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Fractional Reserve Banking: How to Create and Destroy Money

"The key function of banks is money creation, not intermediation." — Michael Kumhof, Deputy Division Chief, International Monetary Fund

In November 18th's remarks I wrote a piece on Quantitative Easing and its implications regarding the money supply and inflation. I received lots of feedback and would like to say thanks to those who took the time to write in. The additional questions posed were very insightful and show there is substantial interest in understanding these concepts in greater detail.

The following piece delves deeper into bank lending and its function as the primary driver of expansion and contraction of our monetary system.

This is going to sound harsh, but any discussion about economics is pointless without a fundamental understanding of the fractional reserve banking system on which our economy is built. The intricacies of this system have profound implications on everything from the money supply to credit market health to price stability and even whether reversion to a gold standard is possible. We're going to start small and lay a foundation of knowledge from which we can then explore some of the these controversial topics.

Jumping right in, fractional reserve banking is the practice where bank deposits are backed by only a fraction of the total deposits. This system predates the formation of governmental banking authorities and regulations. It originated from the practices of early bankers, after they realized that depositors typically do not all demand payment at the same time.

Fractional reserve banking is thought to have evolved through the observations and actions of goldsmiths. Before the advent of central banks, goldsmiths assumed a role similar to depository institutions. They would accept gold and silver for safekeeping and provide a "note" as proof of deposit. These notes slowly gained acceptance as a medium of exchange, thereby acting as a form of paper money. Goldsmiths soon realized that their outstanding notes would not all be redeemed at one time, and began looking for ways to earn extra income from the deposits. As goldsmiths began investing their deposits, they soon ended up with more issued notes than redeemable gold, and the concept of fractional reserve banking took form.

As we're going to see, money in our modern banking system has the ability to multiply through bank lending. Each time a loan is made, money is created. Out of where, you may ask? Out of thin air. Most people would attribute this feat only to the Federal Reserve, but in actuality, every bank does it with every loan they make.

To begin, we'll need to understand what a reserve ratio is. The reserve ratio refers to the amount of reserves a bank must retain based on the value of deposits held at that institution. The reserve ratio varies across different categories of deposits and the transactional volume of institutions. For most standard deposits at large banks, the reserve ratio is currently 10%. This means that if a particular bank has $1 million in deposits, it must hold $100,000 in reserves, either as vault cash or on deposit with the Federal Reserve. The other $900,000 worth of deposits are considered the property of the bank, and the bank can use these funds for profit making activities like investing or lending.

Let's walk through a hypothetical example to show how the act of bank lending creates new money. Say that person A has $100 dollars in cash and decides to deposit this money into a bank. The bank has a reserve ratio of 10%, and so it must keep $10 in reserves but can loan out the other $90. Let's say the bank makes a $90 loan to person B.

Time to stop and recap what just happened. Person A originally had $100 cash and consequently $100 worth of purchasing power. When person A deposits this money into a bank, they still have $100 in purchasing power. The bank then loaned out the $90 that it was not required to hold as reserves and this money went to person B. Now person B has $90 worth of purchasing power, and person A still has $100 of purchasing power. Money was just created.

In the micro economy of our example, $100 in original purchasing power has just turned into $190 worth of purchasing power. The amount of money in the economy that is able to chase goods and services just increased as a result of bank lending.

Taking this forward another step, let's say person B pays this $90 to person C, who then deposits it into a bank. This could be the same bank or a different one, it doesn't matter. The bank must keep $9 of this new deposit (remember 10% of $90 is $9) and can loan out the remaining $81. If the bank lends out the $81, the money supply in the economy grows again. What started as $100 that was available to chase goods and services has grown into $271 of purchasing power ($100 + $90 + $81).

This process can continue over and over as the money is redeposited into banks to be loaned again. If this process continues to its maximum, the original $100 can grow into $1000. Notice that this relationship between the initial deposit and the maximum growth is a factor of the inverse of the reserve ratio. A reserve ratio of 10% allows a deposit to grow into 10 times as much money. What we have just described is the "money multiplier" model. An initial sum of money has "multiplied" through bank lending.

If you understand the concept outlined above, you should already be questioning some long held views on money creation. I must warn you, however, that the rabbit hole of commercial bank money creation goes much deeper than we have covered so far. This idea of a reserve ratio and banks waiting for customers to make deposits before lending is somewhat misleading, but it provides a foundation of thought on which we can build. Although the true mechanisms of money creation are more complex, it's important to understand this model because it is still taught at universities, believed by many economists and employed in the policy making decisions of the Fed.

[Hear More: Steve Forbes: The Federal Reserve Leadership Has No Idea What They're Doing

We're going to crawl further down the rabbit hole in an upcoming column, but for now we'll keep things simple and tie up some loose ends.

You've seen an example of how money is created, and may be wondering how money is destroyed. If the act of lending creates money, then it should follow that money is destroyed through repayment and/or default. Both of these operations reduce the amount of purchasing power in an economy. By the way, we have a handy term for the destruction of money, it's called deleveraging. While deleveraging is often not thought of in this way, its impact to the economy as described in this manner is accurate.

To help illustrate, let's take a brief look at what happened to housing during the financial crisis. On the way up, increases in home prices were driven by a massive expansion of credit. Homes sold for higher and higher prices because banks were willing to lend larger and larger amounts against these homes. The money in the economy expanded dramatically, and as it chased real estate, we experienced the equivalent of home price inflation. During this period, the amount of leverage, or debt, increased dramatically as a result of commercial banks creating money.

This all came tumbling down when homeowners' debt levels had expanded to the point where they were unpayable. Consumers had effectively leveraged up beyond their capacity to pay, and the only thing left to do was default and deleverage. As lending slowed and defaults began to rise, the destruction of money outpaced the creation of money. This is what led to the deflationary environment that occurred during the financial crisis and is still in play to a small degree today. Less money in the economy means prices of assets have to fall, and fall they did. Home prices plummeted as did prices of other goods across the board.

In sum, bank lending is the primary driver of monetary expansion and contraction. As illustrated, the creation of money is not confined to the actions of the Federal Reserve. Each one of us has participated in the creation and destruction of money in some way or another, aided by the underlying fractional reserve banking system.

We have only explored the tip of the iceberg and will continue to work our way towards a more detailed and accurate understanding of the dynamics at work within our economy. The next piece will build on this basic understanding of commercial bank money creation and discuss how the Fed's policies may be inappropriate for the task at hand.

As always, Readers are welcome to email any questions or comments.

The following is an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()