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Fractional Reserve Banking: Engine for Economic Growth or Fraud?

The cornerstone of our monetary system is based on fractional banking. This, along with the Federal Reserve, plays an important role in the value of our money, the dollar.

The cornerstone of our monetary system is based on fractional banking. This, along with the Federal Reserve, plays an important role in the value of our money, the dollar.

Fractional Reserve Banking

The cornerstone of our monetary system is based on fractional banking. This, along with the Federal Reserve, play an important role in the value of our money, the dollar. It also has a significant impact on our wealth (both personal and as a nation). To make better investment and business decisions, and to steer our nation to prosperity, we really need to know how both of those systems work.

The way a bank operates is like this: You deposit your money into a checking account, say $1,000.00. The bank then shows the deposit on the asset side of the balance sheet (I'll go into how a balance sheet works in another article. Suffice it to say here that it means the bank views your money as their money (Murray Rothbard: The Mystery of Banking, page 92). This is the bank's reserves.

The bank can then (and does) take that deposit and lend 90% of it to businesses, individuals, and whoever the bank deems creditworthy. In the process the bank charges interest on the money lent, and it is usually a very long-term note, such as 15 or 30 years in length. Below is an example:

Bank: Deposit: $1,000.00; loans: $900.00

Because the bank has $1,000.00 of hard money (money earned by the depositor through the sweat of his brow or his investments. In the beginning and to a certain extent now, it is gold...hard money) and will then lend out up to $900.00, leaving $100.00 in reserves. So far, so good. There is still $1,000.00 in the banking system.

What happens next? The borrowers of the $900.00 will then deposit it in a bank and spend the money they borrowed into the economy to buy items for their business (or if it is a consumer loan, to buy a car, vacation, etc..). The deposits made into these banking institutions will then be lent out as well leaving 10% in reserves, whereby these loans are then deposited as well. So following the line of money, a little bit looks like this:

  • First deposit: $1,000.00 Loans: $900.00
  • Next set of deposits: $900.00 Loans: $810.00
  • Next set of deposits: $810.00 Loans: $729.00
  • Next set of deposits: $729.00 Loans: $656.10

This can go on for quite a while. Here is what happened. After the initial $1,000.00 deposit, the banks added another $2,439.00 to the system. How? It created money out of thin air.

The banks created "notes" to represent a claim. On what? That is a good question. It used to represent a claim on gold or other precious metals (although the gold above a certain amount does not exist from fractional banking), but now that we are off the gold standard (Thank you Richard Nixon. He took us off of the last remnant of that in 1971), it is simply a claim by the U.S government that it has value.

In a close view, the money system seems a little funny. After all, essentially creating money out of thin air just because a bank has some hard assets to back it up? Doesn't make a lot of sense, does it? How did it come into being?

A Little History

I will come back to modern fractional banking and the pros and cons of it below. But let's first take a look at how it developed in the first place.

Fractional reserve banking started around the 17th century in both Britain and the Netherlands. People during that time used the goldsmiths to store their precious metals, and in return would be issued a receipt for the metals they had deposited.

Over time, these receipts would be used literally as money itself, for it was easier than having to go to the goldsmith to get the gold, then go and pay for items with said gold. After all, the receipt represented the actual gold itself.

The goldsmiths observed that, at most, 10 to 20% of the receipts were ever redeemed at one time, so they started printing more receipts than they had in gold. This they used for lending out to people as loans whereby they would charge interest. Thus was the beginning of fractional reserve banking.

It would seem to be an illegal operation because printing more receipts for gold than they had in gold is fraud. The receipts are basically worthless. So how did it become the legalized institution it is today? By court order. There was a case called Foley v Hill and Others in England in 1848 that actually legalized it. Here Murray Rothbard lists the exact verbiage:

Money, when paid into a bank, ceases altogether to be the

money of the principal; it is then the money of the banker,

who is bound to an equivalent by paying a similar sum to

that deposited with him when he is asked for it. . . . The

money placed in the custody of a banker is, to all intents and

purposes, the money of the banker, to do with it as he

pleases; he is guilty of no breach of trust in employing it; he

is not answerable to the principal if he puts it into jeopardy,

if he engages in a hazardous speculation; he is not bound to

keep it or deal with it as the property of his principal; but

he is, of course, answerable for the amount, because he has


Rothbard, Murray: The Mystery of Banking, pg 92.

