The fractional reserve banking system is the backbone of modern banking, but it’s a concept that often sparks debate and controversy. Understanding how it works and why it’s viewed negatively by some is essential for anyone interested in economics and finance.  I am going to delve into the mechanics of fractional reserve banking and explore why it’s perceived as problematic by critics.

 

 

WHAT IS FRACTIONAL RESERVE BANKING?

At its core, fractional reserve banking is a banking system where banks are only required to hold a fraction of customer deposits in reserve, while the rest can be lent out to borrowers. This fraction, known as the reserve requirement, is set by central banks and varies from country to country. For example, if the reserve requirement is 10%, a bank can lend out 90% of its deposits.

 

HOW DOES IT WORK?

Here’s a simplified example to illustrate the process:

1. Deposits: Alice deposits £1,000 into Bank A.
2. Reserves: Bank A is required to keep a fraction of Alice’s deposit in reserve, say 10%, which amounts to £100.
3. Lending: With £900 left, Bank A can lend this money out to borrowers, such as Bob, who wants to take out a loan for a car.
4. Money Creation: Bob spends the £900 on the car, which then becomes the seller’s deposit in Bank B. Now, Bank B can use 90% of this deposit to lend out again, and the process continues.

WHY IS IT VIEWED NEGATIVELY?

 

1. INSTABILITY:

Critics argue that fractional reserve banking can lead to financial instability. Since banks lend out more money than they actually have in reserves, they become vulnerable to bank runs if depositors lose confidence in the bank’s ability to honour withdrawals.

 

2. INFLATION:

By expanding the money supply through lending, fractional reserve banking can contribute to inflationary pressures in the economy. The more money that’s created through lending, the less each unit of currency is worth.  Interestingly an ounce of gold is today worth $2,294.  In ancient Rome, that amount of gold would have bought you a fine Toga (an ancient Rome garment).  Today the same amount of gold would buy you a good quality suit.  So gold has retained its value.  Since 1972 when the gold standard was abandoned the British pound has lost 90% of its value in real terms (inflation adjusted).

Age UK article

 

3. SYSTEMIC RISK:

The interconnectedness of banks in the fractional reserve system can amplify systemic risks. A financial crisis in one bank can quickly spread to others, leading to a domino effect that threatens the stability of the entire financial system.

 

4. WEALTH INEQUALITY:

Some argue that fractional reserve banking exacerbates wealth inequality by enabling banks to profit from interest charges on loans, which disproportionately affect lower-income individuals and small businesses.

 

WHAT’S THE SOLUTION?

Because of the weaknesses of the fractional reserve banking system, the only way you can protect your cash from losing its value through inflation is to buy real assets which means assets that grow in value and have the potential to match or beat inflation such as property and shares.

Furthermore both gold and cryptocurrency, particularly Bitcoin, have proven to be inflation proof assets, especially gold which has existed for thousands of years whereas Bitcoin has been around for less than two decades.  The advantage of these forms of money is that there is a limited supply of each of them and governments and banks do not control them.  Whereas banks and governments can and do print money which causes inflation and reduces the value of the pound in your pocket.  It is a hidden form of taxation.

 

 

CONCLUSION:

Fractional reserve banking is a fundamental aspect of modern finance, but it’s not without its controversies. Critics point to its potential for instability, inflationary pressures, systemic risks, and exacerbation of wealth inequality as reasons for concern. While the system has its flaws, proponents argue that it also plays a vital role in facilitating economic growth and providing access to credit.  On the other hand, you can protect yourself by investing your spare cash into real assets and alternative forms of money in order to combat the devaluation of fiat money (notes and coins). Ultimately, the debate surrounding fractional reserve banking underscores the complexities of modern banking and the ongoing quest for financial stability and inclusivity.  It is important for you to plan your finances so that your cash does not become devalued.  You know it makes sense.*

 

 

*RISK WARNING

The value of investments can fall as well as rise. You may not get back what you invest. The information contained within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction. All information is based on our current understanding of taxation, legislation, regulations and case law in the current tax year. Any levels and bases of relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. The Financial Conduct Authority does not regulate tax planning, estate planning, or trusts.  This blog is based on my own observations and opinions.  

Don’t invest in cryptocurrency unless you’re prepared to lose all the money you invest. This is a high-risk investment and you should not expect to be protected if something goes wrong.