Reserve banking




Here is a story to help illustrate the risk involved in fractional reserve banking.

Bob has ten thousand dollars that he doesn’t know what to do with, so he gives them to his best friend, Sam, to keep. Bob tells Sam that he doesn’t expect to need the money anytime soon, but that he might want to get some from time to time. And, of course, if the unexpected happens (it always does), he may need access to more or all.

As Sam is an expert in financial matters and has considerable investment expertise, he decides to invest four thousand dollars of Bob’s money in US Treasuries. Sam also lends five thousand dollars to a friend of his who is a home builder. Sam will earn interest on the construction loan in addition to a modest return on the US Treasuries he purchased. Not bad. Especially since he does not have to pay more than a bite of bread to Bob for having “kept” his money in his place. Maybe Bob should pay Sam something for the good job he does (think about negative interest rates).

Sam decided to keep a thousand dollars of Bob’s money on hand in case it was needed. Good thing too. At the end of a week, Bob asks Sam for a reimbursement of a thousand dollars of his money in order to meet certain “unforeseen” expenses. Sam quickly pays Bob his thousand dollars.

Sam now thinks the likelihood that Bob will need more of his money anytime soon is a remote possibility. Therefore, he pledges the US treasury bills as collateral and borrows four thousand dollars. He keeps a thousand dollars in cash and lends another three thousand dollars to his friend, the homebuilder.

Bob sees the success of the builder and the others and decides he wants to invest his remaining nine thousand dollars in real estate. So he goes to see Sam.

Sam only has a thousand dollars of Bob’s money and gives it to him right away. He tells Bob that he will have the rest of his money shortly.

Sam immediately calls his builder friend. The builder tells Sam that a couple haven’t sold their homes yet, and the money to pay off Sam isn’t available until the homes are sold.

Sam could sell the four thousand dollars in US Treasuries in order to access some of the money needed to pay Bob. But the proceeds should first be used to repay the loan for which they are pledged as collateral. Since the loan amount is almost the same as the market value of US Treasuries, no additional funds would be available.

Bob, on the other hand, decides that he won’t start investing in real estate as he had planned. Therefore, he won’t need the rest of his money just yet.

Except when his wife comes home from work, he learns that one of their children needs braces. In addition, the interest rate reset on their mortgage went into effect. The new monthly payment will increase by several hundred dollars. He decides he might need to dip into his money (which Sam is responsible for) after all.

When he calls Sam the next day, Bob is shocked to learn that his money is not available. And Sam doesn’t know when he’ll be available.

Do you see the risk of fractional reserve banking? If too many Bobs want their money at once or can’t make their mortgage payments, what do you think will happen?


All of the credit expansion explained in the illustrations above is an afterthought. The initial credit expansion begins with the US Treasury.

You may have heard the term “steal Peter to pay Paul”. Among other things, the meaning is “to take from one person or thing and give it to another, especially when it results in the elimination of one debt by contracting another. “(The source)

This is how the US Treasury debt is paid. New Treasury securities are issued to repay those that have matured.

The total debt continues to grow because it is never repaid; only replaced by more debt. In addition, the new debt offers must be sufficient to pay the interest on the existing debt and continue to finance the day-to-day operations of the government.

Referring to fractional reserve banking, fund manager and investor Bill Gross said:

“It still puzzles me… how a banking system can create money out of thin air, but it does. According to rough estimates, the banks and their shadows have turned $ 3 trillion of ‘core’ credit into $ 65 trillion + of ‘unreserved’ credit in the United States alone … ”

Mr. Gross’ quote above is from several years ago. Today’s numbers are so much bigger they are almost unimaginable. And the risk of a systemic financial crisis is growing.

Fractional reserve banking is ongoing. It is at the heart of the Federal Reserve’s efforts to increase the supply of money and credit. Therefore, the number of US dollars continues to increase and their value continues to erode. Their value at any given time is always suspect. How do we know what a dollar is worth when there is unlimited and unrelenting supply?

What is really astonishing is how well our banking system can maintain itself. And, however much the Fed’s efforts have kept the system from imploding, it’s interesting that we continue to find and depend on the perpetrator to save us. Worse yet, the proposed solutions are the same actions that led to the current situation. Spend more and borrow more.