So there you have it. The general origins of fractional reserve banking and the legacy of our monetary system. There is quite a lot of controversy as to whether it is or isn't a good system for economic growth. Let us examine the pros and cons.

The Case for Fractional Reserve Banking

The main argument for the use of fractional reserve banking is the multiplier effect. This, in essence, means that by increases in the money base above the stated reserves, the overall wealth of a country increases.

The rationale is that by adding more money or credit to the system, more loans can be made to businesses and new start-ups that can create more and better products.

As an example, a farmer can approach a bank and get a loan to buy a machine that can harvest 1000 plums as compared to the farmer only able to pick 100 plums in the same amount of time. By increasing the plum output, we as a nation are better off...more wealthy. By persuading individuals to store their earnings in a bank (as mentioned above, it first meant the storage of gold and later on, dollars), the banks are now able to use it to increase wealth.

This argument also states that if someone holds onto their gold (say that the person is a hoarder and buries it), it is not wealth. That it really represents nothing, and it certainly is not put to good use.

The Cons of Fractional Reserve Banking

There are, however, some serious issues one must consider in relation to fractional reserve banking.

First of all, it is fraud. If you deposit your money into an account, it is a demand deposit, meaning that you should be able to withdraw all or part of it whenever you want. After all, it is your money. But in reality, only 10 or 20% on average is actually in your account. The rest is loaned out. It is not there.

Second, it is inflationary. Arguments go back and forth as to whether inflation is good for economic growth or not (I'll address this another time), but suffice it to say that inflation in and of itself eats into your savings. Your savings will lose value over time, thus lowering your personal wealth.

Third, the banks almost from the moment they open their doors are insolvent because of fractional reserve banking. If everybody decides that they want their money at the same time, the banks will go out of business. The depositors will lose their money. This is known as a bank run. It happened very often before the advent of the Federal Reserve.

Why doesn't it happen today? Because the Federal Reserve will lend banks money to pay depositor demands. How? Printing money out of thin air. This in and of itself seems a bit funny to me. It certainly makes one question the real value of the dollars they are holding on to.

Fifth, the banks are taking your deposits and using it for loans on their books. They are putting your money at risk, but you get no return. In other words, your money is working for the bank. It gains profits, and if they lose money they get bailed out by the federal reserve. You do not.

Sixth, it creates distortions between economic growth and actual wealth. Increasing the money supply will inspire entrepreneurs to take on more risk to grow businesses, but if the individual's savings and personal wealth doesn't keep up, it eventually leads to excess businesses closing and a contraction of the money supply (in a nutshell, a recession and potential depression).

The Alternative

Economic growth can happen in a sustainable way without fractional reserve banking. For one thing, demand deposits should be treated as demand deposits. They should not be lent out. The banks can make money by charging a monthly fee for the checking account.

In truth, it is similar to an institution that stores gold for an investor. They store it for safekeeping and charge the appropriate fees to run at a profit. Now what banks can do to get investment capital for loans is to offer investment vehicles for customers whereby the customer will lend their money for a given period of time to a bank for a rate of return. This way a bank can lend out that money and make a profit for itself and the individual that lent his money to the bank. This is what a CD is for. Banks and investment institutions can design any number of investment vehicles to suit market needs.


There are many other aspects of our monetary system that must be addressed for our prosperity.

For example, it would be very beneficial if we allow free banking and get back to a gold standard for our money supply, but the fractional reserve money system needs to be changed as well. As explained above, there are many problems with fractional reserve banking. Left unchecked, it plays a major role in inflation, recessions and depressions.

