Fractional Reserve Banking – How The Banks Make Money Out Of Thin Air

How much money do you think is created by the Government in the UK? Half? Three quarters? It’s the Government that prints money so it must be quite a lot right? Wrong. Shockingly, the Government creates only 3% of the money in the UK, the rest is created by banks. And most of that is created out of thin air by a legal banking practice and it’s called ‘Fractional Reserve Banking’.

What is Fractional Reserve Banking and how does it work?

Put simply, banks do not have to keep all the money that their customers deposit. They only have to keep a fraction of that money in the vaults – usually 10%. The other 90% they loan out.

It all started centuries ago with goldsmiths, who are considered to be western civilisation’s first bankers. Goldsmiths used to provide safekeeping services and make a small charge for doing so. When someone deposited their gold or coins for safekeeping, they were given a deposit receipt. When they needed some of their gold or coins back, they would take the receipt to the goldsmiths and use it to redeem them. Once they had their gold or coins, they would use them to buy what they wanted from a trader, who would in turn then deposit the gold or coins they had been given for their goods back with the goldsmith.

The trouble was, it was a lot of bother to keep going back to the goldsmith to do all of this and soon everyone realised it was a lot easier to hand over the deposit receipts directly to sellers as a means of payment. These deposit receipts became the first bank notes, and all someone had to do was take the note to the bank and receive the gold or coins they were owed.

Then the goldsmiths had a bright idea. These notes, these promises of money, could work for them and make them money. They could give these notes to people as promises of money, or what we now know as loans. They could issue many more loan notes than they had gold or coins in the vault because they knew that only a portion of notes they gave out would be presented for payment at any one time. All they had to do was keep enough gold and coins on hand in the vaults to cover what was presented. But the beauty of it was they could charge the people with the loan notes a small sum of money (what we now know as interest) for the privilege of being ‘loaned’ the money, even though technically the money didn’t exist.

And so the goldsmiths learnt how to make money out of thin air and the fractional banking reserve system was born. As long as the goldsmiths kept a proportion of the money deposited to cover the deposit notes that were presented, they could promise many, many times more the gold and coins they took in as deposits and that they could cover.

Today, the same system is at work, although the majority of the deposit notes have been superceded by the electronic banking system.

So what’s the problem with Fractional Reserve Banking?

The problems start when people lose confidence in their bank and start a rush to withdraw their money. Most of us believe our banks will give us our money back, but if we suspect that all is not well we will naturally try and withdraw it from our lender to stuff in a shoebox under the bed. This phenomenon is called ‘a run’. For obvious reasons, if the bank only reserves, for example, 10% of what is deposited in its vaults, if every saver and investor demanded their money back, the bank be unable to cover those payments and would go bankrupt.

This almost happened to Northern Rock and required the UK Government to step in, give the bank enough money to cover its payments to savers and investors, and restore enough confidence to slow down the run.

While there’s no doubt that Fractional Reserve Banking has given many the ability to buy and improve their own homes, it can also be argued that it has led to too much credit being extended and had a direct hand in the recent global financial meltdown. With the UK’s national debt now hitting £1.5 trillion, it’s a sobering thought that much of it has been manufactured by banks from absolutely nothing.