Fractional Reserve Banking and Other Things About Banks That Confuse Me

Fractional Reserve Banking

Where do bank profits come from? If we restrict ourselves to thinking only about commercial banks and forget about investment banks (many banks are both things), I think they make money primarily by making loans and charging interest. Although banks start out life with capital from their investors, they really make money by making loans of the money deposited by you and many other people or businesses. In other words, banks only maintain a fraction of the money deposited with them on hand as reserves to cover daily operations. So, if a bank has deposits (assets) of $100 billion, they may have only $5oo million on hand as a reserve to honor checks that their depositors have written or to cover the credit card purchases their depositors have made or to hand out cash to depositors via ATMs or in person if they come into the bank to make a withdrawal. In this case, the other $99.5 billion is in outstanding loans. This system has worked fine for centuries because it is very rare that all of a banks depositors would all want to take their deposits out of the bank at the same time.

The above paragraph does not reveal the whole story of fractional reserve banking. The practitioners of the Austrian school of economics would look at what I just wrote and say that with fractional reserve banking there would be nine or ten times more loans made on those same deposits. Because I have read some of the works of people like Ludwig von Mise, Murray Rothbard, Frederick Hayek and even Ron Paul; I thought I had a good understanding of what fractional reserve banking was and why it was a bad thing. The people I just mentioned had convinced me that banks were creating money out of thin air with their fractional reserve banking. But, then I came across a blog that had a graph taken from the Zero Hedge blog that made me question what I thought I knew. The graph plots both the deposits in US banks and the loans outstanding from the years 2000 to 2012. I expected to see that there were many times more money in outstanding loans than the banks had in deposits but that was not the case. I’ve included the graph further down the page. Please scroll down and take a look and you will see what I am talking about. The total mount of deposits is often more than the total of outstanding loans. Does this mean the people like Murray Rothbard and Ron Paul are wrong about fractional reserve banking? I was confused and because I am such a nice guy, I decided to see if I could confuse you too.

Let’s see if we can create a very simple way to follow a single $10,000 deposit through the process of fractional reserve banking. Here are the assumptions we will use:

  • The initial $10,000 is deposited in Bank One
  • All the banks are very prudent lenders and all loans are collateralized
  • What ever the deposit the banks always keep $1,000 in their reserve accounts
  • Those taking out loans are creditors and are identified by the letter “C” and a number.
  • Every time a creditor spends the borrowed money, it ends up getting deposited in one single bank
  • All  loans are to be paid by one lump sum in one year of the principle plus 5% interest

Please look at the following table and then I will talk you through it.

Deposits                 Loans               Held in Reserve

Bank One                   10,000                 9,000(C1)                         1,000

Bank Two                     9,000                 8,000 (C2)                        1,000

Bank Three                 8,000                  7,000(C3)                         1,000      



Bank Nine                     2,000                 1,000 (C9)                          1,000

Bank Ten                        1,000                      0                                        1,000    

Total                                                               45,000                                  10,000

Please understand that what is shown in the above table could not happen in the real world, but I think it serves to help us understand what happens under fractional reserve banking. So, let’s walk through it.

Ten thousand dollars is deposited in Bank One whose management decides they can safely lend $9,000 and put $1,000 in their reserve account. And, that is what they do. They lend $9,000 to creditor C1. Creditor C1 then buys something for $9,000 and the sellers deposit that amount in Bank Two. The Bank Two management decides they will  put $1,000 in their reserve account and loan $8,000 to creditor C2. Creditor C2 then buys something for $8,000 and the sellers deposit that money in Bank 3. This process continues until Bank Ten receives a deposit of $1,000 and puts it all in their reserve account.

If we look at the Total line, we see that the original $10,000 deposit is now in the reserve accounts of ten different banks. In the process nine people borrowed and spent a total of $45,000. So, does our little exercise prove the Murray Rothbard is right in saying that fractional reserve banking creates money out of thin air. If so, why does the Zero Hedge graph not show total loans outstanding many times greater than the total of deposits? Instead the graph shows that from 2000 to 2008 the loans and deposit are essentially in balance. Is it possible that Ludwig von Mise and a Murray Rothbard and Frederick Hayek and Ron Paul are all wrong? In our little exercise, all the loans will be paid back with interest after a year. So, maybe when one considers that there hundreds of millions of people making transactions with banks every day; some making deposits, some making withdrawals, some taking out loans and others paying back loans and in the process of so many transactions it all smooths out and there is no money being created out of thin air. I don’t know. A few days ago I thought I agreed with the Austrian economist. Now I am confused. And, there is more about this graph that confuses me. Please keep reading.

