Thursday, March 31, 2016

Regarding Fractional Reserve Banking

I read a page linked today from Facebook which asserted the proposition that banks create "money ... from something called the Fractional Reserve Banking system.... This scam creates money out of thin air."

“Ahhh,” I said, “the old ‘fractional reserve banking’ misunderstanding.” MISunderstanding. (To avoid, ah, misunderstanding.)
Here’s what “fractional reserve banking” really is:

Banking law (the Federal Reserve Act in the US) requires that for each $100 dollars of deposits banks have received from customers, they have to keep 10% on deposit with the reserve bank (those deposits are called, you guessed it, "reserves" they are a form of safety net.) That requirement has the natural consequence or, better yet, corollary that they can only lend out up to 90% of the deposits they have accepted.

One way this reserve requirement is sometimes characterized is by saying “banks can loan up to 9 times the amount they have on reserve.”  Which is true, but incomplete.  And describing it in that incomplete way is what leads to the misunderstanding on the subject.

The folks all worked up about "fractional reserve banking" see the 10% reserves and they see the "9 times that" in loans  they can make -- but they don't see or understand is that a bank cannot loan out any money which hasn't already been loaned to them - that the 10% is 10% of deposits of real money people have  made with them, as is the remaining 90%.  They haven't "created" one penny.

But they think the bank has somehow created money out of thin air: as in the FB post’s proclamation "This scam creates money out of thin air."

They simply aren't “creating money out of thin air." .  This idea is simply wrong.

I've been trying to think of an analogy.  How about this? In US football, the last 20 yards before the goal line is called "the red zone."  That is "20% of the field.  The rest of the field is "4 times that," right?  Claiming "fractional reserve banking" means the banks "create money out of thin" air is like arguing that the football teams have created that other 80% of the field ("4 times the red zone!") out of thin air.  (Not a perfect analogy, but maybe it'll help conceptualize the issue.)

How do I know this about reserve banking?  I practiced regulatory compliance for a couple of the country's largest banks during the last century.  I had to know and, sometimes, work with the reserve requirement of the Federal Reserve Act, as amended over the years.

Does that mean I'm somehow in the tank for banks?  Because I worked for them?

Nope, but it does mean I know a lot more about some of the shitty stuff banks do than most people know.

Our banking system needs major reform, but we simply can't do it effectively if we believe nonsense like this "fractional reserve banking" lets banks "create money" idea.