What Is "Fractional Reserve Banking?"

What Role Did The Goldsmiths Play? Writings by Richard Kotlarz

Column #46 THE FRACTIONAL RESERVE OF THE GOLDSMITH BANKER

(Week 8 – Thursday, Sept. 18)

The mode of banking now in use is commonly described as “fractional reserve banking.” The expression “fractional reserve” is one that is carried forward from an earlier form of the craft known as “goldsmith banking.” As applied to modern practice, this expression is a misnomer that effectively obscures any true understanding of how our present monetary system operates, and why it is currently in such distress. To get a clear picture of this, it is first necessary to gain an understanding of what “fractional reserve” originally meant, and then how the concept has been misapplied.

In Europe of the 15th century there were many smiths that worked with gold, and therefore required vaults to securely store this precious material of their craft. Over time citizens and merchants that owned their own gold and used it in trade found the metal to be inconvenient and hazardous to keep in their personal possession. Consequently goldsmiths engaged in the sideline business of storing people’s gold in their vaults, and issuing a receipt for the storage.

These receipts began to circulate as a currency with tradable value, as if they were the gold itself, and so became a form of paper money redeemable in gold. As payment the goldsmith charged a percentage of the value of the gold stored.

The goldsmith noticed that under normal circumstances only a very small percentage of his customers at any given time would redeem their receipts (i.e. take possession of their gold). For long periods the great majority of their metal merely gathered dust in his vault. At length it occurred to him that he could write more receipts and offer to “loan” the gold he was entrusted to hold to others, with an “interest” charge attached of course. In actuality he had nothing to loan because the gold already belonged to another customer, but who would know the difference. He could, in effect, profit on gold that he had, in a figurative sense, “created out of thin air.”

The key to making this scheme work is that he would need to limit the amount of receipts issued such that the gold that he had on hand would, in the normal course of business, represent at least a certain “fraction” of the face value of the outstanding paper claims against it. This gold on deposit, then, would act as a “fractional reserve” that could be dipped into in the event that he experienced an unusually high demand for redemption at any given time.

The goal of the whole arrangement to the goldsmith was to issue as much “interest-bearing” paper as he dared against the stock of gold in his possession (thereby maximizing his income), while guarding against the possibility that the day might come when he would not be able to redeem with gold a receipt that was presented to him.

At first the scheme was a trade secret. As its workings became an open secret, many people regarded it as simple fraud, but others deemed it a necessary way to get the quantity of medium into circulation that a growing commerce demanded. In any case, the populace was eventually obliged to accept the goldsmiths’ methods as the accepted way of doing business, or effectively forego much of its money supply.

By this mechanism the goldsmiths effectively began to operate as “banks-of-issue” (banks that create and issue money), and “fractional reserve banking” was born. The scheme worked well as long as there was not a “run on the bank”; that is, a rush by depositors to redeem their receipts for the gold because they had lost confidence in the institution.

As a sidebar to the goldsmith-banker story, it bears mentioning that this group has borne a great onus in the historical reckonings of many would-be monetary reformers. It is easy to find good reason for that assessment, but the whole story is not so simple. It could be argued that they were in effect coming up with a money–creation mechanism that did in fact put a great deal of currency into circulation in an age when that was sorely needed for its own inherent reasons. They operated in a time when the society itself did not have a sufficient sense of the science of money to create an adequate system in the public sphere where it rightly belongs (the same might be said of the situation with respect to money and banking that we find ourselves in today).

Were the goldsmiths simply a class of scam artists, or were they people who saw an essential need of the society around them and found an innovative way, however imperfect, to meet it? The answer presumably is both, and all degrees in between. They were, after all, people. Many deem the legacy they left behind as threatening the demise of civilization. It could also be argued, however, that had they not initiated such a practice, the evolution of Western society would have been seriously hindered. I leave that question to the reader’s judgment.

In tomorrow’s column we will begin to examine how a pseudo version of the goldsmith’s method, recreated in our time as the “fractional reserve system,” has planted the seeds of the present collapse of the financial sector.

Column #47 “FRACTIONAL RESERVE” IN MODERN BANKING

(Week 8 – Friday, Sept. 18)

In yesterday’s column I described how the 15th century goldsmith banker held a minimum quantity, “fractional reserve,” of gold in his vaults, relative to the much greater face value of the receipts or claims for that gold that he had issued, to serve as a hedge against not being able to redeem a receipt in a time of unusually high demand (which would signify his operation’s bankruptcy). I also asserted that a pseudo version of the goldsmith’s method, recreated in our time as the so-called “fractional reserve system,” has planted the seeds of the present collapse of the financial sector.

