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Origin And Danger Of Fractional-Reserve Banking

Currencies / Fiat Currency Apr 11, 2017 - 12:17 PM GMT

By: Kelsey_Williams

Currencies

If there is any one thing in particular that threatens the collapse of our banking system and financial structures worldwide, it is the practice of fractional-reserve banking. The subject is rarely mentioned in the financial press. When it is mentioned, a clear explanation is usually not available. 


From History Of Gold As Money …

The warehouse proprietors (‘bankers’) decided they needed to find a way to increase their profits. Earning fees from their depository and safekeeping services wasn’t enough. Since most of the gold remained in storage and most transactions involved exchange or transfer of paper receipts for the gold on deposit, they decided to issue ‘loans’ of the gold/money to others and charge interest. The cumulative amounts of gold loaned out could not exceed the amount of gold held in storage. And, hopefully, not too many depositors would ask to redeem their physical gold at the same time. 

It seemed to be a workable system. But apparently the ‘bankers’ were not content. They soon started issuing more loans/receipts for gold which did not exist. Of course they saw no need to inform anyone of their actions and the receipts still stated 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 still do so. Up to a point.

Fractional-reserve accounting by warehouses/banks was the original starting point for the credit expansion that now engulfs our world economy.

Here is an example of how this works today…

Your brother-in-law pays you thirty thousand dollars he borrowed three years ago. You decide to put the money in a time deposit (one year CD, etc.) at your bank. At the end of the day when your banker balances his books he finds that deposits at the bank exceed the funds which are currently loaned out/invested by an amount in excess of the ten percent US Federal Reserve requirement. And since that surplus amount is now available for new loans and additional investments, your bank’s loan committee and investment department are busily engaged in efforts to allocate those funds on a – hopefully – profitable basis. After due consideration, it loans twelve thousand dollars to Jane, who wants to buy a car and fifteen thousand dollars to a local entrepreneur.

Joan pays the twelve thousand dollars to Mr. Jones who is selling the car to her (private transaction). Jane drives away in her new car and Mr. Jones deposits the money in his bank which subsequently loans out 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 at the same bank that loaned him the money. Voila! The same bank which made the two loans now has fifteen thousand dollars in ‘new’ deposits of which it can lend out or invest another thirteen thousand five dollars. Which it promptly does.

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

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

And that is just the tip of the iceberg. Once the money is deposited, the process is ongoing and continually adds to the amount of dollars in the system.

Historically, early on, convertibility (exchangeable for physical gold) of warehouse receipts – and then paper currency – was maintained.  This provided a restraint on the limits to which bankers could go in expanding the practice of fractional-reserve banking.

As late as the early twentieth century, U.S. paper currency was issued with a clear statement specifying that it was redeemable for specific amounts of gold at fixed rates. In addition, gold circulated concurrently with U.S. paper currency and the two were interchangeable. One was as good as the other. Supposedly.

Questions arose as to the value of the paper currency. And more and more individuals, companies, and countries opted for real money (gold). There simply wasn’t enough gold to meet the redemption demands. And to whatever extent it was available, the banks and the government didn’t want to release it. So…

In 1933 President Roosevelt issued an executive order “forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States”. In 1964, the United States ended its use of silver in the minting of coins used for legal tender. And, in 1971, President Nixon suspended convertibility of the U.S. dollar into gold by foreign nations.

Fractional-reserve banking is ongoing.  It is at the core of the Federal Reserve’s efforts to expand the supply of money and credit. Hence, 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 possibly know what a dollar is worth when there is an unlimited supply and no constancy?

Noted and respected fund manager, Bill Gross said:

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

What is truly amazing is the extent to which our banking system can hold itself together.  And, to whatever extent the Fed’s efforts have kept the system from imploding, it is noteworthy that we look to and depend on the perpetrator of the crime to rescue us. Even worse, the solution(s) offered are the very same actions that led to the current predicament.  Spend more and borrow more.

So what is the danger?  Does over-leveraged use of money really pose significant risks to the viability of our monetary system?

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

Since 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 notes. Sam also loans five thousand dollars to a friend of his who is a homebuilder. Sam will earn interest on the construction loan in addition to a modest return on the US Treasury notes he purchased. Not bad. Especially since he does not have to pay Bob more than a pittance for ‘watching’ his money for him. Maybe Bob should pay Sam something for the good job he is doing (think negative interest rates).

Sam has decided to keep one thousand dollars of Bob’s money available in case it is needed. Good thing, too. After one week, Bob asks Sam for one thousand dollars of his money back in order to take care of some ‘unexpected’ expenses. Sam promptly pays Bob his one thousand dollars.

Sam now feels that the likelihood of Bob needing more of his money anytime soon is a remote possibility. Hence, he pledges the US Treasury notes as collateral and borrows four thousand dollars. He keeps one thousand in cash and loans another three thousand dollars to his friend, the home builder.

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

Sam only has one 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 shortly.

Sam calls his builder friend right away. The builder tells Sam that a couple his homes have not sold yet and the money to repay Sam isn’t available until the homes are sold.

Sam could sell the four thousand dollars in US Treasury Notes in order to access part of the money needed to pay Bob. But the proceeds would have to be used first to pay off the loan for which they are pledged as collateral. Since the loan amount is nearly identical to the market value of the US Treasury notes, no additional funds would be available.

Bob, meanwhile, decides that he won’t start investing in real estate as he had planned. Therefore, he won’t need the rest of his money right now.

Except that when his wife gets home from work, he learns that one of their kids needs braces on her teeth. Also, the interest rate reset on their home mortgage has taken effect.  The new monthly payment will increase by several hundred dollars. He decides that he might need to draw from his money (that Sam has charge of) after all.

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

The above story is imaginary, incomplete, and unending. But it is illustrative of the risks of fractional-reserve banking. I have purposely kept the amounts small and the scenario simple for the sake of clarity. If too many ‘Bob’s’ want their money at one time or can’t make their mortgage payments….

Now consider the implications of adding trillions of dollars of esoteric financial products to the mix.  Things like collateralized debt obligations, leveraged ETFs, options on futures, etc.  And those things are in addition to ordinary securities margin accounts.

It can be argued that the use of funds made available by banks via fractional-reserve accounting is productive and helpful. Nevertheless, that does not reduce the risk to the system.  It adds to it. Because it furthers leverages the same dollars over and over again. And many of the uses are risky enough on their own.

The monetary value we place on anything of consequence is underpinned by an extension of credit.  That credit starts with fractional-reserve banking.  This leads to credit cards, student loans, auto loans, construction loans, mortgages, etc.

Fractional-reserve banking is the ‘foundation’ for the debt pyramid (inverted) that threatens the collapse of our financial system.

By Kelsey Williams

http://www.kelseywilliamsgold.com

Kelsey Williams is a retired financial professional living in Southern Utah.  His website, Kelsey’s Gold Facts, contains self-authored articles written for the purpose of educating others about Gold within an historical context.

© 2017 Copyright Kelsey Williams - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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