Have you ever wondered what banks do with the money you deposit? They keep a portion of it on hand to service folks who need to make withdrawals, but the bulk of it is loaned out. If you take a loan for a house, a car, a business, or a credit card, the source for the money for that loan was primarily deposits made in the bank by other customers.
Many preppers see this as risky, and many small banks failed during the Great Depression, when too many folks tried to withdraw their money simultaneously. The old movie “It’s a Wonderful Life” starring Jimmy Stewart provides a glimpse of what life was like at the time.
FDIC
Today, deposit insurance guarantees the general public should not have a problem if a bank fails. In fact, after the 2008 financial crisis, over 800 banks failed in the U.S.A. As a bank customer, did you have a serious problem? Neither did I.
The process of depositing and lending, followed by depositing and lending, results in a money supply that is larger than the amount of money issued by the central bank and is known as the “Money Multiplier” and is generally viewed as positive for the economy, so the Money Multiplier is a good thing for overall prosperity.
However, the same process, absent deposit insurance, can be referred to, derogatorily, as “Fractional Reserve Banking”. This latter term is meant to emphasize that the bank does not continuously have reserves on hand to pay off all depositors at all times. This is meant to imply that it is just a matter of time until the banks involved fail. A bank run or a series of bad loans could put the bank under. This was a real problem in the early 1930s, but today you’ll go to your bank one Monday and find it was purchased by a larger bank over the weekend.
Of course… if…
Of course, if all the deposits were simply held in the bank, what would be the purpose? The money would be useless to the bank, and they would have to charge you a storage fee just to break even. Instead by allowing the bank to use your money you can earn interest, or at least get free checking.
We now have: Money Multiplier is good. Fractional Reserve Banking is bad. The Money Multiplier and Fractional Reserve Banking are the same thing. Huh?
How Much is Too Much?
There is a bit of truth to both views. Having a system that permits using deposits for loans clearly promotes growth of the economy, but it also clearly has some risk. Deposits are simply loans to banks from depositors. Loans can go bad. Assuming you aren’t a fanatic on either extreme, you are now left with the question of how far you can go using the Money Multiplier without placing the banking system at excessive risk, as occurred in the last financial crisis?
Traditionally, a simple ratio of capital to assets was used, with a ratio of 12.5% being considered very acceptable, i.e. assets could be eight times capital. Over time there was pressure to lower this ratio and one of the methods promoted was to have a “risk-based” capital ratio. The idea was that some assets are riskier than others, and therefore should not require as much of a capital cushion. This idea was formalized by an international banking group known as the Basel Committee.
Unfortunately, measuring risk correctly, and figuring out how to risk weight assets has not been easy to do. As a result, we are now dealing with Basel III, the third set of rules on the subject and Basel IV is being worked out. If this was easy, they would have gotten it right the first time. Unfortunately, these folks have not figured out that Murphy’s law applies, and the assets that go bad are the ones you thought were not risky. ☹
Money – it’s not easy being green…
Of course, with each new set of Basel rules, the calculations and reporting become more complicated. The reporting required has been a bonanza for accountants and systems developers who try to comply with each new set of regulations.
So how much capital is needed to cover a bank’s risk of bad loans? Depends on how good the bank manager’s decisions were in making those loans in the first place, but about a ratio of 12-13% seems to work most of the time.
Conclusion
Banking is all about being an intermediary between folks with money they want to put to work (depositors), and people who want to borrow money (borrowers). While the money multiplier has tremendous benefits to the economy, there is an obvious risk because if the borrowers don’t pay back their loans, the bank and its depositors could be in trouble. Managing this risk is a banker’s job. If you don’t think the bank can do a professional job of managing this risk, there is no need to moan about “Fractional Reserve Banking”. Just don’t bank there. 😊
Well, I have to say you are not just spouting the “preppers company line” on this one.
I don’t pretend to understand this stuff, so I just try to keep in mind that when dealing with bankers, they have their own interests in mind first and foremost
Well, this material is basically covered in any college in USA as second semester of Economics. As for bankers having “their own interests in mind”, you could say that about most anyone. As far as this topic goes, both you and the bankers should want the benefits of the Money Multiplier, but not to push it to a level of excessive risk.