FEBRUARY 11
Fractional Reserve Banking
Is Your Money Really in the Bank?
The Signal
Your bank balance is money the bank owes you, not a matching pile of cash stored in a vault.
The Reading
Yesterday we discovered banks can create new money when they make loans. But what stops them creating unlimited money? There are limits. Banks must maintain financial buffers, keep enough funds available for expected withdrawals and payments, follow banking rules and lend to borrowers they believe can repay. Banks cannot create endless loans.
Now consider your money. You work all week and receive $2,000. Your banking app says: $2,000. Where is it? There isn’t a box in the bank containing your $2,000. Your balance means: The bank owes you $2,000.
Once, monetary systems linked money to something physical such as gold. Today’s dollars aren’t redeemable for a fixed amount of gold. Your bank does not keep one dollar in physical cash for every dollar customers have deposited. There are rules about how much banks must keep available, but they hold far less physical cash than they owe customers.
Imagine 100 customers each have $10,000. Their accounts total $1,000,000. That doesn’t mean $1,000,000 in banknotes is waiting in the vault.
Usually this works because everyone doesn’t demand cash together. If enough people do, a bank run occurs.
Think this through. You worked for your money. You paid tax and saved what remained. Yet when requesting a large amount in cash, your bank may require notice, identification or ask questions. Authorities say these controls help fight fraud and financial crime. Those are legitimate reasons. But the bank doesn’t hold everyone’s money in cash.
You earned it. The bank owes it and the system works because everyone doesn’t ask for all of it in cash at once.
First Principles
Banks cannot create unlimited loans.
Your bank balance is money the bank owes you.
Banks don’t hold everyone’s deposits as physical cash.
Today’s Challenge
Today, you run the bank. 100 customers each see $10,000. Ten demand cash. Fine. Then twenty more arrive. Then fifty more saying “It’s my money. I want it.” You can’t give everyone their balance in banknotes. What do you tell them?
Now swap places.
You’re customer number 83. Your app still says: $10,000. The people ahead want theirs too.
How does your $10,000 feel now?
Tomorrow’s Signal
Credit Creation