How Banks Create Money from Promises: The Inherent Flaw of Fractional Reserve Banking

The economic crisis resulted from banks creating money based on unfillable promises. In 1 minute, discover an inherent flaw of our banking system.

The current rules allow banks to lend out 90% or more of the money of owed to depositors. This is known as "fractional reserve banking". These rules lead to the majority of all deposits in bank accounts being backed only by the promises of borrowers to pay back the loans, on schedule and with interest. If the borrows are unwilling or unable to keep up their payments, the banks enter a state of crisis, and the savings of all the depositors are at risk.

In 2008, such a banking crisis began, where the value of homes dropped to severely, that most, if not all, of the banks owe their depositors much more than the value of their assets, which are mostly mortgages. This situation puts the bank into a state of insolvency, where drastic measures must be taken just to keep the bank operating. The banks, unwilling to make new loans, create a credit crisis, which leads to less economic activitiy and spending, resulting in job losses, and a downward spiraling economic crisis.

In this ultra-compact one minute video, review the essentials of how banks create money from promises, and the inherent risk of such a fractional reserve banking system.

(Note: This is a 1-minute compact summary of longer 5-minute and 10-minute videos which cover the same concepts, although at a more relaxed pace and with many more details, and with different audiences in mind. Please see those videos for additional information.)

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[caveltor]

nonsense! this would be true only if those paper dollars were perhaps something more tangible and limited - like gold.

The banking system is in no way constrained by the amount of 'reserves' it keeps.

This vid should start of with 0 in the bank, then instead of obtaining a deposit, the first thing the bank does it make a loan.

Where does the first deposit come from? From the money created by the loan. No reserves required.

[newculture]

The video describes "fractional reserve banking" in an easy to understand manner. Future videos may look at specific examples of reserve requirements.

For a detailed look at the official rules, search on Google for "reserve requirements". One of the first hits is the Federal Reserve's page.

Practice in various banks, and at various times in the past, have varied. There are certainly ways to bend the rules. I've not heard that a brand new bank can issue a loan with zero reserves.

[UniversityofSteve]

Shouldn't this be 2 minutes long?

Why did you stop there?

Doesn't the bank only accept the PROMISE when it's promised property as collateral, and generally take a big hit when auctioning that property?

[caveltor]

Allow me to apologize for the tone of the first comment. I meant no offence.

Its great that you and others take the time to assemble and post these videos.

Do you know how a newly printed community currency makes its way into circulation?

If its not loaned into existence, who benefits from its initial purchasing power?

I guess they are sold to the groups members, so a pool of funds is then available to a committee representing the group?

[caveltor]

Thanks for your reply.

The fractional requirements are only for savings accounts and only for some jurisdictions - as you state.

This is a liquidity policy and does not limit loan growth.

Banks make loans based on their merit and without regard to cash on hand.

If, at the end of the day, more reserves are needed as a matter of regulation, then they are borrowed across the term structure according to risk via interbank lending or from the fed via its many facilities as needed.