The Banking System Explained
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I. The Economic Functions of a Deposit Bank
Be aware that the following is not a description of the reality of banking today, but a mere deduction of banking’s tasks that derive from its economic function. The primary economic function of a bank is to store people’s physical money securely. That’s necessary because it is dangerous to put all your money under the mattress. Thieves could steal it or you could lose it all in a house fire. As a solution deposit banks offer the service to store your money in a much more secure way than you by yourself could. They may build safeguarded houses, acquire burglarproof safes, hire security staff etc. to make sure that deposits cannot be stolen. The fee they charge for that service is, of course, much lower than the costs would be for an individual that wanted to reach the same degree of safety by himself. If people had to take care of secure storage themselves each individual would have to buy a costly safe. The bank however can build one big safe and spread the costs among the many depositors.
On top of secure storage deposit banks can provide payment services. Depositors get a checking account with a credit entry in the amount of the original deposit. Now they can use this credit to pay instead of the physical money itself. That makes trading within a broader economy much easier. Instead of transferring the physical money, the checking accounts of the trading partners get adjusted according to their agreement. Of course the bank has to charge a fee for the work associated with bookkeeping, too.
100% Reserve Banking Is Expected
At least as important as keeping the depositors’ money safe and having functioning checking accounts is the reputation of the banker. People will only store their wealth at the bank when they trust the banker that he will not misappropriate their funds. They expect that the deposit bank keeps 100% of the funds in reserve so that they can withdraw them any time they want. Since money is a fungible good, which means that units are interchangeable, it’s not important to get the same coins and bank notes back, but the same amount of money that was deposited has to be available on demand.
The Depositor Is the Owner
The contract between the depositor and the bank says that the amount of money, stored safely at the bank against a fee, is still the property of the depositor. The deposit does not become the bank’s property. The trade is: The depositor’s fee against the bank’s secure storage of the full amount of the deposited money. The trade is not: Present money against future money. That would be a loan. To respect the property right of the depositor the bank has to keep 100% of his deposit amount in reserve. Having less than that on demand and speculating with the rest of the deposit would be a breach of contract and therefore illegal. All of that derives from the economic function of a deposit bank. This is not how our banking system today works. But to know the economic principles leading to a deposit bank is a necessary measuring stick, if you want to judge todays banking accordingly.
II. Investment Banks in Disguise
It’s Not a Deposit When You Get Interest
Whenever you give money to a bank and don’t have to pay a fee but get interest instead (however little it may be), it is safe to assume that it is not a deposit bank but an investment bank. To be able to bear its costs and pay you the interest the bank has to invest your money profitably. And that means that the bank has to take risks. Investment is always risky because nobody can foresee the future. It’s always possible that the asset the bank is investing in loses value over time. Therefore by giving money to a bank against interest you run a risk yourself. If the investment of the bank is bad, the money you gave to it might be lost forever when the bank goes bust. By getting interest you trade present money against a claim on future money plus interest. The money now is no longer your property. Basically you give the bank a loan. You appear as an investor not a depositor. To pay you the interest the bank cannot keep the full amount of your money in reserve, it has to work with it, spend it on hopefully profitable investments and take risks that are your risks in the end. You simply cannot expect that it is possible to withdraw all your money any time when you give it to an investment bank against interest. If both parties of the trade know what kind of contract they agree on, there is nothing wrong about that, but you should always be aware of the difference between deposit banks and investment banks.
Who Benefits from the Confusion?
Being an investment bank can mean two things: You investing in the bank and hoping that it will be able to pay you back your money plus interest in the future or the bank being an intermediary between you as an investor and a company or asset class you can invest in. In the second case it is obvious that you are taking a certain risk as an investor. But where does the confusion come from that this could be any different in the first case? Well, short and crisp it’s in the interest of banks and governments to equate deposits and loans and disguise their difference. Does your bank tell you that you give it a loan when you pay money into your checking account? When people believe that they deposit money to get safekeeping and payment services while in fact and de jure they are giving a loan to the bank, the bank can legally speculate with the depositor’s money and lend it out to the government. That’s a huge advantage for the banks and the legislator. Whenever people believe they make a deposit and maintain full availability of their money, which in reality is not the case, there is much more money available for the banks to speculate and the government to borrow – much more than there would be, if people knew what they are doing.
A Historical Predecessor: Interest as Usury
The historical predecessor of the disguise of loans as deposits harks back to the Middle Ages. Due to the religious beliefs back then it was illegal to invest by lending out money against interest. Interest in general was seen as the sin of usury. Since monetary investments where nevertheless economically necessary people helped themselves by officially calling a deposit what intentionally was a loan. When the apparent safekeeper could not pay back the deposit on demand he had to pay a certain penalty. Paying this penalty was legal on the one side and functioned economically as a payment of interest on the other side. In this way the prohibition of interest could be ignored. Today interest is no longer illegal, but still loans are somehow being disguised as deposits. A common justification for that reads: “Saved money is useless; we need to redistribute it to make the economy prosper.” However, saved money is not useless at all. It is used by the saver to make sure that he can make purchases in the future, because he doesn’t want to buy things in the present. His only goal is saving, so he doesn’t want to take any risks at all. What he seeks is safe storage. Let’s articulate this clearly: Investing his money in something else while telling him that it is always available would be fraud and theft. But there is some responsibility on the side of the saver, too. Everybody could know how our banking system works. You cannot expect to get interest on your bank account and at the same time hope that the bank keeps a 100% reserve available on demand.
