Everything You Need To Know About Money – What are you saying? Don’t know the first thing about what fractional reserve banking is or how it works? You are not alone. We recently surveyed 1,000 US consumers and nearly 26% of respondents believed that banks were required to keep 100% of customer deposits in reserves.

This article will explain why that is not true and is intended to be the primer on fractional reserve banking by answering basic questions about what exactly fractional banking is, how it came to be, how it works, and the pros and cons. You may just discover that fractional reserve banking is, or could be, a bigger part of your life than you ever realized.

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And, for crypto-enthusiasts, this article may serve as a confirmation that we need to move away from fractional reserve banking to more stable, largely fair and secure methods of exchange and wealth management.

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Fractional reserve banking is a system by which banks lend to their customers to generate profit through interest. You might think your money is being stored in some vault at your favorite bank – 26% of respondents to our recent survey of 1,000 US consumers were believes that banks must keep 100% of deposits in their reserves. Newsflash: they don’t need to keep customer deposits on hand – not by a long shot.

The ‘fractional’ in ‘fractional reserve banking’ refers to the fact that banks are only required to keep a fraction of deposited funds in their reserves. While that fraction is still stored in an account within the central bank or in the bank’s immediate cash reserves, much of the customer’s investment funds are lent back to to earn the bank’s money through interest payments.

Fractional reserve banking basically allows banks to use the capital of savers as credit to borrowers. Advocates argue that this is essential to powering the wheels of the American economy, while critics are more concerned about bank runs and other risks that have arisen from the flaws in the fractional reserve banking system.

Some believe that fractional reserve banking dates back to an anonymous goldsmith who realized that he could lend out a portion of his gold, earn interest on it, and return it to the reserves. before anyone was wiser. That may be true, but we tend to point to more visible examples when detailing the history of today’s fractional reserve banking system.

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Most believe that the origins of fractional reserve banking lie in the Middle Ages. As more people stored their wealth with banks, they wanted to simplify the process of paying for goods and services. So instead of being sure that you would get the exact coins you put in when a customer chose to withdraw them, banks started treating deposit balances as an IOU of sorts.

This allowed banks to transfer coins from one account to another as a form of payment between two customers, instead of a customer withdrawing their coins, paying a fee to do so, the to give those coins to the person they wanted to pay, etc. These systems evolved into the 1400’s and today, where banks are free to transfer money between accounts and even lend to a third party, as long as they keep the legally required amount of deposits. -buy in their resources.

To understand fractional reserve banking, it is helpful to start with 100% reserve banking. Banks that are 100% reserve banks keep one hundred percent of their customers’ deposits in their reserves, either internally or in an account with the central bank. Fractional reserve banking states that banks are only required to hold a fraction of customer deposits – usually far less than 100% of them – in deposits at any given time.

So, let’s say a bank has $50 million in customer deposits. Most banks are required to keep 10% of customer deposits in their reserves, so in this situation the bank would need to keep $5 million on hand. Once they’ve satisfied that requirement, bank decision makers can lend out the remaining $45 million in customer deposits as a way to collect interest and add to their coffers.

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Reserve requirements in America are set by the federal reserve and can be treated as a tool to stimulate economic activity. The interest that the banks collect as loans are repaid grows on the money supply, and that growth is often unprecedented. Here’s why:

Once a bank loans the $45 million available in deposited funds to, let’s say, Tom, then Tom can deposit those funds in another bank. So the lending bank keeps the $45 million on their books, and Tom pays it back (at least in theory) over time, plus interest. But the bank in which Tom deposited the $45 million loan is also adding that money to their books. This cycle can continue from bank to bank, leading to massive growth in the total money supply.

Fractional reserve banking has advantages, including access to cheaper credit and the ability for banks to obtain additional funds for their reserves. At least theoretically, that additional income will be seen by the customer in the form of interest on their bank deposits.

Critics of the fractional reserve banking system aren’t holding back: it’s a Ponzi scheme, they say. You are robbing Peter (the investor) to pay Paul (the borrower), and this is not sustainable in the long term. Whether you agree with this view or not, fractional reserve banking has significant disadvantages that are hard to deny.

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For one, the money-multiplying effect of fractional reserve banking leads to an ever-increasing money supply. As the money supply grows – especially in the exponential way created by lending financial resources – the value of the dollar becomes lower, which we also call inflation. A steady increase in inflation, say three percent, is expected and is generally associated with a healthy, growing economy. But over time, the rapidly growing money supply appears to have led to a significant decline in the purchasing power of the US dollar.

Bank runs are also a concern. Say signs of economic trouble cause 50%, or 100%, of bank customers to withdraw their deposits. Well, the bank only has 10% of that money on hand, let alone 50% or 100%. This condition can cause widespread panic leading to Depression.

Similarly, if banks give out their money unwisely (see: sub-prime mortgages), money may never be paid back as unqualified borrowers based on their loans. This means that you have essentially moved bank customers’ deposits down the drain, and doing this systematically can lead to recession or worse, as we saw in 2008–9.

Critics of fractional reserve banking argue that the system contributes to the destruction of the true intrinsic value of money. Along with the rejection of the gold standard in both 1933 and 1971, fractional reserve banking has rendered money truly fiat.

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For this reason, many see cryptocurrencies as a viable option with real intrinsic value and systems that prevent straying too far from being truly collateralized exchange.

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Julian is a staff writer at . It has covered a range of topics, such as technology, travel, sports and commerce. His previous work has appeared in print and online publications, including New Mexico Magazine, TV Guide, Mental Floss and NextAdvisor by TIME. On his days off, you can find him at Isotopes Park in Albuquerque watching the ball game.

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