On a personal level, we can keep most of our wealth out of the banking system. At the very least, one can keep low balances in their checking accounts. This makes it harder for the banks to leverage up their balance sheets.

We can also store our wealth in precious metals. The value of gold and silver will not go down due to inflation like the dollar will. I believe that if the majority of people get into gold and silver, the money system will have to be changed. It can bring back a gold standard. And finally, if we all do a better job of researching investment vehicles and other opportunities, we will be better off as a nation.

This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.


StevePorter6 on April 28, 2020:

I quite agree that fractional reserve is legalised fraud. In particular for the reasons given here:


Gregg Hoffman (author) from 510 S. Corona Street. Denver, Co 80209 on September 07, 2012:

? So money is a promissory note? That is a good one. I thought money was, well, money. A promissory note has very clear terms between the debtor and creditor, .i.e. how much is the loan, what interest rate, length and so on. I never have the bank sign a promissory note to take my money. Believe me, I wish it did work that way. When you put your money in a checking account, it is a demand deposit, meaning the bank has to pay you back that money at your will. What they do is loan out a portion (hence fractional reserve) of the demand deposit. Here is the real problem: that money is obligated to 2 different positions. That cannot be done, unless there is fraud of some kind. It is fraud, but it became legal through a court order as I mentioned in my article. Simple because it is legal, does not change the fact that it is fraud. Your last comment, ironically, is proving my point. I agree that it is a ponzi scheme, which is, in essence, to beat a dead horse...FRAUD.

John on September 06, 2012:

Banks do not loan out depositor's money! That is illegal! The money they loan out, which isn't a loan at all, comes from the promissory note that you give them. The note is an asset, the check they give you is a liability. They never lend you anything, and yet they charge you the principal that they never gave you, the interest on the principal they never gave you and if you can't repay the fake loan they foreclose on you! That's what really happens my friends. It is the biggest ponzi scheme the world has ever known!

Davesworld from Cottage Grove, MN 55016 on March 01, 2012:

No argument about checking account monies. They should not be loaned out - or at least not on a 90/10 ratio - since I expect to be able to drain that account on a whim at any time. Savings, on the other hand, is a different story. Here, there is an implied longer term to the deposit and the banks should be able to do something with the money other than just look at it.

The Federal Reserve's bailout doesn't bother me as much as the Fed's manipulation of the money supply. This is the true driver of inflation and reason enough for expanded scrutiny on their actions.

AKA Winston on February 29, 2012:


P.S. I support your anger. But it is misguided. It is not the Fed but the mindset of laissez-faire as promulgated by idiots like Phil Gramm who caused the problems. These free-marketers eliminated or ignored all the safeguards that had kept banking safe and sound since the Great Depression, and by doing so set up a situation that was so eerily similar as to be first cousin of the Great Depression.

Good luck to you. But the real enemies have been people like Rubin, Gramm, Gingrich, et al, and I am quite aware that Obama has bought into the same tripe with Summer and Geithner, so this is not a partisan rant. As a nation, we need to restore the rules that worked in banking from the 1930s until they were dismantled in the 1990s and 2000s.


AKA Winston on February 29, 2012:


Sorry to pick on you, but there is so much incorrect information on libertarian and gold bug websites about FRB and the Federal Reserve I can't help lashing out.

If you want to quote a narrative from someone you believe is an authority, then you are practicing a religion, not thinking for yourself.

Banks have a simple business model. They borrow short term and lend long term. That they can do this an make a profit is why we do not have to pay them storage fees. It is not a conspiracy.

I sympathize with your distrust of bankers, but it is misguided. It is the failure of regulation along with the free-market ideas that created the Great Recession (a debt recession). It is not a systemic failure of FRB, the Fed, or fiat currency.

Deposits are liabilities to banks - calling it anything other than that is simply wrong. Loans are the assets. The problem occurred when despositor indstitutions were allowed by the repeal of Glass-Steagall to also act as investment banks - and they lost their bets.

But that has nothing to do with FRB.

Again, I like that you are thinking outside the box, but I suggest looking more deeply into the situation and subject - and look at all aspects and then make up your own mind. Thanks for allowing me to comment.

