Fractional Reserve Banking and Other Things About Banks That Confuse Me

Posted on January 14, 2013

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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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