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What is the alternative to fractional reserve banking?

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October 21, 2010 – Comments (34)

I dont know much about it, so its a serious question.  I hear a lot of people saying fractional reseve banking is a fraud because it expands the money supply.  But whats the alternative?  How would people make loans if they had to keep all of the money in the bank?  And then banks wouldnt pay interest, they would charge interest for the sake keeping, right?  So whatsd the alternative?

34 Comments – Post Your Own

#1) On October 21, 2010 at 1:44 AM, SundayRider (< 20) wrote:

Actually there has been non-fractional-reserve banking at various times in various places, but you're right--it does constrict the money supply. If there were only money to lend equal to all the gold and silver in the world, there wouldn't be a lot of lending going on. However, I'm not sure that would be a completely bad thing. People and businesses would have to save a larger amount  before buying something or starting a project, and those savings would add to the reserves for lending, and the system would definitely be solvent. So you'd be trading a more stable financial world for everyone being less materially well-off. I'm not sure that's a bad trade-off, but that's a matter of personal values.

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#2) On October 21, 2010 at 1:58 AM, Valyooo (99.55) wrote:

Wait maybe I am misunderstanding.  I know how the system expands the money supply, but wouldnt non-fractional reserve banking mean that all of the savings had to be in the banks at all times?  In which case, how would money be lent out?

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#3) On October 21, 2010 at 2:48 AM, SundayRider (< 20) wrote:

 Most diatribes against fractional reserves are about the currency, which used to be a banking function. Starting out, banks only created scripts (paper money) for the gold they actually held. (These were discounted, so this was lending with interest.) They then started issuing scripts on more gold than they actually had. That is fractional reserves. Governments also followed that path, until Bretton Woods when even that was abandoned. So we don't even have "fractional reserve" currency now, and neither does any other country (even the Swiss).

The big multiplier right now is not fractional reserve, but the fact that deposits can be lent out multiple times. The bank makes a loan, then sells the loan to someone else, and loans the money again. However, this is what the "credit crisis" was about: suddenly there was no one to buy these loans, or to even buy the short-term operating debt of banks and other companies. So the money velocity went way down. It still hasn't really recovered, and may never do so to the same extent.

The real money supply is not how much cash is sitting in banks (which is where most of the Fed's recent money-printing has gone). It's the supply of cash multiplied by the velocity with which it's turning over. This is why there's not much inflation, and a lot of worry about deflation, because most people and businesses want to just pay off their debt--not create new debt. So no matter how much the Fed does QE2, they can't make people borrow the cash and create any velocity. So the result is a constriction in the real money supply, which is the Fed's "liquidity trap" that is now being talked about. This is why there can be deflation even while the Fed "prints" tons of money.

 I guess this is off-topic a bit, but so is "non-fractional reserve" right now. No one's really going there anyway. 

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#4) On October 21, 2010 at 2:54 AM, sawchain (< 20) wrote:

Banks should not loan out people's money without them knowing about it.  People do not expect their deposits to be in any risk, so what banks are doing is essentially fraud.

From a certain perspective, you do benefit from a bank investing your dollars.  With the return the bank makes from those investments, they can provide you "free" banking and other services.

IMO, a more "honest" system would be to pay banks to secure our cash.  Then, if a bank wanted to loan money out, it would entice you into "risk of loss" arrangement by allowing you to share in the returns.  In this situation, the bank is the facilitator.  They take your money, loan it out with interest, take a portion of that interest for themselves, and give a portion to you.

In this system, you are fully enabled to make a risk/reward assessment to match your personal financial objectives.  Everything is above board; no shadiness and no hidden risk.  What's more, in this system, fractional reserve banking would never occur because a bank couldn't loan out dollars it didn't have.

A more interesting question: how did fractional reserve banking ever come about in the first place?  Have you ever considered loaning out money you don't have?  What magic has to occur to  allow you to loan out money you don't have?  Why is Bernie Madoff treated differently than any fractional reserve banker?

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#5) On October 21, 2010 at 3:25 AM, ikkyu2 (99.18) wrote:

Sawchain is talking like he doesn't understand the banking system.  This is disingenuous.  The more "honest" system he proposes is the one we have now, except that rates are so low that us retail depositors at the end of the chain essentially get nothing.

I can think of a few alternatives:

1)  Central lending.  Only one entity, probably the government, is permitted to lend money.  Everyone goes there to get their loan and their interest rate is custom-fit for them.  This entity could take deposits too, but would not be obligated to in a fiat money system like we have now.  There is an argument to be made that the reserve requirement is a sham and that this is the arrangement that we actually have today, but with middlemen.

2)  No reserve requirement - allow banks to police themselves so they don't go out of business.  This has been tried.  It doesn't work.  As SundayRIder points out, asset securitization, looked at one way, is simply the latest attempt at this.

