What Does Fractional Reserve Banking Mean for Your Finances?

Have you heard the term “fractional reserve banking” before but aren’t sure what it entails? Perhaps you’re wondering exactly what happens after you’ve made a deposit with your bank? Whatever reason you’re reading this article, we’re here to help answer both of those questions.

Here, we’ll run through reserve banking in more detail, dive into its history, and provide some of the advantages and disadvantages that this kind of banking has to offer.

What is fractional reserve banking?

You may be under the impression that banks have to hold onto 100% of customer deposits in reserves. However, that’s not actually the case.

Notice the fractional in fractional reserve banking? It’s there for a reason. See, fractional reserve banking is a banking system that requires banks to hold only a portion of the money you deposit with them as reserves. Your fraction stays with an account within the central bank, while the rest – and this may surprise you – is free to be invested or lent out by the bank.

So, rather than simply sitting there, small deposits are grouped together to make loans and earn the bank money. The remaining funds ensure that there’s enough to cover customer withdrawals.

For example, if someone deposits $1,000 in a bank account, the bank cannot lend out all the money. It is not required to keep all the deposits in the bank’s cash vault. Instead, it’s only required to keep 10% (or $100) as reserves. From here, it can then lend out the other $900.

The history of fractional reserve banking

So, how did this concept first come about? It’s never been fully confirmed, but some state that it originated through an unnamed goldsmith. Realizing he could lend out a portion of gold, and earn interest on it, the crafty goldsmith would then sneak it back into the reserves before anyone else twigged what he was doing.

Others point to the Early Middle Ages as the source of its origins. With people increasingly storing their money with banks, they wanted a simplified way of paying for goods and services. Rather than guaranteeing that you would receive the exact same coins that were originally deposited when a customer chose to withdraw them, the deposit balance acted more as an IOU.

By doing so, banks could then transfer coins from one account to another as a form of payment between two customers, rather than a customer having to withdraw their coins, pay a fee for the trouble, and hand the coins to the person requiring payment.

What are the pros and cons of fractional reserve banking?

The pros of fractional reserve banking

The system has its merits, namely more readily available credit, and the ability for banks to earn additional money for their reserves. In theory, customers will benefit from these additional reserves in the form of interest on their bank deposits.

The cons of fractional reserve banking

Fractional reserve banking can be something of a catalyst when it comes to inflation. The system gives rise to the money multiplier effect – the proportional amount of increase in final income as a result of an injection or withdrawal of capital. This increases the supply of money, which decreases the value of a dollar, which in turn decreases the US dollar’s purchasing power.

If everyone under a fractional reserve system attempted to withdraw their money at the same time, the system can easily collapse. Banks do not hold enough cash in reserve at any one time to supply people with all their cash when they need it.

These instances, known as bank runs, happen when a customer believes that banks are about to fail. In fact, it’s what happened during the Great Depression, with many people losing their life savings. We have this to thank for the creation of the Banking Act of 1933, which protects deposits in participating banks up to certain limits.

Likewise, if banks recklessly lend their money out, as in the case of sub-prime mortgages, money may simply never be repaid, as unqualified borrowers default on their loans. This can cause recessions to take place, as it did in 2008. Bear Sterns lent excessively more than they had in their deposits, while over in the UK, Northern Rock did exactly the same.

The relationship between fractional reserve banking and the gold market

In the same way that your monetary deposits are affected by fractional reserve banking, so too is gold – if it’s held in an “unallocated” account. So, while it’s safely locked away from thieves in a well-protected bullion bank vault, it’s still subject to the same risk as your cash is – meaning that only a fraction is only immediately available for withdrawal.

Allocated gold like the gold offered by Glint, on the other hand, is exempt from these effects. That’s because you genuinely own it. It’s allocated to you, and the gold is held in allocated storage under a custody agreement.

That means banks or financial institutions are unable to lease out your bars for the simple reason that they don’t and can’t have access to the allocated bullion. That’s not all: if you buy gold through Glint, then you’ll only be paying for the actual amount of gold that you want.

As a result, you can rest assured knowing that your gold is free from the risks of fractional banking, and any sneaky thieves who may be lying in wait to make their move. And since you own the gold, it can be used to make the same everyday purchases online and in-store, from something as small as a cup of coffee to your next vacation!

At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.

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