Reserve banking


The phrase “elephant in the room“…

“…an important or huge controversial topic, issue or subject that is obvious or that everyone knows about but no one mentions or wants to discuss because it makes at least some of them uncomfortable or is personally, socially or politically embarrassing, controversial, inflammatory, or dangerous. (The source)

Let’s start with a bit of history. The following is an excerpt from one of my previous articles…

Warehouse owners (“bankers”) decided they had to find a way to increase their profits. Earning commissions on their custodial and custodial services was not enough. Since most of the gold remained in storage and most transactions involved the exchange or transfer of paper receipts for the gold on deposit, they decided to issue gold “loans” / money to others and to charge interest. Cumulative amounts of gold loaned could not exceed the amount of gold stored. And hopefully few depositors would ask to redeem their physical gold at the same time.

It seemed like a workable system. But apparently the “bankers” were not happy. They quickly started issuing more loans/receipts for gold that didn’t exist. Of course, they saw no need to tell anyone about their actions, and the receipts still showed that they were redeemable in fixed amounts of gold. And when someone wanted to take possession of their gold on a physical basis, they could always do so. Until a certain point. (see History of gold as money)

If any of this sounds familiar, it should. Warehouse/bank fractional reserve accounting was the starting point for the credit expansion that now funds our global economy.

As we become more dependent on credit, we also become more vulnerable to events similar to the one that happened twelve years ago. Another credit crunch is not just a possibility, nor just very likely. On the contrary, it is inevitable.


On a personal, retail level, here is an example of how fractional-reserve banking works today:

Your brother-in-law pays you the thirty thousand dollars he borrowed three years ago. You decide to put the money in a term deposit (one-year CD, etc.) with your bank. At the end of the day, when your banker balances his books, he finds that the deposits in the bank exceed the funds currently lent/invested by more than the US Federal Reserve’s 10% requirement.

And since this excess amount is now available for further lending and investment, your bank’s loan committee and investment department are actively working to allocate these funds on a hopefully profitable basis. After careful consideration, he lends twelve thousand dollars to Jane, who wants to buy a car, and fifteen thousand dollars to a local contractor.

Jane pays the twelve thousand dollars to Mr. Smith who sells her the car (private transaction). Jane drives off in her new car and Mr. Smith deposits the money in his bank who then lends ten thousand eight hundred dollars to a local dentist who is expanding his practice.

The local entrepreneur deposits the fifteen thousand dollars in his business account which is in the same bank that lent him the money. There it is ! The same bank that made the two loans now has $15,000 of “new” deposits on which to lend or invest another $13,500. He does it quickly.

Where are we now? The initial deposit of thirty thousand dollars has grown to $81,300! How? ‘Or’ What? By lending/investing the majority of the same money over and over again.

US Federal Reserve regulations require banks to hold on deposit an amount of money equal to ten percent of the deposits they receive (checks, savings, CDs, etc.). The remaining ninety percent can be loaned or invested. (There are exceptions, allowances, and variations to the requirements based on type of deposit, amount, etc. There are also ways to meet the requirement other than simply holding cash reserves.)

Once the money is deposited, the process is ongoing and continuously adds to the amount of dollars in the system.


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

Bob has ten thousand dollars he doesn’t know what to do with so he gives it to his best friend, Sam, to keep. Bob tells Sam that he doesn’t expect to need the money anytime soon, but 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 – of it.

As Sam is a specialist in financial matters and has considerable investment expertise, he decides to invest four thousand dollars of Bob’s money in US Treasury bonds. 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 doesn’t have to pay more than a pittance to Bob to “monitor” his money for him. Maybe Bob should pay Sam something for the good work he’s doing (think negative interest rates).

Sam decided to keep a thousand dollars of Bob’s money available in case he needed it. Good thing too. After a week, Bob asks Sam for a thousand dollars of his money in order to cover some “unforeseen” expenses. Sam promptly pays Bob his thousand dollars.

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

Bob sees the success of the builder and 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 available and gives it to him right away. He tells Bob that he will have the rest of his money soon.

Sam immediately calls his builder friend. The builder tells Sam that a couple of his houses have yet to be sold, and the money to pay Sam back isn’t available until the houses are sold.

Sam could sell the four thousand dollars in US Treasury bonds 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. Since the loan amount is almost identical to the market value of US Treasury bonds, no additional funds would be available.

Bob, meanwhile, decides that he won’t start investing in real estate as he had planned. Therefore, he will not need the rest of his money for the time being.

Except that when his wife comes home from work, he learns that one of their children needs braces. Also, the interest rate reset on their home loan 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 in charge of) after all.

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

Do you see the risk in 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 United States Treasury.

You may have heard the expression “rob Peter to pay Paul”. Among other things, the meaning is “taking from one person or thing to give to another, especially when this results in the cancellation of one debt by contracting another. ” (The source)

This is how the US Treasury debt is paid. New Treasury securities are issued to redeem those that have reached maturity.

The total debt continues to grow because it is never repaid; only replaced by more debt. Additionally, new debt offerings must be sufficient to pay interest on existing debt and continue to fund day-to-day government operations.

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

“It still mystifies me…how a banking system can create money out of nothing, but it does. in $65 trillion+ of “unqualified” credit in the US alone…”

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

Fractional-reserve banking is underway. It is central to the Federal Reserve’s efforts to increase the supply of money and credit. Consequently, the number of US dollars continues to increase and their value continues to erode. Their value at any given time is always suspect. How can we know what a dollar is worth when there is unlimited supply and there is no constancy?

What is truly amazing is the extent to which our banking system can sustain itself. And, no matter how much the Fed’s efforts prevented the system from imploding, it should be noted that we continue to look to the perpetrator and depend on him to save us. Worse still, the proposed solution(s) are the exact same actions that led to the current situation. Spend more and borrow more.


This article originally appeared on FX Empire

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