3)  Hard money lending.  All loans must be backed and guaranteed by assets commensurate to the loan value.  In case of default, the assets are forfeit to the lender.  In other word, the lendee risks something he owns.   This idea you have, that credit is a human right, is a fairly new one in history.  Throughout most of history, the majority of human beings could not obtain any kind of loan.

4)  No growth.  Loans are not really strictly necessary in a stable society that is not growing or innovating nor in need of new jobs.  Restricting the availability of credit reduces a society's structural capacity for growth.  This is or is not the end of the world, depending on if you are an economist or an anthropologist first.

 

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#6) On October 21, 2010 at 9:05 AM, Valyooo (99.55) wrote:

What do you mean banks shouldn't be able to loan your money to others? How would they make any money then?

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#7) On October 21, 2010 at 9:13 AM, Valyooo (99.55) wrote:

And credit seems like the best way to obtrain growth

My question though, is how is the bank lending out more than it has?

If they have 100 in reserves and lend out 90 of it, yeah now there 90 lent out and "100" in deposits in the bank...but at some point that 90s gonna come back into the bank to pay off the deposits

And if the banks are creating 1/1-c money...how is there stuff (real hard goods) to back that stuff up

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#8) On October 21, 2010 at 9:23 AM, SkepticalOx (99.44) wrote:

Valyooo,

There's full-reserve banking http://en.wikipedia.org/wiki/Full-reserve_banking

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#9) On October 21, 2010 at 9:27 AM, SkepticalOx (99.44) wrote:

Valyooo,

Check this specific entry to explain what they mean by lending out money they don't have: http://en.wikipedia.org/wiki/Fractional-reserve_banking#Example_of_deposit_multiplication

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#10) On October 21, 2010 at 9:37 AM, Valyooo (99.55) wrote:

I already checked that out.  I still dont get how they dont have the money.  Assetts still equal liabilities dont they?

You give me 100 dollars.  I lend 90 to Joe.  So Joe has a 100 dollar loan (liability) you have a 100 dollar deposit (assett).  Even though you "have" 100 in the bank and joe has 90 in his hand, the money supply is not now 190, because he is just borrowing your money.  Once he pays the loan back, you have your 100 dollar deposit and he has no loan and we are back to square one.

 I know I am wrong somewhere, show me where.

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#11) On October 21, 2010 at 9:40 AM, Valyooo (99.55) wrote:

What would be the point of full reserve banking?  If people couldnt get loans and pay interest on them, then people wouldnt earn any interest in the bank; in fact they would have to pay fees to the bank.

Why the heck would I put my money in the bank and pay fees on it if I could just stay it in my mattress for free?

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#12) On October 21, 2010 at 9:54 AM, SkepticalOx (99.44) wrote:

Valyooo,

Joe deposits $100 into Bank A. Bank A lends out $80 to Mary, holds $20 in reserve. Everything is fine here right? 

Mary pays Mike $80, who in turns deposits that $80 into Bank B. Bank B lends out $64 to Albert and holds $16 in reserve.

So now Joe has $100 and Mike has $80 ($180 total in deposits), and the banks have lent out $80 + $64 in total so far ($144 lent out). All out of the initial $100. 

Repeat. 

Make sense? 

 

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#13) On October 21, 2010 at 9:59 AM, SkepticalOx (99.44) wrote:

You can even just have one bank by the way in the example.

Joe deposits $100 into Bank A. Bank A lends out $80 to Mary, holds $20 in reserve.

Mary pays Mike $80, who in turns deposits $80 into Bank A. Bank A then lends out $64 to Albert and holds $16 in reserve.

So just one bank alone, the initial $100 from Joe means $180 in deposits in the bank and $144 in loans? You see what they mean by lending out money they don't really have? 

 

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#14) On October 21, 2010 at 9:59 AM, SkepticalOx (99.44) wrote:

You can even just have one bank by the way in the example.

Joe deposits $100 into Bank A. Bank A lends out $80 to Mary, holds $20 in reserve.

Mary pays Mike $80, who in turns deposits $80 into Bank A. Bank A then lends out $64 to Albert and holds $16 in reserve.

So just one bank alone, the initial $100 from Joe means $180 in deposits in the bank and $144 in loans? You see what they mean by lending out money they don't really have? 

 

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#15) On October 21, 2010 at 10:03 AM, Valyooo (99.55) wrote:

Right, but  Mary has to pay back the loan, which can then be used to give Joe back his money if he so wishes to retrieve it.  So when Mary takes out a loan, even though he has $80 in money, she also has a $80 liability to repay the loan (plus interest)

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#16) On October 21, 2010 at 10:05 AM, starbucks4ever (98.50) wrote:

Banks would still make loans, they just wouldn't loan more money than you deposited with them.

