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Fractional Reserve Currency

Fractional reserve system

There is so much wrong with the current way of managing the money supply, will try to break it down into components. There are many alternatives to the Fractional Reserve system. I am quite surprised to get that question from you, but great question. Have been looking into the banking system for about 5 years, so will try to answer with as much as I know.

The system of fractional reserves means that for every unit of currency that the lender receives, they can re-lend out a % of that again.

So if there was $100 printed in the economy and only one bank that must keep 10% of the money it receives in reserve, that means there will be up to $1000 circulating in the economy. 
($100/10% = $1000)
($900lent out +$100 reserves)   

Table xxx
Reserve asset ratio effects

Why can banks/lenders do this

The banks can do this because the government generally sets a monopoly on the production money supply(legal tender). This is usually done by a central bank. The Central bank doesn't want to be in the business of direct lending as it is risky. So they lend to retail banks to lend out on their behalf. Because all the money enters the money supply this way, all money is debt. The cash you hold is an obligation and not an asset, all money is owed back to the central bank.

In order to get the banks to lend, they have to make it worth while to do so. So the central bank lends the money to the retail banks as low interest rates. In addition to this, the central bank allows the retail banks to use fractional reserve banking to create extra money to enhance their margins. 

So what's the problem with Fractional reserve system?

  • The retail banks must pay the central bank interest each year, so the central bank must always create more money in order for the banks to pay them this interest.
  • Once a retail bank has a reserve requirement of say 10% , its very hard to change that to 20% as the retail bank will have to call in loans it has lent out, putting businesses under stress. 
  • Moving to a lower reserve requirement causes inflation.
  • The central bank has to manage the risk of retail banks having too low reserves(financial crisis) and having too high (money that could be used to stimulate economy). Central banks quite often gets this wrong, then blame the retail banks when it does.
  • The central bank doesn't like to lose money, so insures the deposits of the of depositors and when there is a financial crisis the taxpayers bail out the retail banks instead. Meaning the public pay.
  • The deposits of the depositors are insured, so the depositors don't care which retail bank they deposit their money in, which means that retail banks can engage in risky behaviour and depositors will keep funding them.

Minimum capital ratios

Having minimum capital rations for banks and guaranteeing the banks debt makes no sense.

Subpages (1): Inflation