Financial Education

What Is Fractional Reserve Banking?

July 1, 2021

Have you ever wondered what makes a “run on the bank” possible, or how banks make a lot of their money?

A run on the bank, amongst numerous other activities, is made feasible via fractional reserve banking. 

Fractional Reserve Banking

So, what exactly is fractional reserve banking?

First off, let’s back up. Did you know that banks can loan out more money than they physically have in their vaults? This is because they are only legally obligated to reserve a certain fraction of the funds that are deposited by their customers. Thus the term, “fractional reserve banking.” Although this percentage varies from bank to bank, let’s say, for the sake of example, that the percentage is 10%.

Essentially, this means if you deposit $1,000 into the bank, they are legally obligated to keep at least $100 (10% of 1,000) physically in the vault.

What do they do with the remaining $900? They loan it out to business owners, investors, new home-owners, and basically anyone who desires a loan to finance a purchase. This is one of the ways banks make their money - charging interest on loans. 

But this is nothing new so far. It’s the trade-off that banks offer: they keep your money safe, and in exchange, you allow them to loan it out to various investors and leverage it for profit.

The issue comes into play when banks start creating money out of thin air.

Yes - they can do this - and it’s sadly legal.

Here’s how it works:

You loan the bank $100 of your hard-earned money. The bank then has a reserve of $100 in their vault. This technically means, if they keep all of your money in their vaults as a reserve, that they can loan out $1,000 legally, since they will have the required 10% on hand from your initial deposit. 

In short, $900 got created out of nowhere and loaned out to collect interest for the bank.

This would be a good time to explain a “run on the bank.” A run on the bank occurs when all individuals who have their money sitting in a certain bank all come and demand their money at the same time. This, obviously, is an issue because banks rarely (if ever), have all the money that was entrusted to them on hand at a single moment’s notice. 

For example, let’s say you owned a car that you were trying to sell. Someone comes up to you and wants to buy the car, but only wants to drive it on Saturdays and store it at your house the rest of the week. The paperwork is drawn and this individual now owns the car outright. The only thing is it’s being stored at your house for 6 out of 7 days in the week.

Now, what’s to stop you from selling the same car, at full price, to 6 other people on the same terms? So that every day of the week, a different person “owns” the car, but they each paid full price and think they are the sole owner of the car? 

You’d get in a lot of trouble if any of them came to you at the same time and demanded their car on the wrong day.

Normally that would be called theft, and would be considered illegal; however, banks are doing that today all over America with no consequences.

Fractional reserve banking contributes to the issue of inflation, which occurs when the money supply is artificially inflated. One avenue of inflation is government-printed money, but another source is fractional reserve banking and banks loaning out money that simply does not exist. 

What Can We Do?

With all that said, let’s look at a few ways you can hedge against inflation and beat the financial system that seems to be stacked against so many citizens. 

First, it’s common practice to invest in assets that will not depreciate over time (that are “inflation-proof”). Many choose to invest their funds into precious metals such as gold or silver, and also in cryptocurrencies. 

Gold and silver are considered “inflation proof” because they are metals that are durable, not easily destroyed, and cannot be created. This makes them excellent candidates for a viable, non-inflatable, currency. 

Crypto was created with this concept in mind, but aimed to solve some of the major issues gold presented. For instance, gold is heavy and not easily transported, and many people over the years have tried to scam others by shaving off parts of their coins to create more coins, or diluting the gold and therefore artificially inflating its supply. With crypto, this is impossible due to its digital nature. It’s also easily transported since you only need a device (such as a mobile phone) to move funds from one place to another. 

Second, we can continue to spread the word and educate others! We can’t solve a problem we are unaware of. Ultimately, we share this educational information not to bring about despair, but to create awareness and visibility into an important issue in today’s world.

You can spread awareness by sharing resources such as blogs, YouTube channels, or public forums (feel free to share our blog or YouTube channel as well)! If you’re able to write or create content yourself, that would be another excellent way to educate those around you.

However, the best and most effective way to spread the word on anything is word of mouth. Having conversations around this topic on a regular basis helps in more ways than you can know! You never know the ripple effect you can have on someone by just sharing your knowledge and discussing potential solutions with others. This is especially important to do with our children, as they are the next generation.

We are so glad to have such an amazing community here at Digifox that cares about creating a better financial future for all, and we look forward to seeing it grow in the years to come!

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