The Banking System

One of the most important roles a bank plays is in serving as intermediaries to transfer savings from some people to others who need to borrow. Modern banks do more than simply transfer cash. It creates credits, which in effect add to the money supply through what is called “fractional” reserve banking.

Goldsmith’s have for centuries had to have some safe place to store the precious metal that they used to make jewelry and other items. Once they had established a vault, or other secure storage place, other people often stored their own gold with the goldsmith, rather than take on the cost of creating their own secure storage facility.

Goldsmiths gave out receipts entitling the owners to reclaim their gold whenever they wished to. Since the receipts were redeemable in gold, they were in effect, “as good as gold” and circulated as if they were money, buying goods and services as they were passed on from one person to the next.

From experience, goldsmiths learned that they seldom had to redeem all the gold that was stored with them at any given time. If a goldsmith felt confident that he would never have to redeem more than one third of the gold that he held for other people at any given time, then he could lend out the other two-thirds and earn interest on it. Since the receipts for gold and two thirds of the gold itself were both in circulation at the same time, the goldsmiths were, in effect, adding to the total money supply.

In this way, there arose two of the major features of modern banking. 

    1. Holding only a fraction of the reserves needed to cover deposits. 

    2. Adding to the total money supply.

One of the reasons this system worked and has worked is that the whole banking system has never been called upon to actually supply cash to cover all the checks written by depositors. Instead, if Acme Bank receives a million dollars worth of checks written by depositors whose accounts are with Zebra Bank, it does not ask the Zebra Bank for the million dollars, but balances off against whatever checks were written by Acme Bank depositors and ended up in the hands of the Zebra Bank.

For example, if its own depositors had written $1.2MM worth of checks to people who then deposited those checks in the Zebra Bank, then Acme Bank would just pay the difference, using $200k to settle more than $2Million worth of checks that had been written on accounts in the two banks.

This system, called “fractional reserve banking”, worked fine in normal times. But it was very vulnerable in times when many depositors wanted hard cash at the same time.

The Federal Reserve is a central bank run by the government to control all the private banks. It has the power to tell the banks what fraction of their deposits must be kept in reserve, with only the remainder of the money being allowed to be lent out. It also lends money to banks, which the banks can then re-lend to the general public.

Because the Federal Reserve Chairman has such power, and one misconstrued word could literally set off a panic, Fed Chairmen over the years have learned to speak in highly guarded and Delphic terms that leave listeners puzzled as what they really mean.

The Federal Reserve system was established in 1914 as a result of fears of such economic consequences as deflation and bank failures. Yet, the worst bank failures in the country’s history occurred after the Federal Reserve was established.