What is Fractional Reserve Banking?

Two reference works are available for those who wish to undertake a serious study of Money Creation.

The first is a White Paper, entitled “Understanding the Dangers, Pitfalls and Systemic Risks Associated with Fiat Currencies“.

The second is an articled entitled “Modern Money Mechanics” issued by the Federal Reserve Bank of Chicago.

In Part II and Part III of the White Paper, the author sets out details of the evolution of money since 1933. An extract from Part II and Part III is recorded as follows:

EVOLUTION OF THE U.S. MONETARY SYSTEM SINCE 1933.

In modern economies, currency is a form of money that is issued exclusively by the sovereign (or a central bank as its representative). It is a liability of the issuing central bank (and sovereign) and an asset of the holding public. Currency issued by the sovereign is fiat money. Hence, fiat money is government-issued currency that is not backed by a physical commodity such as gold or silver, but rather by the government that issued it. It is legal tender. Currency is usually issued in paper (or polymer) form.

• Pillar # 1:  MOVE TO A DEBT-BASED SYSTEM OF BANKING.  The central bankers strategy over decades past was to gradually move us from away from a Gold Certificate (a stable and valuable form of money, redeemable for gold coins) issued by the Treasury of the United States to a complex debt-based system of banking where the medium of exchange is a mere promissory note of the issuer replaces gold. Because the transformation was so gradual and complex simultaneously, few were those who had the mental bandwith to even understand the subtle transfer of power that took place in just this strategy.  It was a genius plan that transferred to private bankers, rather than the Treasury, the ability to print an unlimitted amount of paper debt (currency) out of thin air in order to indenture people and nations.  It was both subtle and effective.
• ….

HOW DEBT-BASED FIAT CURRENCIES ARE CREATED AND PLACED INTO CIRCULATION

Fiat money is placed into circulation through a complex debt-based system of banking that is built on the following two other supporting pillars:

• Pillar # 2:  FRACTIONAL RESERVE BANKING EXPLAINED.  Fractional Reserve Banking (“FRB”) is a process through which leverage is applied to the system of money issuance.  It provides a way for compounding the leverage at every other level of banking and finance to turbo-charge the artificial creation of profits for private bankers.  This system had the dual advantage of maximizing profits for a few bankers while simultaneously indenturing people and nations to entrap them into an illusionary system of banking that gave the appearance of soundness but was actually the most pervasive and nefarious Ponzi Scheme ever conceived.  
• Here is how this two-step process works.  First banks, assuming a 10% reserve requirement, are legally allowed to leverage their risk-weighted assets up to 10 times. This is done through a process of debt creation that allows banks to grow and profit through a process that allows the weight of massive debt to rest on a razor-thin base of supporting capital.  Here is an example that applied prior to the 2008 crisis. 

This diagram explains how an 8.5% Tier I Reserve Capital will provide the bank with an 11.7% leverage.

This diagram explains how banks use the Fractionalk Reserve Banking multiplier to create leverage and liquidity.

The above diagram illustrates how the expansion of the monetary mass through a debt-based system of lending and borrowing.  When a borrower executes a note (e.g., in the case of a mortgage for instance), few realize that the bank is not lending them a monetary value that is considered to be an existing asset of the bank.  Instead the lending bank will artificially issue and distribute cash they do not have that they just produced through an accounting slight of hand which gave rise to the funding of a new morgrage where the bank receives a security interest on the house just purchased while the borrower has possession of the house, so long a he continues to make monthly payments of principal and interest.

This is how the Chicago Federal Reserve Bank illustrates Money Expansion in their own manual.

• Pillar # 3:  THE 3-6-3 PRINCIPLE OF BANKING EXPLAINED.  When the secretive fractional reserve banking is combined with the 3-6-3 principle of banking, it produces a turbo-charged process that expands the monetary mass and profits for the banks while indenturing entire nations and borrowers everywhere, making him subservient to a lender.  It is these complex principles that worked together to produce an out-of-control and run-away financial system that gave birth to a derivative buble that is so highly leveraged that it was already akin a gigantic iceberg back in 2008 and 2009.

The 3-6-3 principle of banking creates massive profits and liquidity for banks.

The 3-6-3 principle of banking demonstrates how banks pay their depositors a 3% interest on deposits (steps 1 and 2 above) to book a deposit as an asset of the bank.  Having booked this deposit as an asset of the bank, the bank can now lend 90% of this cash ($90) while 10% ($10) is retained as a reserve deposit (steps 4 and 5) to satisfy the regulatory constraints.  After step 5 the bank technically has no cash left fund additional loans.  However, the bank is now holding a note or debt obligation of the borrower which provides a 6% income stream to the bank and which the bank has now booked as a receivable on its balance sheet.  To regain fresh liquidity based on its balance sheet ratios, the bank can discount its loan receivables books at a discount paying only 3% in this case to the money-center banks or the central bank under the Borrower in Custody program of the Fed to refinance itself.

It is the combination of the 10:1 leverage made possible through the fractional reserve banking process combined with the process of discounting to generate liquidity that dangerously fuels the entire banking system globally.

The second diagram illustrates how a mere $100 deposit can easily be multiplied into $1,000 of fresh liquidity the bank can then lend at a substantial profit.