One of the things I try to do here at Sector Ocho is educate my readers. We need to understand the game if we want to win the game. Also, it’s pretty boring to read nothing except another tale of the latest chimp out, crooked politician, or proposed gun control law. Let’s talk about something that’s misunderstood by many: fractional banking.
Many people think fractional banking means the bank can simply lend out at much money as it feels like, while just creating money out of thin air. That’s not the case. Any bank that tries this will soon find itself out of money. See the story of the Silicon Valley Bank. That bank allowed its reserves to drop too low, and when the FED raised rates, this caused the bank to run short of funds and triggered the bank to sell some assets at a discount in order to raise their liquidity so they could meet payment demands. When news of this got out, it caused a run on the bank. That is: depositors were afraid the bank was running out of money and rushed to withdraw their funds. Too many did this, and the bank collapsed.
A bank is in the business of buying and selling, just like any other. That business buys at a lower price, then resells that product (money) at a higher price. The price difference is caused by relative risk and cost. Let’s look at any other business to see how that works.
You pay depositors for their money at a low rate before lending it out to at somewhat higher risk to borrowers. You hold some of that money back just in case some of your depositors need some of their funds back at some point.
So how do banks seem to create money from thin air? The answer is they don’t. They take in your money, and lend the majority of it out to others. Your money still exists, but only as a ledger entry. Your actual money is no longer in the bank’s possession, it’s been loaned out to someone else. In that sense, the money loaned out and your deposit simultaneously exist, but only one of you can have it at a time.
If it helps, think of your money as being a suit. You don’t need a suit at this moment, so you hand it to the dry cleaner, who gives you a receipt for it. At any time, you can redeem that receipt with the dry cleaner, who will give you a clean suit and a little cash for your trouble. At the same time, people who need a suit can borrow one for a somewhat larger fee. Anyway, your suit is soon loaned out to someone else. When you need a suit, you hand over your claim ticket, and the dry cleaner hands you a clean suit and a couple of dollars for your trouble.
You have your suit stored at the dry cleaner, your claim ticket says so. Other people are wearing suits, so did the dry cleaner create suits from thin air? Of course not. You theoretically have a suit that you aren’t wearing, someone else has temporary possession of a suit that isn’t his, and everyone makes money from the arrangement in the meantime.
This system works well until the Yule Ball comes around and everyone wants their suits at the same time. To minimize the chances of this being a problem, the dry cleaner resolves to always have a percentage of suits physically on hand: usually between 10% to 30% of their suits are physically in the store at any one time. That way, if a depositor has a funeral, wedding, or job interview, they can always get a suit. God help that dry cleaner if people start to believe their suits are no longer safely deposited at the dry cleaner. Everyone will demand their suits back, but many of them are currently loaned out and not available. The dry cleaner just went out of business.
If you want to see how all of this is tracked, the balance sheet is a good place to start. You can read that here.
