The comparative virtues of fractional reserve banking have been a source of controversy. Space limits do not allow us to do the topic justice, here.

All we can do here is to introduce the general topic, which will open the opportunity to briefly review the arguments on either side of that debate. First then, what actually is fractional reserve banking?

The actual practice is not difficult to grasp, though, often, those unfamiliar with the idea sometimes have difficulty appreciating the implications. The practice can be stated in a couple sentences.

Depositors are those who open accounts at the bank for purposing of storing their savings. These savings are then put to work by the bank: they are loaned to borrowers to achieve timely completion of their projects. (In some cases, of course, the borrowers and also depositors. This is not necessarily so and doing the linguistic back flips to express the double relationship provides little return on investment for greater insight. Thus, depositors and borrowers are discussed as though different people.)

In theory, this is good for everyone. The borrowers get the funds needed to start businesses or buy homes or otherwise improve their and their families‘ life prospects. The interest charged to the borrowers pays for the operations of the bank and allows them to also pay interest to the depositors, giving them a return on their savings and incentive to deposit, allowing the whole system to function.

Put this way, we clearly have a classic win-win-win scenario on our hands. Alas, it turns out that the practical rollout of this situation is more complicated than these first impressions may suggest.

The observant reader may have noted that the banks seem to be in something of a precarious situation in all of this. They’re making more promises than they can keep. Consider the depositors, who, after all, are not investors. When you invest in something, you understand that your money is tied up – you can’t spend it while it’s invested. Depositors though consider their savings being stored at the bank. Some actually regard the arrangement as analogous to renting a mini-storage unit: they stash boxes of knick-knacks and keepsakes they can’t bring themselves to trash. The boxes though are always there to be retrieved when they want them. Most depositors think this about the money they’ve deposited in the bank.

Technically, of course, though, their money isn’t actually in the bank; it’s been loaned out. Most of the time, this arrangement can work without immediate disaster, since most depositors, most of the time, have no reason to withdraw most of their money.

Consequently, the banks don’t lend out all the deposits, but they reserve a fraction of them, kept on hand, to fill the withdrawals of depositors who have some need of some portion of their money. Hence, the term fractional reserve banking.

Certainly, most of the time, this operation manages to keep afloat. It does seem though that such success may be based largely on the majority of depositors not understanding for what it is they’re actually signed up. For instance, many are not cognizant of the small print in their banking contracts, denying them withdrawal on demand for sums in excess of that which is compatible with the bank’s fractional reserve position. Often a bank-stipulated waiting period is required for such withdrawals.

Additionally, if their withdraw demands are over a certain threshold, the bank often reserves the right to interrogate them about their intentions regarding their own money. These are tools used by the banks to forestall the danger of withdrawals that exceed or make vulnerable the reserves they’ve kept on hand.

Usually, though, in the course of routine banking life, such measures are unnecessary. The banks‘ ability to anticipate reserve levels sufficient to cover expected withdrawals is generally effective enough to keep most people adequately contented with the arrangement.

It would be a major mistake though to infer from this that fractional reserve banking is not controversial or risky. On the contrary, its many critics allege it is continually poised on the precipice of financial catastrophe. This is true for any individual bank, but, in light of the extensive interconnectivity of our globalized banking system, the entire world economy is thereby under a constant low resonance, but high ceiling, threat.

And that’s not all, as serene as the daily business of banking may appear, it contributes to more insidious effects that tangibly increase the likelihood of global economic catastrophe. Events as novel as our recent first ever digital bank run at Mt. Gox and as ancient as the history of inflationary destruction of the money supply are all tied into the fate of today’s fractional reserve banking practices.

To understand the wider debate of what’s at stake, check out this article on the pros and cons (and con jobs) of fractional reserve banking.

Those who want to be well-informed about managing their money need to stay tuned to the Fractional Reserve Banking Review to keep tabs on all the ways, new and old, that the banking system erodes your wealth. Wallace Eddington has emerged as a leading voice on how to detect and beat the scams of the mainstream financial system. Check out his recent provocative article on a Free Market Economy in Money .