There’s a big, fundamental flaw with any banking system that allows banks to take money from savers then loan it out to borrowers. It isn’t that savers can’t always get to their money when they need it. It isn’t that borrowers don’t always pay it back. It is, however, that banks loan out more money than they have been given by savers to look after and investors to gamble.
Were it as simple as banks loaning out more money than they have in knowledge that they need only keep so much in reserve for the fraction of their savers and investors whom withdraw their money on any given day then there wouldn’t be a problem. What banks actually do is far more serious: they not only loan out more money than they physically have in reserve they also take money from people who borrow it from other banks. Why’s that an issue? Here’s how it works:
Simple World has a population of 8 and enough gold to make $300.
- Bank A has $100,
- Bank B has $200,
- Bank A has 4 customers saving $25 each (A1,A2,A3,A4),
- Bank B has 4 customers saving $50 each (B1,B2,B3,B4),
- Bank A knows that its only competitor is Bank B, Bank B knows that it’s only competitor is Bank A.
Both bank A and bank B know that on any given day only a quarter of their capital is going to be withdrawn and the same amount is likely to be deposited by another saver. So at anyone time, Bank A will hold approximately $75 and Bank B, $150.
Because each bank knows that only a quarter of its funds will be withdrawn at any given time they conclude that it is safe to loan out the remainder. Further, because they know that when they loan money they will receive extra back, they gamble they can loan more money than they actually hold. This is called Fractional Reserve Banking.
Both Bank A and Bank B assume they can safely loan 4 times more money than they hold.
Bank A will usually hold $75 so it will loan out up to $300,
Bank B will usually hold $150 so it will loan out up to $600,
When Bank A’s customer A1 uses his loan of $200 he spends $100 of it and deposits the other $100 in Bank B.
Bank B now has $300,
Bank B now assumes it will need $75 in reserve to cover withdrawals and can loan out up to $225×4 which is $900 to borrowers.
So the bank balance is:
Bank A had $100, reserved $25 for withdrawals and extended the capital it could loan by a factor of 4 to $300 of which $200 has been loaned out to customer A which leaves it with $25 reserve and $100 to loan (of which only 1 quarter of the $100 is backed by real capital) Bank A is now worth $50, is owed $200 and owes $100. In other words, if its customers all try to withdraw their savings then Bank A will not be able to pay out until customer A1 has repaid his loan of $200 which (because $100 of it has been put into Bank B) will contract Bank B’s balance.
Bank B had $200, reserved $50 for withdrawals and extended the capital it could loan by a factor of 4 to $600 of which none is loaned out. However it took in an extra $100 so will now loan out up to $900 (i.e. 200/4x3x4).
Can you see what has happened?
From an initial amount of $300 the banks have created a potential $900 for loans with a reserve of $75 i.e $225 have been turned into $900 of debt for borrowers. But, since money has been moved about from Bank A to Bank B without proper tracking, Bank B thinks it has $300 working capital – Banks A and B between them have created money out of thin air.
Bank A has $25,
Bank B thinks it has $300, so
$300 has now become $325. We have $25 extra to the real $300 that Simple World actually has.
The real world situation is much more complicated than my example shows but it is similar enough for the example to hold true. Our current banking problems have been caused by improperly tracked real money being used to create a currency of debt.
To resolve this problem, wouldn’t it be better to enforce a new type of bank account, one that allows savers to decide how much of their money they’re willing to let banks loan out and invest, one that permits savers to invest their own money and control currency trades without incurring bank charges, an account that tracks loans but not savings. I believe it’s possible to create such an account. We need a bank account that allows savers to divide-up their deposits as they see fit that also separates credit from debt. My solution is a bank account that is split into 5 deposit types,
- Bank Investment,
- Personal Investment,
- Non-Withdrawal, and
Anything put into the Withdrawal deposit would be untouchable by banks; and savers would always have immediate and full access to their funds. This would not need to be tracked as it would not contain any loaned monies. This would not receive any interest.
Anything put into the Bank Investment deposit would form (and be equivalent to) the bank’s fractional reserve. This would be the saver’s investment in the bank and as the bank would use this money for investments and loans, it should attract interest from the bank. Funds here would need to be passed to the withdrawal account for the saver to use it.
Personal Investment deposits would be the money the saver wishes to invest in stocks and currencies. This would not be touchable by a bank. If the saver wants a safer bet then the Bank Investment deposit would be the better place for investment money.
The Loan Deposit would contain any money loaned to the account holder by the bank. It would have to be tracked and would not be drawable as hard-currency, it should remain digital or as a physical IOU. This would not be transferable to the Withdrawal deposit and as tracked money it would not be transferable to either investment accounts; it would however be transferable to other banks but only to a Non-Drawable deposit.
Non-Drawable deposits would hold funds transfered from Loan deposits and other Non-Drawable deposits. Funds here would be usable to balance Loan deposits (funds created by fractional reserve banking practices would be used to settle each other), they’d be usable to buy goods and services from others they just wouldn’t be usable as hard currency.
The exception to Non-Drawable deposits from being converted to hard currency is this: when one account receives a payment from another account’s Loan Deposit it would be transfered to the one account’s Non-Drawable deposit; as the other account’s Loan Deposit is repaid, because the transfers are tracked, the one account’s Non-Drawable funds would be converted to drawable funds at an amount equal to the amount paid to the other’s Loan deposit (the actual amount could be specified as an exact payment else as a fractional payment based on the repayment amount spread across the number of active recipients from the other’s Loan deposit).
The intention is to keep credit and debt separated such that credit can be used to cancel debt but debt cannot be used to create credit.
The deposits would work like this,
Withdrawal, Bank Investment and Personal Investment deposits would be cross-transferable between each other, drawable and usable as hard-currency in the real world (as long as they’re transfered to Withdrawal accounts first);
Non-Drawable deposits would be transferable to both Non-Drawable deposits and Loan deposits of any bank;
Loan deposits would be only transferable to Non-Drawable deposits of any bank;
Loan deposits and Non-Drawable deposits would be tracked between banks to ensure they do not create money erroneously; and,
Loan repayments would lower a loan deposit’s balance and would generate the exchange of funds between the Non-Drawable deposit recipient of the repaid Loan deposit and the associated Drawable deposit. Effectively, banks would be brokers between debtors and creditors aswellas being guarantors of loans.
It would be like having credit accounts and VISA accounts but keeping VISA as VISA not credit. Debt would be less anonymous for everybody, people who do not use debt would not be hit by failing banks as hard as they currently are because their savings would be as safe as they choose them to be, creditors would always know whom holds their debt, and people would have greater choice over the amount of debt they choose to accept as payment.
The only two flaws I see are that people would need bank accounts before they can take a loan from a bank or accept a payment from a loan held by someone else; and people might be more bashful about taking on more debt than they can service (were it possible). Are they flaws or benefits? You decide.
If you really want to investigate fraction reserve banking and its implication for money creation then take a look at this very long Wikipedia article