Fractional Reserve Banking
'When something seems too good to be true... it probably is'
Ben Miles | 6 March 2016

Fractional reserve banking: a key antagonist of the Global Financial Crisis, yet a driver of economic growth. Whilst most banks call for progressively lower reserve holdings, others would like to see the system’s demise - but what does all this mean and how does it affect us?


The fractional reserve system requires a bank to hold only a small proportion of its total liabilities, deposits and borrowings, available for withdrawal. That is, for a 10% reserve requirement, when a bank receives a deposit of say £100, they can then lend out £90 of that, while keeping £10 for the ATMs.


This system is key to banks’ business, allowing for vast profits, as they lend money to people at higher interest rates than those at which they borrow. If someone deposits £100 into a bank account, the bank may pay 0.5% interest to be able to ‘borrow’ that money and lend it to other people. Whereas, if someone takes out a loan from a bank, they will be charged approximately 5% interest. As such, the cost to banks of receiving deposits is far less than the payoff they will receive from lending some of that same money out – hence the large profits to be made from millions of global transactions.


Changing tides…


The 2008 Financial Crisis was, amongst other things, due to banks desiring and being able to create money – too much money. From the earlier example, when the bank loans out £90 of the initial £100 deposit, it ‘creates’ money – there is £100 deposited that belongs to one person and £90 held in loans by another, totalling £190. This money could yet be put in another bank and lent out ad infinitum. It turns out, after a bit of playing around with number series, that the financial system can turn our initial £100 into £1000.


So it seems that banks can simply ‘create’ money. A fact that was most evident in the seven years before The Financial Crisis, when banks literally doubled the money supply. In fact, they were able to continue creating so much of the stuff that, to most, it seemed impossible that such a trend could end. Lending, the supply of money and profits continued to grow, banks became increasingly exuberant and the complexity of credit chains grew, along with the wealth of investors. However, as the old saying goes: ‘when something seems too good to be true… it probably is’ and this time it most definitely was.


Of the trillions of pounds that were created in the economy between 2000 and 2007, 51% went into the real estate market. This drove up prices, along with the level of personal debt, at such speed that debt was rising even faster than incomes. Repayments were becoming extremely difficult and there was a rising fear that banks would default and declare bankruptcy. Fear is a self-fulfilling prophecy in the financial world and so, as lending started to fall, so too did some banks. The cut in lending froze the financial system dead in its tracks, and as contagion spread, investors stopped borrowing, consumers stopped buying and the economy stopped growing - bringing about the worst recession in over 70 years. This vicious circle of banks crumbling, investors caving and businesses going bankrupt was named ‘The Great Recession’ and we have been feeling its effects ever since.


Toughening up…


In 2009 the UK imposed new policies to try to encourage banks to increase their reserve requirement ratios, despite still not having any official regulations like in the US. The governing body implemented interest on excess reserves so that, if a bank kept back more money than was needed, it would be rewarded with higher interest payments from the Bank of England. This was still not as strict as in the US, but was an improvement nonetheless - a half-hearted attempt to try and avoid another financial crisis.


However, the Bank of England is reluctant to force banks to hold back too much money in their reserves, as large amounts of lending and money creation encourages growth in the economy - growth that we desperately need. So the Bank of England has to find the right balance, treading the fine line between harshly regulating the fractional reserve system and allowing banks to inject fuel into the economy. It is safe to say that they got the balance wrong in 2008 and that even now the regulation is arguably not strict enough, but when will bankers ever learn from their mistakes?


Image issued under the Creative Commons license

James Routledge 2016