Source: Federal Reserve Board weekly H.8 report

If you look at the far right side of the graph, it shows that at the end of 2012 US banks had $2 trillion more in reserves than in outstanding loans. We said earlier that banks make money by earning interest on the loans they make. So, why haven’t they loaned that extra $2 trillion in reserves they have? This is not where my confusion comes from because several people, including John Galt at America’s Chronicles, know why. The reason, as is so often the case, is that central planning seldom if ever works. Hers is what is happening. One central planning entity, the Federal Reserve, has set interest rates at near zero in part to drive down home mortgage interest rates so more people will buy houses. But, another central planning entity, the Congress, passed the Dood-Frank bill to keep banks from making sub-prime loans and apparently banks are having a difficult time finding qualified borrowers under the new rules. Therefore,we have  one central planning entity cancels out the effort of the other and that is why banks are not lending as much as they could. My confusion comes from the fact that banks are making record profits when they are lending less. How do they do that? Are they making high risk bets at the Wall Street Casino again? Do you have a better explanation?

Well, now you know what I’m thinking. What are your thoughts?

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18 thoughts on “Fractional Reserve Banking and Other Things About Banks That Confuse Me

  1. I share your confusion. Maybe it is explained by accounting methodology? I don’t know.

    What I do know is that monetary manipulation is like a short fellow shrinking the size of an inch to the point where he can declare himself six foot tall.

  2. Two points. First, let’s not forget banks aren’t just lenders that make money on interest on loans. They also normally pay interest to depositors but thanks to the Fed, they’ve paid out essentially nothing since 2008. That goes directly toward profits.

    Secondly, record bank profits are a direct result of the Fed’s policy of artificially holding down the interest rate. Don’t forget that banks are required by the Fed to hold their excess reserves in an account at the Fed not at their bank.

    So when the Fed needs money, it merely extracts it from a member reserve account by selling a note to the bank which makes a couple of points in interest. This has been done on a large scale since 2008 leading to the record bank profits.

    What a deal. The banks build their balance sheets by taking out loans at a nearly zero interest rate, deposit the same money back in the Fed in an excess reserve account and then loan it right back out to the Fed and charge interest for it. Cronyism is great!

  3. It’s just leverage. You don’t need to be a rocket scientist to figure it out.

    You simply have a fraction held in reserve. The standard ratio in banking has been 9-1, meaning that you can loan 9k for every 1k on deposit. That applied to commercial bankers. After the repeal of Glass Steagall in 1999- commercial and investment bankers went nuts and managed to bankrupt our system with the help of derivatives in only 8 YEARS.

    You are actually making money (interest) on money that does not exist. It’s a great scam and it has been going on for centuries. Banks went absolutely bat shit crazy loaning and leveraging money beyond 40-1 ratios. As all of those guaranteed loans went bad, banks became insolvent. They still are. The FED has been bailing them out secretly, trillions. And worldwide loans- not just American banks.

    It is the greatest lie never told.

    1. “You are actually making money (interest) on money that does not exist.”

      Apparently not if the Zero Hedge graph is right. It seems to me that all that happens is that loans are created and are paid off out the creditor’s future earnings. The graph shows that loans and deposits were in balance until Quantitative Easing began in 2009.

      1. You are borrowing non existent money from the future. It may exist one day and it may not. Since late 2007- it still does not exist. So the Fed just manufactures it.

  4. Well, that does it! Jim, you are the bravest soul I know. The Paradox [mine] of Fractional Reserve Banking, or the economic swamp where greater minds than mine have muddle in contradiction.

    I am not going to take a stand or even try to explain it here (an impossibility). The literature is extensive for any interested party (on the thousands of pages).

    Let me just say that you, Jim, understand it better than the average bear, and more than you let go. Therefore, you know that on this one Hayek and Von Mises did not agree with Rothbard, and much less with Ron Paul. I know that you have a soft spot for Ronnie, the guy that helped to give us Obama, but well inside of you I trust you will agree with Federico Hayek and me.

  5. Well, there’s a lot more to it than what the chart purportedly shows.

    As 5etester already noted, banks make money not on interest alone, but in many different ways. Banks don’t necessarily have to lend every cent they can either (although in usual circumstances they like to try). Also, what are, or, where did those “deposits” come from?

    Quick background … The Austrian perspective on what fractional reserve banking is, and how it works, isn’t “controversial.” I put that in scare quotes because none of it should be. What’s “controversial” is their conclusions: inflation, inherent instability, fraud.

    Now, using your example, Bank One starts out with a $10,000 deposit from you, giving them $10,000 in assets. Then they loan out $9,000 of it to Tommy Tutone, making their total assets how much? Remember, loans are an asset to a bank, so they now have $19,000 in assets on a mere $10,000 investment. Hmmmm …

    But wait, there’s more … Tommy Tutone used that $9,000 loan to buy widgets from me, and thus wound up in my account at Bank Two. Now, on only your $10,000 deposit, you and I have a total $19,000 in assets. Where did that extra $9,000 come from? How did Tommy Tutone pay me with, and I deposit, $9,000 still sitting in your checking account?

    Sure, Tommy is still sitting on a liability. But if you personally lent Tommy $9,000, you’d only have $1,000 in your account and wouldn’t have $10,000 until he paid you back. Yet through fractional-reserves, your deposit, Tommy’s new (borrowed) money, and my deposit exist all at once! So sure, my $9,000 deposit in Bank B offset Tommy’s loan from Bank A (thus the illusion of the chart), but how can both banks now be sitting on that same $9,000 ($18,000 in assets)?

