Two main types of transactions established the banking system: deposit and loan. In the first case, you give money to the bank for safekeeping; in the second, you lend it to the bank for a certain period. The purpose of the deposit transaction is storage and the convenience of managing your funds—you can pay with receipts, instruct the bank to make payments, withdraw money from your account at different locations, and so on. The purpose of the loan transaction is to earn income. In this case, the bank is the borrower; its role is financial intermediation—it issues the money borrowed from you as loans to third parties. Note that we are dealing with fungible things, where the object of the transaction is a quantity of fungible goods (liters of water, barrels of oil, tons of wheat), not specific coins, ingots, or grains.
| Deposit Transaction | Loan Transaction | |
|---|---|---|
| Purpose for client | Managing funds, payments, etc. | Income from transaction |
| Purpose for bank | Income from account servicing | Income from transaction |
| Ownership rights to money | Remain with depositor | Transfer to bank for duration of transaction |
| Access to funds | Funds always accessible | Lost after transaction is concluded |
| Term of transaction | Indefinite (on demand) | Has a limited term |
Note also that in the case of a loan, the lender typically earns income not upon completion of the transaction but regularly, in the form of interest on the amount transferred to the bank. With deposits, it is the depositor who pays the bank for servicing.
It is clear that bankers have always been tempted to lend out the money given to them for safekeeping. The realization of this temptation in practice is called “fractional reserve.” Note that this term itself, and especially the opposite concept of “100% reserve,” presents itself as some kind of technical requirement. In reality, this terminology comes from the times when “fractional reserve” had already become a banking privilege. “Reserve” is a euphemism—a shameful name for the share of demand deposit funds that the bank does not put toward new loans.
The idea is that “depositors never come for their deposits all at once.” Therefore, through empirical observation, a banker can calculate approximately what sum needs to be kept in the vault as a “reserve” to serve demand deposit holders. This allows the remaining funds to be issued as loans.
Fractional reserve enables the issuance of money—initially in the form of gold receipts, or banknotes—many times greater than what the bank actually holds, because the bank not only appropriates depositors’ money and lends it out; additionally, a multiplier effect arises that repeatedly increases the money supply.
The multiplier works as follows. For simplicity, let us take the case of a single monopoly bank, meaning only one bank operates in our country. With a 10% reserve requirement, of the funds flowing into the bank as demand deposits, only 10% is kept intact, and the bank may lend out the rest. So, let us assume I deposited 100 hryvnias in gold into the bank. The bank reserves 10 hryvnias and issues 90 as loans in banknotes. Since we have only one bank, these 90 hryvnias immediately become a deposit in the same bank—owned by the person who received the loan. From his 90 hryvnias, the bank reserves 9 and issues 81 as a loan, which again becomes a deposit, and so on. In the limit, the bank inflates 900 hryvnias of money from my original 100—money that never existed and that is not backed by anyone’s efforts or useful actions for other people.
The single monopoly bank scenario is, of course, a simplification; in reality, many factors affect the multiplier, such as the number of banks (the more there are, the smaller the multiplication effect) or the public’s desire to keep their loans as cash under the pillow (again, the higher it is, the smaller the multiplication effect). One must understand that fiduciary money is generated by the banking system as a whole, not by individual banks. As you spend the money received from the bank, your loan inevitably becomes deposits in other banks, which also subject these funds to multiplication operations.
One must also understand that inflating new money from demand deposits allows the bank to issue more loans, thereby lowering their price. That is, the bank producing air gains—thanks to fractional reserve—competitive advantages over those who do not do this. Under normal circumstances, with full reserves, a bank could only lower the price of loans by attracting more people willing to lend it funds “for profit.” As they say, feel the difference.
This celebration ends when customers’ needs for their money exceed the bank’s ability to satisfy them.
Essentially, the story with coin debasement repeats itself: more gold receipts in denominations of monetary units are produced than actual gold that exists. It is very important to understand the following. In banks, “money” exists in the form of “entries in bank books.” When the bank issues 90 hryvnias of loans from my 100 hryvnias, it does not physically move my money to the new borrower. It simply makes an entry indicating that the person who received the loan is now the happy owner of 90 hryvnias. My ownership of 100 hryvnias supposedly remains untouched, and new property appears—90 hryvnias with a new owner. Theoretically, I can dispose of my sum, and the new owner can dispose of his. Therefore, it is said that banks “create money out of thin air”—these are merely accounting entries.
However, if we both come to the bank and demand our gold in receipts, the bank will go bankrupt, because it has receipts for 190 hryvnias but only gold for 100. The same mechanics apply in the case of purely paper money. Receipts work as money substitutes exclusively as long as the public trusts the bank that issued them and does not rush all at once to withdraw money from deposits. These money substitutes “work on trust” and are therefore called fiduciary (fiducia—trust) money.
Incidentally, banks’ secretive nature is due precisely to the fiduciary nature of modern money and the fact that all banks are technically bankrupt by definition, as they are unable to satisfy the demands of all clients. A bank with 100% reserves has nothing to fear from rumors or panic, since it can always fulfill the demands of demand deposit holders. By the way, there were such examples in history, in particular, the history of the Bank of Amsterdam, which successfully survived two mass bank runs caused by war.