Now that you understand how simple banking works, let’s take a look at fractional reserve banking.
A very detailed look at this can be found in a document titled “Modern Money Mechanics” that was put out by the Federal Reserve several years ago. On the first page it states “the purpose of this booklet is to describe the basic process of money creation in a “fractional reserve” banking system.”
In layman’s terms, fractional reserve banking can be summarized this way:
The United States government decides that it needs some money, so it calls the Fed (Federal Reserve) and says “we need $1 million”. The Fed says “we will buy $1 million worth of bonds from you”. The government then creates some fancy pieces of paper and calls them Treasury Bonds. Then they put a value on the bonds of a total value of $1 million and give them to the Fed. The Fed then creates their own fancy pieces of paper calling them Federal Reserve Notes which also total $1 million. (remember, the Fed just created these out of thin air.)The government then takes the $1 million from the Fed and deposits it into its bank. As soon as the government deposit that money into its bank account it becomes US currency.
That just illustrates how money is created in a way you can understand. Since only 3% of US currency is coins and notes, all of this is done digitally with no paper being created at all.
This million dollars was created out of debt and nothing else.
So now $1 million is siting in the governments bank account….. This is where it gets interesting.
This money is now part of the banks reserves and, regarding bank reserves, according to Modern Money Mechanics, a bank must maintain the legally required reserves equal to a prescribed percentage of its deposit. It goes on to say the current regulations the reserve requirement most transaction accounts is 10%.
So let’s look at what this means regarding the $1 million that was created originally out of thin air.
The government takes this $1 million and deposited into is bank account. That bank is required to hold 10% in reserve or $100,000. The other $900,000 it has available to loan at interest. So instead of having $1 million in new money, now we have $1.9 million in new money. Also according to modern money mechanics, ” Of course, they (the banks) do not really pay out loans from the money they receive the deposit. If they did this, no additional money would be created. What they do when they make loans is to except promissory notes (loan contracts) in exchange for credits (money) to the borrowers transaction accounts.” As long as there is a loan demand and the bank has the reserve requirements as spelled out in Modern Money Mechanics, this process can continue with the $900,000.
So let’s say somebody takes the $900,000 and deposit into their bank. That bank then takes 10% or $90,000 and hold it in reserve and it has the remaining $810,000 available to loan…. and so on and so on and so on.
This process can be repeated over and over again such that $9 million can be created from the $1 million actually deposited.
Can you believe it???
Nine times the amount of money deposited in the bank can be created out of thin air!!!