually pay the depositor interest for his patronage, loan out the depositor's gold to someone else, and in turn make even more money off the "reserves" of gold on deposit.

As the system evolved, it because evident that these new "banks" could loan out not only the money they had on deposit, but money that they alone created through their reserve banking system. That's right; fractional reserve banks actually create money. When a private party creates money, it's called counterfeiting. When a bank does it, it's called fractional reserve banking. Here's how it works.

Let's say there is only one bank in your community. You decide to deposit $10,000. The banker decides that 10% of deposits are going to be kept "in reserve," and the rest can be loaned out. The banker then keeps $1,000 on hand in case the original depositor needs some of his money and proceeds to loan out the other $9,000.

The loan is made to another member of the community—let's say a small business that wants to buy some equipment to expand operations. The loan is made by giving this business owner a new checking account with $9,000 credited to the account.

Here's where it gets interesting. You and I might assume that the 10% reserves would apply to the original deposit, not subsequent "redeposits" of the same money (remember, the $9,000 loaned out came from your deposit of $10,000). Not so. The bank can keep 10% of the $9,000 as "reserves" and loan out $8,100...again.

You can see that the same money is getting loaned out over and over in the fractional reserve system. Here is a table showing the money "created" by this fractional reserve bank using only your original $10,000. (Interest and other overhead costs are ignored for simplicity, of course.)

If you're not sure what this all means in the current economy, you're not alone. While worries persist that banks are engaged in legalized counterfeiting (aided by the Federal Reserve and the central banking system) no one really knows with certainty what will happen if the whole structure collapses under the weight of the debt it depends on to make its books look solvent.

The fact is, many experts fear that a few too many defaults on the part of homeowners or municipalities could substantially destabilize the fractional reserve banking system, causing a massive panic worldwide. Of course, the Federal Reserve would rush in to "save the day" and fund the banks overnight, but this could lead to Weimar Republic-style hyperinflation.

The best course of action? Learn everything you can about the banking system, watch the economy closely, and don't rely on the system to protect you. Start the process now of becoming debt free, and live within your means so you will be solvent if and when the rest of the world around you becomes insolvent.

I want to make it clear that capitalism, per se, did not create the problems with the fractional reserve banking system, the government via the Federal Reserve banking system and political favoritism did. There are many enemies of capitalism currently who are using the banks as villains to promote a socialist agenda through Soros-funded front-groups, the communist party, socialist activists, unions, etc. I do not stand with those groups in the slightest.

What the banks are doing is legal because it has been made legal through regulatory and political favoritism. The real reform needs to start first with electing new political leaders who understand the banking system and are not beholden to it for their political livelihood. That requires an educated public, so please spread the word and share this page with your friends.