Gregg Hoffman (author) from 510 S. Corona Street. Denver, Co 80209 on February 29, 2012:

As is evidenced in the comments, I need more clarification.

1) on the point of where the deposits are placed on the balance sheet, I agree that they should be considered a liability, but they do consider it an asset. I will once again quote Murray Rothbard:

"For the duration of the deposit, the gold or silver now became an owned asset of the bank, with redemption due as a supposed debt, albeit instantly on demand" (Murray Rothbard, The mystery of Banking, pg 94). Here he is talking about gold as money, but it also applies to federal reserve notes of late. I can also prove that they consider it their money and not the depositer's money. When you open a checking account, do they ever ask you how you want the money to be used? No. They do with it as they wish without your input, hence they treat it as their money.

2) On the point where bankers learned that that not everyone will demand their money at the same time, I also stated that, but many times in history people did want their money at once. It happened when people realized that the bank is in trouble (which it is, because they are insolvent), this leads to bank runs. I am aware that the FDIC was created to cover losses, but in essence more money needs to be created to cover the losses one way or another. This leads to inflation and opens the door to moral hazard, which I explain in another hub. Ultimately this practice leads to currency devaluation, meaning savers will lose value on their savings.

This one is to Davesworld. Personally, I have no problems with a bank using a fractional reserve business model. My only catch to that is they cannot be bailed out by the Federal Reserve if they do become insolvent. The Federal Reserve creates a big, unchecked moral hazard whereby banks will take on bigger risks chasing bigger returns. If a bank wants to do that, fine, but the customers need to know what the bank is doing. In a free market banking system, I am sure some banks will use fractional reserve banking, others will not, but it will be up to the customer to decide where he wants to bank, and why. Personally, I would rather put my checking account money in a 100% reserve bank and pay the fees, for it would be more secure, and use my own investment money for taking on more risk.

BTW, hiding money around one's house or yard does have it's own reward...and risk too. It's up to each of us to choose what we want.

Davesworld from Cottage Grove, MN 55016 on February 26, 2012:

Banking as an institution goes back to Roman times, if not before. Banks have loaned out their deposits since banks were invented.

I think you are wrong in the Fractional Reserve System. It is not so much that it *allows* banks to lend out 90% as it *prevents* banks from lending out more than 90%. In the bad old days, banks could, and did, loan out 100% of their customer deposits. When those banks failed there was absolutely nothing left.

The argument, if any, over the Fractional Reserve System should be centered on what the proper percentage is - and it certainly is NOT zero. If you don't allow the bankt o loan out my deposits, how can the bank earn money in order to pay me interest on my money? If I have to pay a fee to the bank to hang on to my money, why would I put it there? Why not just break it up into a bunch of small piles and hide it all over the house, in the car, carry a bunch in my pocket and bury some jars in the back yard?

AKA Winston on February 25, 2012:

Once again it is shown that a little knowledge is a little knowledge.

Without fractional reserve banking, we would be paying a fee to banks to secure our money or hoarding it under the mattress. The reason we have fractional reserve banking is due to the realization over time that not everyone would demand his money be withdrawn at the same time, thus it was safe for banks to lend more than their reserves. The exception was the Great Depression, and the FDIC insurance program was created just to prevent similar banks runs from occurring in the future.

As for a deposit being the bank's money, again you are misguided. The fact that they lend it does not mean they consider it "their money". A deposit is a liability on the balance sheet - it is the loan made that is the asset. Banks loan more than their reserves and earn profits, which then allows the banks to pay depositors interest on their accounts instead of charging a storage fee to protect a person's money.

A lot of libertarian websites pass along a lot of bad information about banking - I suggest a more diverse knowledge in order to come to a reaonable understanding of what really transpires.

The loss of Glass-Steagall was a massive blow and has come back to haunt us. Many banks have caused grievous harm - but that is not because of the central bank or because of FRB.

It is because of free-market fools like Phil Gramm.

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