The “fractional reserve system” of the modern banking era operates according to a formula that defines two-levels of money creation, the second being constructed upon the foundation of the first.

Level 1: “High-powered money” is the bankers’ term for money created and put into circulation as a result of “borrowing” from the Federal Reserve itself by our Federal government.

Level 2: “Credit money” is money which is created and enters into circulation through the private-bank-loan transaction by which participants in the economy (except the Federal government) “borrow” money from private banks.

Creation of “High-Powered Money”:

When the Federal government determines that it needs to “borrow” money, the Treasury Secretary (or his agent) approaches the Fed, and asks for a loan. The Fed agrees to “loan” the money, but requires security (collateral) in the form of bonds offered by the Federal government and signed by the Secretary of the Treasury.

The government prints and delivers the bonds to the Fed in exchange for newly created dollars being credited to its account at the Federal Reserve. These bonds, then, act effectively as “loan contracts” between the government and the Fed. It is critical to note that the Fed created this money out of nothing (“thin air”) at the moment it credited the account. In addition, the face value of the bonds (the value printed on their face indicating the amount due the holder upon maturity) is much greater than the amount of money the government “borrowed.” This is due to the “interest” charges which accrue from the date the bond is issued to when it is redeemed (paid off).

As the Federal government spends these new funds they end up on-deposit in the bank accounts of those contractors, builders, suppliers, service providers, employees, etc. to whom the money was paid.  For purposes of this illustration, let us ignore the relatively small amount that circulates as pocket cash, and assume that all of it winds up on deposit in the banking system.

This new money “borrowed from” (in actuality “created by”) the Fed and on-deposit in banks is referred to as “high-powered” money. The total quantity of high-powered money on deposit in the banking system, combined with a number known as the “fractional reserve ratio” mandated by the Federal Reserve Board of Governors, determines how much “credit money” the banking system can create through the bank-loan process. The formula that governs the procedure works basically as follows.

The “Fractional Reserve Ratio”:

Let us assume that the “fractional reserve ratio” has been set by the Fed at 1/10 (10%). In mathematical terms, this means that the banking system as a whole (The Fed and the private banks it oversees combined) have the potential of creating an amount of money that is the quantity of high-powered money on deposit, times the inverse of the “fractional reserve ratio.” If the ratio is 1/10th, this allows the banking system to create overall an amount of money which is a multiple of the inverse of that number (i.e. 1 ÷ 1/10), which equals 10.

Simply put, this means that if borrowing and spending by the Federal government causes a billion dollars of “high-powered money” to be created and put on deposit in the banking system, the private banks can use this billion dollars as a foundation (“fractional reserve”) to create another nine billion dollars of new “credit money.” The total amount of new money, “high-powered” and “credit,” that can be created through this process, is equal to what the Federal government “borrows” and spends into circulation, times ten (in this case, ten billion dollars).

Creation of “Credit Money”:

To show how the process unfolds, let us suppose that $10,000 dollars of high-powered money has wound up on deposit in a given bank. The banker at this institution has thereby gained $10,000 dollars in new “reserves” against which he can create new money to “loan” out. The question is, how much can he create?

Since the banker in our example has $10,000 dollars of “reserves” on deposit, he can create up to $9,000 dollars in new money to “loan.” Let us suppose that someone comes in and asks for a $9,000 loan, and his application is approved. The banker writes a check for (or electronically credits an account in the amount of) $9,000 dollars, and gives it to the “borrower.” According to the way bankers think about this process, the banker in our scenario has just “loaned out” $9,000 dollars, and has, as required, left $1,000 “in reserve” as a hedge against the bank becoming “insolvent” (i.e. going broke).

At first glance, the process described in the above paragraph looks very much like the method the goldsmith banker used to protect his bank from becoming insolvent. Common sense dictated that he keep in reserve in his vaults an amount of gold which represented a reasonable percentage (fractional reserve) of the face value of gold receipts he had issued that were circulating as money in the economy, as a hedge against an unusual level of demand for the redemption of those receipts by his clientele who, overall, had been “loaned” the  same gold several times over.  Similarly, the rule governing modern banking which requires banks to keep in “reserve” a certain “fraction” of their money when they create loans, would seem to be a common sense measure to provide a margin of insurance against the possibility that the banks might find themselves in the position of not being able to redeem their depositors’ accounts for cash at the teller window.

