How the Banking System Really Works

Bank

If you’re reading this, chances are you have a bank account, perhaps multiple accounts, to manage your ‘savings’ and investments (we’ll get to why savings is embraced by inverted commas later). Your salary, business, or other income is most likely paid into your bank account, and you spend it using a little plastic card. You may also have another plastic card, possibly several, that allow you to buy things even when your main account balance is zero.

You can also use your card to withdraw cash from little machines sprinkled all over town, in fact all over the world, a convenience that has become increasingly inconvenient as  more and more merchants accept card payments for even the smallest of transactions, thereby eliminating the need and associated risk of carrying around ‘bulky’ paper notes.

This evolution from cash to cards over the last three decades has undoubtedly made transacting more convenient, but it’s also gifted the banking system full control over the currency supply. How so? Well, in simple terms it’s because cash is created by the government and electronic currency is created by banks. Few people really understand how the banking system works, so let’s break it down:

The first thing you need to understand is that when you deposit currency in a bank, you’re not putting it in a big safe, you’re lending it to the bank. When you make a loan to anyone, there is always a risk they won’t pay you back, and banks are no different (just ask anyone who had money in one of the 9,000 banks that failed during The Great Depression).

In the old days, banks made profits by collecting currency from depositors and lending it (at a higher rate) to borrowers, always keeping a little in reserve in case some of the depositors wanted their cash back. The reserve amount was dictated by the central bank (typically around 10%) so as long as no more than 10% of all depositors wanted their cash back at the same time, the bank would have enough reserves to cover withdrawals.

Let’s say a bank had $1,000,000 of deposits. It would reserve $100,000 and lend the rest out.  The $900,000 that was loaned out typically gets used to buy stuff, and the beneficiaries most likely deposit this money back into a bank.  Now the bank has $1,900,000 of deposits so it reserves an extra $90,000 and lends $810,000, which gets used to buy more stuff and the beneficiaries eventually deposit this cash back into the bank, so now the bank has $2,710,000. It reserves 10% and makes even more loans…. As this process repeats, the original $1,000,000 cash eventually creates up to $10,000,000 of deposits and $9,000,000 of loans. This system is known as fractional reserve banking.

Now, since there’s only $1,000,000 of actual cash, all of which is sitting the banks as reserves, where does the cash to repay loans + interest come from? Clearly more cash must be printed and put into circulation… but that too gets multiplied by the same process, so eventually more cash needs to be printed again, and again, and again over time. Whether by accident or by design, fractional reserve banking is no different to a Ponzi scheme: just as a Ponzi scheme constantly requires new investors to pay returns to old investors, the Ponzi currency system constantly requires new cash to repay loans created by fractional reserve banking.

Most people think this is how banks work, but it’s not: fractional reserve banking has been subtly replaced by a far superior system (superior for the banks, that is), thanks to the almost complete elimination of cash. Recall that in a fractional reserve banking system, banks need cash deposits to make cash loans, so the bank can’t ‘multiply’ the cash until it’s re-deposited. Well, when money is electronic it’s re-deposited instantly, so banks can now creating currency out of thin air knowing it will be loaned back to them immediately.

Remembering that deposits are not stored by, but loaned to the bank, the increasingly cashless system we have today effectively forces you to lend all your currency to the banking system. All for a pittance in interest, most of which is recovered by the banks though transaction fees and other charges. And the best part (for the banks) is that it’s a ‘heads I win, tails you lose’ system: when you fail to repay a loan, the bank takes your assets, when the bank fails, you end up bailing it out.

Your little plastic cards may offer you great convenience, but when the cost of that convenience is freedom, the question must be asked: is it worth it?

 

 

 

2 thoughts on “How the Banking System Really Works

  1. And the next subsequent question is: as an average consumer/person, what are your alternatives if you decide it’s not worth it? Or do you simple submit to the system?

    Liked by 1 person

    • Indeed, that is next question, and one that the invisible hand of the market will solve over time, but not without casualties… Banking in its current form is simply unsustainable as it’s built on an underlying ponzi system that is on the brink of collapse as private debt is close to it’s absolute limit. The fallout from the next crash will be so bad, a fundamental re-think of the banking system will be needed, and (hopefully) a better system will prevail.

      Like

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