Coffee Space

What is Fractional Reserve Banking?

I think for this, we will start with the Wikipedia article:

Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, and are at liberty to lend the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank. The country’s central bank determines the minimum amount that banks must hold in liquid assets, called the “reserve requirement” or “reserve ratio”. Most commercial banks hold more than this minimum amount as excess reserves.

This means that banks can operate on the majority of the cash customers have deposited with them, usually to perform operations that earn them interest and offer their customers interest on the amount they have deposited. They take into account some risk of their investment or loan going badly (and they are very good at this), and they have fractional reserve in place encase anybody wants to withdraw. Sounds good?

Note: At the time of writing, I can only find information regarding the Bank of England’s (BoE) foreign currency reserves. I have requested more information regarding this and will update if I learn more. According to a random reference in Wikipedia from 2017, the BoE holds $101.59 billion USD in an unknown breakdown of foreign currency, gold, etc.

The Problem

Consider the following: Joe Bloggs can sign up to one bank, get a loan (where customer deposits are used) and deposit this into another bank. That bank could then use this deposit to loan out money to another person.

This could happen through more complex means - Joe Bloggs may get paid for some resource by somebody who loaned this money, and then he deposits this into the bank. The link between bank to bank can be as complex a chain as it needs to be, but eventually that money ends back in another bank, maybe even the same bank.

Let’s play out a simple scenario, where Bank A has £100 deposited by some customer:

1. Unknown customer deposits £100 (in the form of gold) into Bank B.
2. Bank A loans Joe Bloggs £95, keeping £5 back to meet their minimal fractional reserves requirement of 5%.
3. Joe Bloggs now deposits that £95 into Bank B, either directly or through a chain of custody. Bank B now has £95.
4. Bank B loans John Smith £90.25, keeping back £4.75 to meeting their minimal fraction reserves requirements of 5%.
5. John Smith now deposits £90.25 in Bank A, either directly or through a chain of custody.

At this point, the banks are currently holding the following for their customers:

• Bank A - Unknown customer: £100 (deposited in gold), John Smith: £90.25
• Bank B - Joe Bloggs: £95

Only £100 of real value (gold) exists, and yet £285.25 is believed to be owned by customers. The money only exchanged hands 4 times, and has near tripled in supposed value.

Now you may say “yes, but they need to repay that loan and there is interest”. Sure, but that’s a problem for next month. This month, they are all going to buy a concert ticket. Normally this ticket would be £80, but because there is now more demand and limited supply, the ticket is £90. Unknown customer is left with £10, Joe Bloggs is left with £5 and John Smith is left with 25p. (The ticket company got 3x £90 instead of their normal price of 3x £80.) We have accidentally created inflation, with Unknown customer getting the worst deal - baring in mind that the interest on the money ‘in the bank’ will be less than these inflationary effects.

Now for the part that should scare the living shit out of you… This has being on globally for 50 or so years all over the world. The only people who have any real thing of value are those who have assets, not money in the bank.

How Does It Affect Me?

There is about to be a large recession, interest rates are raising rapidly. This means that big organisations such as governments with enormous amounts of debt will be unable to get loans, which they need to have just to pay the interest on the loans they already have.

Putting this back in the context of the previous scenario, if John Smith or Joe Bloggs is unable to repay their loan, Bank B and Bank A need to foot that bill, otherwise the money will not be there if Unknown customer wants to withdraw it. If the amount that the banks are liable for exceeds their reserve value, they have no options left.

In 2008, the UK government bailed out the banks to keep them afloat with high interest loans (despite a AAA credit rating) in return of shares, then the government sold the shares back, ultimately being a loss to the UK tax payer.

The real problem is, this time, the UK government has less borrowing power. It’s credit rating has dropped, it’s up to its eyeballs in debt that it cannot pay the interest for. There is nobody to help the banks when they fold this time.

In what will quickly become the largest and fastest contagion event ever, we will see bank and company one after another completely unable to pay their debts, or operate effectively as those who they rely on (for example in supply chains) have themselves folded.

The people who will really shit out are those currently with unfixed loans, or will have unfixed loans in the future. The interest rates will continue to rise and stay high until the system begins to balance itself. We saw only a small amount of this in 2008, but this will likely be much worse.

Finally

I hope I am wrong, I really do. This shit really keeps me up at night. This will negatively affect many people I know for many years, they may lose assets or properties over this. I have been warning for years since 2008 that this would come, and I suspect we are finally here.

In the face of complete economic collapse, I am unsure precisely how we recover. My initial suggestions are:

1. Fractional reserves of at least 50%, with a small percentage of that in foreign reserves that have a similar policy. The rest should be held in real assets, such as precious metals. The large percentage of fractional reserve prevents the same money being “recycled” too many times.
2. Governments should not have the possibility to spend more than they generate via taxes, they must under no circumstances burden future politicians with the debt they generate under their leadership. The only exception I might put on that is in the face of war, but it would need to be a direct threat to the UK itself.
3. There should be some checks to prevent loaning on the same money. We should at all costs avoid scenarios where loans exceed total assets held.
4. Each bank must allow for their reserves to be inspected if they want to be invited into this system. If they refuse they are blacklisted for some years. Better yet, a central bank (such as BoE) holds onto their reserves for them.

Anyway, they are just some initial ideas. Hopefully it does not become the case where people are looking at this article for ideas…