    And nevermind the potential bank run, what if (circa 2008) Tommy can’t pay off his loan? What does Bank A do now? … collapse.

    There’s more to the story of course, including the fact that much of the banks current reserves are made of money printed (out of thin air) by the Fed. Yes, merely printed (as even Krugman and the Bernank himself agree). But leaving that aside, I think you can see the flaw in fractional-reserve banking which creates its inherent instability (and which most Austrians consider fraud).

    And the system hasn’t “worked fine for centuries” either. It’s always been unstable and produced catastrophe. In fact, protecting this racket is the primary reason for the Federal Reserve.

    P.S. – John Galt: Rothbard, Hayek, Mises and even Paul agree on fractional-reserve banking and the consequences thereof. The differences exist on what to do about it. Paul is 100% in Hayek’s camp on this.

    1. The nore I think about it, CL, I have to humbly disagree with the great minds of Rothbard, Hayek, and Mise.

      Let’s stick to my overly simple example of fractional reserve banking and leave the Fed’s funney money for another discusion. In my opinion, no money was created in my example. All that was created was debt obligations of the creditors to pay back their loans in one year with interest. Originally there was a couple paragraphs more in this post that I took out because of length and, in hindsight, maybe I shouldn’t have taken it out. I had said that years ago I remebered reading tha when one makes a deposit in a bank, you have effectively loaned the money to the bank. Sadly, you do not get a promaosary note from the bank obligating them to repay you. All you have is your faith in the bank and the knowedge that the government(FDIC) insures your money uupto $200,000. I did a search to see if I could find a source that said what I remembered. All I could find was this from Investopedia

      Investopedia explains ‘Bank Deposits’
      When someone opens a bank account and makes a deposit of $500 cash, the account holder surrenders legal title to the $500 cash. This cash becomes an asset of the bank; the account becomes a liability. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance that guarantees the deposits of member banks up to $250,000 per depositor, per bank. Member banks are required to place signs visible to the public stating that “deposits are backed by the full faith and credit of the United States Government.”

      That alone is more than enough reason to hate banks. But, it is what it is. So, let’s follow that $10,000 deposit and let’s say it was you that made the deposit in Bank One. When you made the deposit, you traded your $10,000 asset for an effective asset we could call an account receivable for $10,000 backed only by the bak’s moral obligation to return your money whenever you ask for or, in a worse case, you will get your money back from FDIC. The bank books your $10,000 as an asset of the bank. Bank One then decides to loan $9,000 to creditor C1, after getting C1 to sign a loan agreement and provide appropriate collateral. Bank One now has $1,000 in reserve and a account recivable for $9,000. The bank still has $10,000 in assets.

      Credit or C1 now owns $9,000 in cash, but also has an $9,000 + 5% interest account payable obligation C1 then takes his $9,000 and exchanges it for goods and services. The sellers exchanged their goods and services for $9,000, which they then exchange for an account payable from Bank Two. Bank Two books a $9,000 into their assets account and the take $8,000 out of their asset account and lends it to creditor C2 and books $8,000 in their account receivable account. Creditor C2 exchanges his cashh asset for goods and services and he also has an account payable with Bank 2 for $8,000. The sellers deposit their $8,000 in Bnak Three inechange for accounts payble in the same amount.

      Okay, let’s stop there. Do you see that the ownership of what was your $10,000 has changed several times already. Each owner used it to satisfy some need. The original $10,000 still exist but is now spread over three differnt banks. There are two loans outsatanding for $17,000. If you go to the bank to take out some money from your account receivable, you will get it as you always do. No money was created. The sellers of goods and services received cash. $17,000 in debt was created. Because the banks were prudent in who they loaned the money to, after a year the creditors will pay of the loans with interest of 5%. The world is solvent again. Your $10,000 circulated through the economy and debt was created and paid. If we assume that the creditors used their borrowed on consumer goods or services, no wealth was created.

      Anyway, it now makes sense to me.

      1. Okay …

        Example One: You drop $10,000 in your checking account at Bank One, who in turn lends $9,000 to Tommy Tutone to buy widgets from me. You are also a widget retailer, and on that same day you cut me a check for $9,000 too. At the end of the day, I deposit a total of $18,000 in my checking account at Bank Two.


        Example Two: You have $10,000 in your pocket. You lend Tommy Tutone $9,000 which he uses to buy widgets from me. With only $1,000 in your pocket, you can no longer afford to stock your shelves with more widgets. So at the end of the day, I only deposit $9,000 in my account.

        If no money was created out of thin air in our first example, how was I able to deposit twice as much as I was in my second?

        But, but, what about the reserves? Using 10% as our reserve requirement, the bank already kept 10% ($1,000) when it made the initial loan. But a loan is not a liability to a bank, it’s an asset, thus giving them an additional $9,000 (of which only $900 is required for reserves). Since only a total of $18,000 was withdrawn (your check + Tommy’s loan), they’re still above required reserves with $2,000 in assets.

        Yet only $10,000 in real money was ever on hand.

        If no money was created out of thin air via fractional-reserve banking, our first example would look no different than example two (in which you lent the money straight out of your pocket and had no more for yourself).

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