Fractional Reserve Banking Lessons For Investors

 
In a discussion we were having at our Wealth School Cashflow meeting last month, the topic of fractional reserve banking came up. Although you can be an investor without understanding economics and monetary policy, it is a good idea to have some knowledge of how the economy works – it will give you a bit of perspective on why we see the ups and downs of the economy, and why banks are so precious about getting their hands on our cash!
So today we will look at Fractional Reserve Banking and what it means for investors.

 
 
Have you ever thought about how a bank works?
When we are growing up, most of us are encouraged to save money, after all this is important. As a kid we opened up a kids bank account and got paid a high interest rate on our savings. Even today, some banks offer “bonus” 10% interest and no bank fees for kid’s savings. Try getting that kind of interest rate with no risk and no restrictions from a bank as an adult!

 
(Encouraging kids to save and deposit in banks, by offering limited-time high interest rates is perhaps a way of establishing a good relationship from an early age, in an effort to encourage continued patronage as an adult – not dissimilar to “Happy Meals” and “Birthday Parties” at fast-food chains. However we digress…)

 
The reason why savings for banks is so important, is that banks regard your savings as a “low interest loan”, which they borrow against to loan the money to someone else. Most savings account interest rates range from 0.1% to around 5%PA. This money can then be lent for homeloans (7% plus interest rates) or credit card loans (20% plus interest rates) and you can start to see where banks make some of their money.
However, this is only half the story, as we haven’t got to the “fractional reserve” part of things yet.

 
 
Fractional Reserve Banking

 
When a bank loans your savings, they won’t loan the whole amount – after all, what if you came in the next day to withdraw your cash? They have to be able to repay it. However they also won’t keep the whole amount. A bank will keep a “fraction” of the savings / deposits they are entrusted in reserve (eg 20%) and they will lend the rest.

 
The magic happens when the money that is lent is spent by the borrower, and re-deposited by the person who receives it from the borrower, in another bank allowing the 2nd bank to lend a fraction of this amount again, and so-on. However, the original full deposit amount is still “available” for redemption to the person who first deposited it. Through this system, a $100 deposit could be expanded into $500 or $1,000, depending on how much reserve needs to be kept.

 
This system works so long as not everyone requests their deposited money to be returned simultaneously – in this event we have what is called a “bank run” where the bank cannot repay all the requested withdrawals and the whole system collapses.

 
In our regulated society today we have “central banks” or “reserve banks” whose job is to ensure that the system does not collapse. These special banks have money, commodities or other assets that are kept in reserve to stabilise the banking system, and these banks are available to lend money to commercial banks in the event they get into strife. Examples of this occurred in the GFC when reserve banks around the world “bailed out” commercial banks to keep them afloat and prevent our global banking system collapsing.

 
 
So this is all very interesting but what does this mean for investors?

 
I think the first message is be cautious of who you deposit your money with (whether traditional banks or other investments). As an investor, cash is very valuable – and not easy to come by! Our system is not 100% fallible although we hope that we won’t see a collapse of our banking system in the near future.

 
The second message is the importance of cash and fractional reserve banking in expanding the economy. When as investors we are looking for finance, it is much easier to find a lender if we are able to offer a cash amount as a deposit to the bank, to lower the loan to value ratio (LVR). Knowing what the bank does with this deposit gives a perspective as to why this is so important for the bank.

 
As investors, we like the idea of “no money down deals” however for an investment to make money, it must be financed from somewhere. When a bank requests a 20% deposit for finance, this may represent the reserve they need to keep in order to maintain a viable balance sheet.

 
The implications of Fractional Reserve Banking when the economy is contracting (eg during a recession or depression) are significant, but this is a topic for another blog.

 
If you liked learning about this (or if it didn’t quite make sense), come along to our next Wealth School Cashflow meeting and join in the discussions.

 
 

 
 
 

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