These two scenarios have, upon cursory look, a very similar appearance. If one examines more closely what is really happening, however, it will be found that these respective processes are very different, and have, not similar, but virtually opposite effects.  The fractional reserve practice of the goldsmith banker lent a measure of stability to their system, but the so-called “fractional reserve” formula of modern banking is the very source of its chronic instability.  In tomorrow’s column we will continue with the description of how the “fractional reserve formula” unfolds, and take up the thread of how it is at the root of the collapse in the financial markets at present.

Column #48 THE “FRACTIONAL RESERVE FORMULA”

(Week 8 – Saturday, Sept. 20)

Two columns ago I described how the goldsmith banker of the 15th century initiated the practice of keeping a quantity of gold in reserve in his vaults which represented a fraction of the outstanding receipts that he had issued against that gold (and which now effectively circulated as money). This fraction was determined by the size of reserve he deemed necessary to be reasonably certain that in the normal course of business (apart from a “run on the bank”) he would have enough gold on hand to redeem any receipt for it that was presented at the teller window.

Yesterday I described the first steps of the “fractional reserve” mode of money creation used in modern banking, and asserted that it is superficially similar to the fractional reserve method of the goldsmith banker in that it requires the banker (in the language of the profession) to keep in “reserve” a quantity of money that is at minimum a certain “fraction” of what he is giving out as “loans,” as a hedge against the bank becoming “insolvent” (going broke). Anything “reserves” beyond that level are called “excess” (i.e. “reserves” upon which new money could be created, but has not yet been).

Note that in each of these processes the banker is essentially creating new money; the goldsmith when he is writing out multiple claims against a reserve supply of gold in his vault, and the modern banker when he is writing out a check against a “reserve” supply of paper or electronic deposits of money in his bank.

Despite what may seem like close parallels between these two processes, they are fundamentally different, and have opposite effects.

The goldsmith banker is in possession of an actual reserve supply of something (the quantity of gold in his vault) that can be dipped into to stave off catastrophe in a time of emergency (much like a reserve of grain can stave off starvation during a drought). Catastrophe in this case would be defined as the goldsmith running completely out of the precious metal, with the result that he could no longer redeem at his teller window a promissory note he had issued that said the bearer was entitled to receive his (the note bearer’s) gold. In this event, public confidence in his operation would collapse, notes still outstanding would become worthless paper, and his business would be declared “insolvent” or “bankrupt.” It should be noted, however, that this would not have transpired until his reserve of gold was completely exhausted.

The modern banker is not in possession of any such reserve supply of something that he can dip into to stave off catastrophe in a time of emergency. His “fractional reserve” is a bookkeeping illusion. In yesterday’s column I described how if a banker has $10,000 in “reserves” on deposit in his bank reserves, he is allowed to create $9,000 in new money to “loan” out.

In the idiom of the banking profession, of this $10,000, the banker has loaned out $9,000, and kept $1,000 “in reserve.” Note, however, that none of the original $10,000 of “reserves” on deposit is actually loaned out. It all remains on deposit. The status of the $10,000 has changed only in the sense that this particular $10,000 has now been spoken for as the baseline of money on deposit that the banker could use to create $9,000 in new money. To speak as if $9,000 was loaned (as if some money on deposit was lent to someone and left the bank), and $1,000 kept “in reserve” (as if it were in any way comparable to the tangible reserve of the goldsmith banker) is to mutter nonsense.

According to the rules of “fractional reserve” banking, if the person who had that $10,000 on deposit came to the teller window and withdrew it, the $9,000 that had been created using it as a baseline would now be unsupported. If the owner of the $10,000 withdrew even a small part of it, say $100, that would mean that 9/10 of $100 ($90) would be unsupported in their formula, and a way would have to be found very quickly to either “call in” (cause to be repaid) $90 of that loan, or find $100 dollars in new “reserves” (money that was not yet designated as supporting newly created money on top of it).

If a modern bank dips into its “fractional reserve” for even a single dollar, the formula by which it is governed is violated, and the whole fragile structure by which it creates “credit money” comes undone. This singular fact transforms what should be among the social order’s most stable institutions (banking), into a game of brinksmanship by which, in the pursuit of their mandate to maximize profits, bankers are obliged to come as close to “needing” to use their “fractional reserve” as possible, while knowing that if they miscalculate and step over that line their bank will instantly “fail” (be declared “insolvent”). The banking system as a whole has been moving ever closer to the “fractional reserve” tipping point, has gone past it, and can no longer stop its own fall. That is why the Federal government is, in people’s perceptions, being obliged to step in.

Column #49 THE “FRACTIONAL RESERVE” PYRAMID

In yesterday’s column I gave a brief description of how a banker who has $10,000 in “reserves” on deposit in his bank can use them as a basis for creating $9,000 in new money to “loan” out. When the borrower spends the money, almost all of it winds up in the bank accounts of the people he pays it to.