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#17) On October 21, 2010 at 10:28 AM, SkepticalOx (99.44) wrote:

Of course Mary has to pay it back, but in the mean time, that $100 in Joe's bank account is real money, and so is Mike's $80. When Joe looks at his bank account it doesn't say $20, it says $100. He can use that $100 to buy goods, to buy stocks, which affects a whole multitude of things (inflation, asset prices, etc. etc.). Mike too. With a reserve requirement of 20%, that initial $100 could theoretically become $500 which can be spent. 

One of the complaints against a fractional-reserve banking system is it's fragility. Imagine Joe one day decides to withdraw all $100. What happens? 

I'm no expert on these things, and there are merits as well as flaws to this system.  

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#18) On October 21, 2010 at 12:38 PM, Valyooo (99.55) wrote:

oh I got you. Well how is there stuff to back up all of this new money?

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#19) On October 21, 2010 at 1:46 PM, SkepticalOx (99.44) wrote:

"Due to fractional reserve banking, in aggregate, all lenders and borrowers are insolvent" (Wiki). 

That's why we have the Fed and the government has the ability to print money to bail out the banks :). Woila! If Bank A runs out of money and no one else is willing to lend to it, the Fed can just bail them out. And the Fed can create money out of thin air to do it if necessary.

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#20) On October 21, 2010 at 2:12 PM, Valyooo (99.55) wrote:

So then why do it in the first place if it does nothing but create inflation and insolvency? What are the pro's?

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#21) On October 21, 2010 at 2:14 PM, SkepticalOx (99.44) wrote:

Read the Wiki article on it man! It says it right on there.

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#22) On October 21, 2010 at 2:27 PM, starbucks4ever (98.50) wrote:

#20,

This practice started in the Middle Ages when capital was so scarce that anything that helped increase it was overall a positive thing. Today we have the opposite situation. We have more capital than we can profitably invest. All our assets are already overvalued because too much capital has flown into them as a result of earlier printing.  

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#23) On October 21, 2010 at 2:33 PM, mtf00l (46.60) wrote:

Videos regarding the current system and how it got here...

http://caps.fool.com/Blogs/lesson-1/460918

There are 8 videos.

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#24) On October 21, 2010 at 2:34 PM, TMFHousel (92.41) wrote:

"Banks should not loan out people's money without them knowing about it.  People do not expect their deposits to be in any risk, so what banks are doing is essentially fraud."

 A) FDIC insurance. B) What depositor doesn't know banks make loans? C) If you honestly feel this is fraud, I recommend you you sue every bank in the country. Let me know how it goes. 

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#25) On October 21, 2010 at 2:58 PM, leohaas (32.65) wrote:

rec for #24!

If you really want to know more about fractional reserve banking, full-reserve banking, the gold standard, and a boatload of related topics, start reading wikipedia.org. It is a pretty good source. Even most Libertarians who always claim that the mainstream media is biased will agree...

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#26) On October 21, 2010 at 5:43 PM, Valyooo (99.55) wrote:

I don't see anything explaining where the "stuff" to back up the money comes from.  I see that it vaguely says it leads to growth and doesnt necessarily lead to inflation, and that there is more money chasing the same amount of goods, but it doesnt explain how creating more money leads to more stuff being there.  If i gave you one "Valyooo ticket" for your computer, and that was your only computer, and then I went home and printed 100 more of those, you wouldnt be able to print 100 more computers to back it up

 

Sorry sometimes i get confused in the abstract

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#27) On October 21, 2010 at 10:03 PM, ikkyu2 (99.18) wrote:

Valyooo, there's only one difference between a dollar and a Valyooo ticket, and that is that if you offered me enough dollars, I'd go out and steal or build a computer to give to you.  I don't trust that other people will honor a Valyooo ticket, but I am sure they'll beg, borrow, steal, work, build, or do whatever, given enough dollars.

The "stuff" is, to a first approximation, land, labor and capital.  The dollar is a unit of exchange, a medium of account, and a store of value, all as it relates to land, labor and capital.

If you go home and print 100 more Valyooo tickets, I might not give you a second computer for one Valyooo ticket.  I might hold out for 5, or 10, or even 100 Valyooo tickets, figuring that now that Valyooo tickets are everywhere, I'ma get mine.  That's called price inflation, and it's one of the ways that limited 'stuff' adjusts to the expansion of the money supply.  Then, because I'm flush, I go pay 10 Valyooo tickets for an 8-ticket steak, and suddenly the steakhouse owner is well on his way to buying a computer of his own. 

