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Fractional Reserve Banking -- a defense of the system.
from: http://www.primeronmoney.com/fractionalreservebankingdefended.html
The leading letters (a) to (n) below are put here to make communicating about this section easier. Such communication might be necessary because the simple system is not easy to understand without some deep thinking.
The Fractional Reserve banking system is actually simple -- but it is so counter-intuitive that it is very difficult to understand. It just does not seem possible that a bank can lend out ten times as much money as it has -- but that is the genius of the system.
When I first came across a discussion of Fractional Reserve Banking in Patman's book in 1964, I thought it was an outrageous system and some sort of a scam or rip-off designed to enrich bankers at the expense of the public by allowing the bankers to magically multiply their money. However when I closely read the laws and studied the system in about 2003 (I intended to open a bank specializing in reverse mortgages -- because no banks would make such loans in my community) I realized that the system has buit in controls and safeguards that make it perfectly safe for everyone; the bank, the depositors. the borrower, the banking system, the Government and the public. The only thing wrong with the system is that aside from Patman's book, there is no honest information that explains the system fairly --- see the following links. ((1) are we being lied to?) ((2) knowledge supression)
a) One good but often overlooked thing about having the bankers run the banking system is that if they lose money on bad loans -- that money theoretically comes out of the banker's pockets (simply because the bankers own the banks).
b) If the government ran the system and owned the banks -- all losses would come out of the pockets of the taxpayers. Of course what happened in the Money and Banking meltdown of 2008 shows that in any case -- the taxpayers will probably pay the bill for the losses caused by unpaid debts. In that 2008 case -- the government basically pumped taxpayer money into private banks and corporations, thus shielding them from losing money. That certainly seems to be, at least, a perversion of Capitalism -- if not Sociaism, or Statism, or some other ... ism we do not yet have a name for. Shall we call it Daddyism?
c) Most people do not realize that the basic Fractional Reserve System operating on (for instance) a 1 to 10 ratio of "reserves" to loans (the basic underlying system we use now) gives the managing or owning institution -- whether the Fed or Congress -- a system that has enormous leverage, both up-side and down-side built into it. For every dollar of capital invested by the owners of the system - those owners can make loans adding up to ten times the amount of the invested capital. In other words -- if a Federal Bank opens its doors with one million dollars of invested capital -- it has the right to lend out $10 million at whatever interest is currently in vogue.
d) And they actually have much more leverage than that. If a depositor deposits another $1 million with the bank -- the bank can lend out another $10 million. It turns out that there is no limit to how much each banker or the entire system can lend out. But do not think about that now -- it adds what looks like complications
e) The upside leverage comes into play because the bank can lend out 10 times as much as it has in invested capital. If it has $1,000 in capital and lends out $10,000 at 4% interest per year -- that $400 / year is a 40% return on their invested capital of $1,000.
f) I know that sounds impossible -- but it is the way the system works.
g) The downside leverage comes into play when, for instance, a 4% -- $1,000 loan goes bad (a borrower does not pay back the loan, and collateral can't be seized). In that case, the bank must call back $10,000 in loans ( so that its reserves are in accordance with the law) and lose the income on the $10,000/ In that case the loss of a $1,000 loan costs the bank $400 / year -- or 40% every year on that bad loan.
h) Originally, it must have been thought that the enormous leverage would work to keep the Bankers prudent, conservative and cautious. It appears that this was not a conscious decision of any group. As far as I can tell, it never appeared in print as a goal of the Fractional Reserve System. Patman often (show link?) points out that everyone in the know tries to keep the actual mechanism a secret -- but in any case the downside leverage built into the system, naturally and organically forced that prudent, conservative, cautious and very important behavior on the bankers -- because for every dollar of bad loans they made, they would have to call back TEN dollars of loans and they would therefor lose the interest on that 10 dollars. That loss was painful.
i) Somewhere along the line, it appears, and I believe, that three major things happened that messed up the system -- see (A) to (C) below.
(A) Bankers forgot the downside of the leverage and thereby took chances that were not prudent.
(B) The Government allowed, and even encouraged, (by setting up Fannie Mae and Freddie Mac) the banks to sell-off the loans they placed, thinking that would free up money and would allow the banks to make new loans. Whoever did that did not understand that the Fractional Reserve System works -- the banks do not need new money to make loans. They can prudently create whatever money is needed if they have a trustworthy lender with good collateral who has a reasonable plan to creat new wealth with the money in the loan. And why should it be otherwise?
(C) The Government did not know that the inherent control built into the Fractional Reserve System was important. They simply did not understand the ramifications of the system. They did not realize that an unintended benevolent consequence (that "control" of the previous sentence) was built into the sysytem. Unintended consequences do not always have to harmful -- lots of times (in evolution for instance) they are very valuable. Any good scientist, investigator, explorer or engineer knows this instinctively -- they are always on the alert for benevolent, unplanned results. Serendipity and fortutious accidents are very important (think of Christopher Columbus and Isaac Newton's apple). They may have led to more great discoveries than planned action.
j) I can find no authoritative or official mention of what I consider to be the fact that the Federal Reserve system, as enacted, is set up in such a way so as to rely on bankers being very cautious when making loans. There are no explicit words to that effect anywhere in the law as far as I know -- but the obvious result of the Federal Reserve mechanism shows that bankers must be cautious -- or they will wind up going bankrupt. There is enormous leverage built into the system and the result of that leverage is that losses are magnified by the system. Any intelligent banker must know this when he signs up to operate under the Federal Reserve system -- it is fairly obvious. This is an important reason why the Federal Reserve system can work and has worked for years. If however that point is not clearly made -- over time the bankers may forget that they are under enormous pressure to be conservative and they may take chances that have the potential to cause them great financial harm. In fact, I think the present (2008) money and credit problems in the U.S. are a direct result of bad loans and those bad loans are a direct result of the bankers simply not being careful when making loans.
k) Clearly, the paragraph immediately above represents my unvarnished opinion and is not herewith presented as fact -- I am not trying to completey prove that point here.
l) In my opinion -- if you do not understand the words in this text-block, you can't understand Fractional Reserve Banking. On the other hand -- if I am wrong on this -- I do not understand Fractional Reserve Banking. That is a possibility.