To keep the math simple for our illustration let us assume that our borrower spends all the money in one place, and the entire $9,000 ends up on deposit in one bank. From the perspective of the banker at this institution this newly borrowed and spent money is regarded as $9,000 dollars in “fresh reserves.” In other words, he can use this $9,000 as a basis for creating yet more money to “loan.”

Let us suppose another person walks into the office of the banker in whose bank the $9,000 in “fresh reserves” has been deposited, and asks to borrow some money. Based on the $9,000 that has just been put on deposit in his bank, he can now write a check for newly created money to lend to this new borrower in an amount up to $8,100 ($9,000 times 9/10), leaving, as the banking system describes it, $900 ($9,000 times 1/10) as a “fractional reserve.”

The person with whom he spends this newly created $8,100 will presumably deposit it in his bank account, and this deposit will be seen by his bank as $8,100 in “fresh reserves,” upon which, in turn, this banker will be able to create another $7290 ($8,100 times 9/10), and leaving an additional $810 dollars ($8,100 times 1/10) “in reserve.”

This process can continue for many successive cycles as new money created and loaned out by one bank is deposited in another, where it is seen as fresh reserves that can be used as the basis for creating yet another round of money to loan. For each cycle the amount of new money created and fresh reserves deposited diminishes in proportion to the fractional reserve ratio. In the long run it approaches “0”, but it never quite gets there. The amount does, however, become so small that the procedure does effectively provide a limit to how much “credit money” can be created from the quantity of “high-powered money” originally borrowed into existence from the Fed by the Federal government, which ended up on deposit in the banking system, thereby seeding the fractional reserve process.

It may be helpful for the reader to visualize the monetary system as a pyramid. The foundation stones of the pyramid are Federal bonds, which are essentially the “loan” contracts by which the Federal government borrows money from the Fed, and which winds up on deposit (as “high-powered money”) as the initial “reserves” in the banking system. The first cycle of “credit money” created by a bank and then deposited in the banking system forms the next course of blocks in our pyramid. From there, each cycle of new money created through the loan process, and deposited in the banking system is represented by successive courses of stones. Each course of stone is shorter by the fraction represented in the fractional reserve ratio (1/10 in our example), so the lengths of the courses (the amount of new money that can be created and re-deposited as a fresh reserve base) are never quite zero. This suggests the image of a pyramidal-shaped wall with ends that slope towards each other, but also curve in such a way(asymptotically) that they reach for the sky, but the slopes never quite meet. The fundamental shape imparted by the fractional reserve ratio gives this pyramid an appearance that is relatively tall and slender, so much so perhaps that it is suggestive of a degree of instability.

Still if the courses of stone are sound, the structure might stand. The problem is that in monetary terms, the courses are not sound; they are crumbling. This is because they are being eaten away by “interest” charges against the money supply.

If a person takes out a bank loan and spends the money into circulation, the value of those dollars (the stones in our monetary pyramidal wall) are, from the moment they are issued, beginning to be eaten away by the interest charges on the loan. For example, suppose a person borrowed and spent $100 from a bank. He has thereby added $100 dollars to the money supply. There is, however, an “interest” charge attached to that money that is accruing as long as that $100 is in circulation. Because this “interest” charge in practical terms constitutes a net subtraction from the net value (amount of money) realized from that loan, it is effectively eating into the principal proceeds of the loan that brought it into being. Given enough time, the monetary value of the loan will be fully consumed (e.g. $100 will still be owed, despite $100 or more having already been paid in, as is typical in a revolving credit scheme).

Looking at the face of the wall, one sees a shape that resembles a pyramid, but one that is fundamentally unstable because the courses of stone of which it is composed (the bundles of dollars that are created and put into circulation via bank loans) are crumbling (being eaten away by “interest” charges). The present monetary system is the ultimate “pyramid scheme” (new “debt” money attracted to the scheme by old “debt” money). One can scramble to find new material to repair the growing holes in the blocks (find new borrowed money to “bail out” the financial interests whose bundles of money are “invested” in the lower courses of the wall), and thereby attempt to save the wall itself (keep the monetary system from collapsing), but patching can be effective only for so long. Ultimate collapse is inevitable.

For one with eyes to see, this is precisely the image, I would suggest, of what is happening with our monetary structure at present.

Read More at www.richardkotlarz.com

Note: Richard gave this book to my father, originally. Zarlenga and Kotlarz were close friends and shared “poetic space” about the lost/obscured/distorted history of money.

I am just trying to say we don’t know what we don’t know.

I intend to read the whole Zarlenga book, in 2023.