Fractional Banking

Fractional Banking

By Jim Fredrickson on March 5, 2010 | 1 Comment | Edit

You and I understand what it means to loan somebody something. If a friend or relative asks to borrow $100,  we reach into our wallets and give the money to them. Everyone understands that we will suffer a loss in the event that the borrower fails to return what he has borrowed.


We unthinkingly assume that when we get a loan from the bank, that a similar dynamic exists. The bank gives us money from their “wallet”, and will suffer a loss if the money is not paid back.  But that is simply not true.  The dynamic is completely different in the case of a bank.


Maybe you are familiar with the term “fractional banking”.   More than likely you either don’t know what it means, or simply have not taken the time to think it through.   Lets’ take a moment to get our arms around the concept.  Banks are required to maintain only a small fraction of their deposits on reserve.  So, they can actually loan many multiples of their deposits to borrowers.


So,  if you or I were to charter a bank, and capitalize it with an initial investment of $1,000 we could then loan out much more than $1,000 – as much as $100,000 – to future borrowers.  But think about that for a moment.  If we only have $1,000 in the cash drawer, how can we loan someone $100,000?   Where does the extra $99,000 come from? Banks engage in this sleight of hand every day, whether it be for home loans, personal loan, or credit cards.  Where do they get the money to lend, that they don’t actually have???


Do they run to a different bank to borrow the money they are loaning out? NO.   They actually create the needed money out of thin air, like a magician pulling a rabbit from a hat.  “Money” that did not exist a minute ago, is created at the moment that the borrower signs a note.  The $10/hour bank teller makes an accounting entry, and PRESTO!  the bank has a new $100,000 asset on their books.   Sweet…


So now imagine our newly chartered bank, having a mere $1,000 in the cash drawer, suddenly has an accounting entry for a $100,000 asset as a result of a borrower signing a paper.  A corresponding liability for the same amount is created simultaneously.  And our bank’s books are balanced. There is both an asset and a liability, or a debit and a credit, for $100,000 on our books.  Mind you, our books are balanced before the borrower pays us a dime in principal or interest.    Think about that for a minute.

As a 21st century society, we should ask the question if our bank merits a 30 year stream of payments, at interest, for having done nothing but make an accounting entry. We did not loan money in the sense that we  typically understand it.  Our books were balanced before we made the loan, and after.  The $100,000 did not come from our cash drawer.  We still have all the cash we started with.  We risked nothing in this transaction.  The whole charade was just an accounting entry. Pretty good deal for our bank though, don’t you think?  As bank owners/shareholders. we will now collect interest payments for the nest 30 years.  Every month.

But then it gets better.  We conned the borrower into giving us a mortgage on their house, in exchange for making an accounting entry.  If they ever hit a rough patch, we will take their house and sell it , possible for much more than they borrowed.  If we were immoral bastards we might even secretly hope that they hit such a rough patch at some date in the future.

It took maybe 3 months of labor by semi-skilled laborers, and an accounting entry by our bank clerk, to build the house, yet our borrower is on the hook to work for 30 years before he can get title to the home. This my friends, is a racket.  Organized crime would be embarrassed to admit to this kind of activity.


But it gets even better (if you are the banker).  Our bank then sells the note our borrower signed and probably sells the mortgage as well.   Now we have significantly more than $1,000 in the cash drawer.   Let’s say we now have $70,000 in the cash drawer.  We then start the process all over again, with an upper limit of the amount we can loan greatly increased, since we have more cash in the drawer now. Maybe now we will loan some real estate developer a couple $ million – at interest.  Pretty soon my banking partner and I will start looking at buying new yachts or private jets…


Now that we understand that our bank did not actually lend any of our money, but created the loan, by making an accounting entry, does your feelings of the dynamics/fairness of “paying what we owe” to the banks change?    Do our borrowers really “owe” our bank anything at all?

Was not the book’s balanced before our borrower paid the bank a single dime?    Further, was it not the borrowers’ signature that created the money in the first place?  Then, whose “money” was it, that was supposedly borrowed?   The bank’s, or the borrower’s, whose signature created the money?


Food for thought.

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