III. Our Banking System Today
Fractional Reserve and the Risk of a Bank Run
As you might know already, since you are visiting a Bitcoin Academy, in our banking system today checking and saving accounts are not backed with a 100% reserve. If you want the comfort of a bank’s payment service you have to accept its fractional reserve system. The only way to have the bank keeping your money safe with a full reserve would be a lock box at the bank, where you can store physical money. But the amount of money you keep there will not be credited to your checking account. Therefore you lose the comfort of the bank’s payment service. In addition to that you have to pay a fee for a lock box, whereas you get interest when you pay your money into your bank account. That makes accepting the fractional reserve system even more attractive for customers, particularly since for now they might never have experienced problems when withdrawing money from their bank account. Their money seems to be available on demand. But one thing is for sure: Whenever people lose trust in the bank’s ability to redeem their account credits for physical money a bank run will happen and due to the fractional reserve only very few people will get their originally deposited money back.
Deposit Insurance by the Government
To make bank runs less probable governments provide a deposit insurance. In Germany for example deposits up to 100.000 € are guaranteed by the state. This is just another way of seducing people to lend out their money to banks. Basically it’s a government grant for the banks, helping them to maintain the ability of speculating with the depositor’s funds.
Legal Tender and Central Banks
Now let’s take a closer look at how our banking system today works. First of all the government declares the product of the central bank as legal tender. In Europe that’s the Euro. You might still be allowed to use other mediums of exchange in a voluntary agreement with your trading partner. But in the end you will have to pay your taxes with Euros and nothing else. Since everybody has to pay taxes, there will always be a great demand for Euros and therefore it is very difficult for other forms of money to compete with that artificial demand for Euros. The legal tender is cash only, bank notes and coins. Only the central bank is allowed to create them. But how does this money enter the economy? Cash or central bank money can be introduced into the economy by the central bank purchasing financial assets or giving loans to commercial banks. The rules of doing so are set by the main tasks of the central bank’s monetary policy: price stability, economic growth and a high rate of employment. Today central banks in the US and EU believe to be able to fulfill these tasks by managing the inflation rate. In their opinion inflation, measured in a certain basket of goods, should be at around 2%.
The Primary Credit Rate
To influence the inflation rate, central banks have certain instruments. The most important instrument is the interest rate at which commercial banks can lend cash from the central bank. It is called primary credit rate. This interest rate is much lower than the interest rate you as a private person or company have to pay for your credits. Only acknowledged commercial banks are allowed to borrow money directly from the central bank at these low interest rates.
Commercial Banks Create Money
But the central bank is not the only creator of money in our banking system. Commercial banks create money, too. Cash is also called base money. On top of that base commercial banks create checkbook money that buys things just like cash. They create this form of money whenever somebody takes out a loan with them. Most of the money commercial banks lend out to debtors did not exist before. Startling enough, but the loan is not somebody else’s savings or base money from the central bank. Banks are legally allowed to create it out of thin air and charge interest for it. This book money credited to the borrowers account functions like cash since you can buy real things with it. Whenever you use a credit card or buy anything by transferring money from your checking account to the seller’s account the book money is used like base money. Therefore it expands the money supply. Of course, the money creation of the banks is somehow limited. There is an equity ratio and the central bank forces the commercial banks to hold a certain fraction of the checkbook money they create as a reserve in base money. But if you take a closer look at these limits, they are in fact not very limiting. In Europe the minimum reserve rate is only 1%. And the equity ratio required for credits to top rated states is zero. That means that a commercial bank can borrow 100€ base money from the central bank and the banking system as a whole can theoretically create 10.000€ of checkbook money. The same effect occurs when you deposit a one hundred Euro bill at the bank. Without considering the equity ratio the multiplication of base money works like this: You deposit a one hundred Euro bill at Bank A. Now the bank lends out 99€ and has to keep 1€ in reserve. The borrower withdraws the 99€ in cash and buys something. Since you can still buy things by transferring your account balance of 100€ it is correct to say that new purchasing power worth of 99€ has been created by Bank A. Now there are 199€ in existence. Let’s assume the seller deposits the 99€ into his checking account at Bank B. Again, Bank B is allowed to create 98.01€ and has to keep a reserve of .99€. If somebody borrows these 98.01€, there are 297.01€ of purchasing power in circulation. If this process goes on until the end, 10.000€ could be created by the banking system. Although the money created by commercial banks is not base money but checkbook money, which is destroyed when the debtor pays back his credit, it temporarily expands the money supply and has effects on price inflation. Borrowing money into existence happens straightaway, paying a loan back in rates is a process that takes a longer time. There can be no doubt that commercial banks through fractional reserve lending expand the money supply.
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