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#28) On October 22, 2010 at 10:10 AM, Valyooo (99.55) wrote:

Right, but what I am saying is what does it matter how many dollars are out there? If there is 1 computer out there and 5 dollars, you earn 5 bucks and go buy a computer.  If theres 10 bucks and 1 computer, you earn 10 bucks then go buy a computer.  Now the 10 bucks are easier to come by, so even though you need more, they are proportiantely equally as scarce.  So whatever the price level, computer is still worth all of the dollars out there.

So if theres less or more dollars, theres still the same amount of stuff right?

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#29) On October 22, 2010 at 4:02 PM, ikkyu2 (99.18) wrote:

Valyooo, if you ask an economist, he will tell you that as more and more dollars are floating around, more goods get produced; more services get rendered; more land becomes developed to higher uses; more commodities get extracted out of the earth; and more enterprises make future plans to do more stuff.  All of these activities increase GDP, and ultimately increase the supply of "stuff."

Take SkepticalOx's examples above.  Joe could easily hide his hundo under his mattress.  In that case, Mary never gets into the picture and therefore she engages in no economic activity at all.  She was going to do some buying and some spending and maybe even some value-creating, but now that Joe has hidden his hundo under the mattress she won't do anything.

That's what it's about.

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#30) On October 22, 2010 at 11:56 PM, Valyooo (99.55) wrote:

So then why not print trillions of dollars a second and just throw it all over the place like germany in the 20s?

Or instead of mattress stashing, he can give it to the bank and his account can say "20 dollars on deposit, and 80 dollars that mary owes u" so that mary can borrow to produce instead of creating money

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#31) On October 24, 2010 at 1:21 AM, ikkyu2 (99.18) wrote:

So then why not print trillions of dollars a second and just throw it all over the place like germany in the 20s?

a)  Are you not paying attention? :)

b)  My latest blog entry links to a 1977 article by Warren Buffett where he answers this question very eloquently, much better than I could do. 

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#32) On October 25, 2010 at 2:39 AM, Valyooo (99.55) wrote:

There seems to be a clash of ideas then.  I understand why inflation is bad.  However, if inflation is bad, and printing money is bad, then how can all of this leverage and multiplier effect and expansion of money created by fractional reserve banking be any better?

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#33) On October 25, 2010 at 2:42 AM, Valyooo (99.55) wrote:

When a company does a stock split, the value of the company is the same....more shares out there, less value of each share.  This makes no difference at all.  So when there is more money due to fractional reserve banking, how does that do anything except change the amount of dollars out there and reduce the value of those dollars proportinately?

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#34) On June 24, 2012 at 2:05 PM, bob1476 (< 20) wrote:

It seems that people do not understand the true nature of fractional reserve banking as it exists today.  "Fractional reserve" does not mean that the bank can only loan out 90% of the money it has on deposit.  In reality banks do not loan out depositor's money at all...this money is uses as "reserves" to backstop the loans that the bank makes.

 The money that banks "loan" is created out of thin air, or to be more precise, it is created by the promissary note signed by the debtor.  This note is "money" in every sense of the word.  The bank itself actually brings NOTHING to the transaction and is merely a facilitator where the debtor creates new money by pledging his future earnings to back his note. The note then beceomes a negotiable instrument (money).  The bank is then free to sell the note to someone else at a profit or to keep it and collect the principle and interest, again for a profit. 

 This is how fractional reserve banking works.  This idea that reserve requirements are 10% is also a myth.  Many banks have reserve requirements far lower.  3% is not uncommon and when you get to the major international investment banks, they have no defacto "reserve requirements" because they have direct access to and control of the FED...which not only sets their reserve requirements, but has the ability (and the willingness) to provide interest free money in virtually unlimited amounts to the major banks as they may need it.

 This system is nothing more than legalized fraud giving a small group of bankers control over the money supply.  Just as the house always wins in a casino, this system ensures the transfer of real wealth (currency is not wealth but only a medium of exchange) from the general population to these banking interests.  This outcome is guaranteed by the system regardless of what people do, or do not do; A good example of this is the ownership of real property.  In 1913 when the FED was created (and the bankers gained complete control of our money supply) most Americans owned their homes/land outright.  Those who had mortgages had what we would consider today to be short term notes.  Today these banking interests own the vast majority of real estate in the USA.  Most Americans live in homes which they pay taxes and upkeep for, but which are in fact majority owned by the banks. 

What backs the dollar?  It is debt, period.  If you really want to learn about how money really works there are numerous videos on youtube which explain it in simple terms.  Just search for "money as debt".  If you really want to learn about the system,  search for Damon Vrabel and watch his excellent videos where he explains the global capitalist machine and how it works.  Armed with this knowledge, what previously appeared as incomprehensible lunacy on the part of the government and PTB suddenly appears to make perfect sense.

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