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The Fractional Reserve Banking System. PDF Print E-mail
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Written by The New Straits Times.   

The following article was published in 'The New Straits Times' Kuala Lumpur during August 1997.

The interest-based banking system, which now forms the foundation of the monetary system in every modern nation, developed from the practices of goldsmiths who established the first banks in Europe many centuries ago.

These goldsmiths were prepared to offer their services to those who wished to deposit gold coins for safe-keeping. Upon taking a deposit of coins, the goldsmith would issue a receipt to the depositor. The receipt would be issued in 'bearer' form, meaning that any individual bearing it could claim back the face value in gold from the goldsmith on demand.


As time progressed, the public found that the goldsmiths' receipts would be accepted in payment for goods and services. The receipts had become the earliest form of 'bank money', and were of an entirely different nature to the gold coins produced by the state.

On most banking days, the coins withdrawn from the goldsmith by some customers would be offset by new amounts of gold deposited by other customers. Therefore, there would be little substantial change in a goldsmith's stock of gold from one day to the next. The temptation to lend this otherwise idle gold was irresistible. However, sufficient quantities would be retained in the vault in order to satisfy expected demands for redemption of receipts. The amount of coins kept in reserve, as a proportion of the amount of receipts outstanding, became known as the 'reserve ratio'.

The subject of how large a reserve ratio was required for safe operation became one of fierce debate among the early goldsmith bankers in England. Some argued in favour of a 100% reserve on the basis that if goldsmiths had issued £100 of receipts promising redemption on demand, then they should keep £100 of gold in the vault to honour this promise. Others foresaw the lucrative possibilities of holding a 'fractional' reserve ratio. The debate was of vital importance. If it was safe to keep, say, a 20% reserve ratio, then the remaining 80% of gold could be lent out at interest. The lower the reserve ratio, the greater the profit.

It soon became apparent that there was little need to lend the vault gold itself. Since the goldsmiths' own receipts were by now regarded as money among the general public, it would suffice for these receipts to be lent out as a proxy for gold coins. Such a policy had the great advantage that receipts could be manufactured at almost no cost, whilst gold itself could not be.

But, if it were indeed the case that the banker had the power to manufacture money, why did he not simply print receipts and spend them on his own consumption? Simply because, in spending his receipts, the banker would no longer own them. It would then be certain that in due course all of the receipts would return to his institution for redemption in gold - gold which never existed in the first instance. By lending the receipts instead, the banker could charge interest on the amount lent. Upon repayment, the receipts could be destroyed as easily as they had been manufactured, but the interest charge would remain as revenue.

In seeking to protect their loans of receipts, it became common for banks to avoid profit sharing investments altogether and to concentrate instead upon interest based loans supported by collateral. The collateral would act as a cushion to protect the banker's loan in the event of the borrower's default. Such criteria for extending loans naturally biased the lending of funds towards wealthy individuals, thus explaining the origin of the quip that "bankers are people who lend you money if you can show that you don't really need it". Wealth would therefore tend to circulate amongst the rich of a community, by-passing those poorer individuals whose business ideas might nevertheless have been worthy of receiving finance.

A problem soon arose in the operation of this new industry, the most profitable business idea of all time. The bankers charged interest on money that only they could create. How then could borrowers hope to repay loans of this manufactured money plus the interest charges? Imagine that, initially, the total amount of state money in existence is £100. If bankers now create £400 of bank money there will be a total money supply of £500. Let us further imagine that the £400 of bank money is loaned for three years at 10% interest per year, and that an amount of £532.40 will therefore be due for repayment. Now, if the total money supply at the beginning of the loan period is only £500, where will the extra £32.40 come from?

The required new amount of money could only come from two sources. Either the bankers would have to expand the supply of bank money, in other words lend yet more, or the state would have to increase the supply of state money. This simple fact would have enormous repercussions for the economy as the practice of banking spread. In the long run, both money supply and debt would increase despite all attempts at control. And, in due course, a whole spectrum of economic problems would result. Among these problems would be endemic inflation, a 'business cycle' whose ups and downs would follow the creation and destruction of bank money, and an increasingly imbalanced distribution of wealth.

A speculative boom and bust would be an extreme form of the business cycle in operation. Those who wished to buy property or shares could do so by taking a loan from a banker, thereafter providing the purchased asset as collateral. The bank would typically lend an amount equal to half or three quarters of the value of the collateral, so that even if there was a modest fall in the market price and a default by the borrower, the collateral could still be sold at a price that was sufficient to repay the banker's loan. As the newly manufactured bank money was spent by the speculator, the price of assets would begin to rise. Others, noticing the trend, would join the game to borrow bank money and buy into the rising market. A self-fulfilling speculative bubble could thereby arise, financed partly by speculators' own funds but mostly by bank money.

Unfortunately, the bubble would always burst when the bankers became nervous of creating further bank money. With less new money being created, few new buyers would enter the market to buy assets, and with fewer buyers the market would begin to drop. Now the bankers would become still more nervous, since the value of their collateral would also be dropping in value. Some borrowers, who had relied on making speculative profits in order to pay their interest costs, would now begin to default. The banks would then seize and sell their collateral on the market, pushing prices down still further. And so the vicious circle would continue in a process that is nowadays described as 'debt deflation'.

The authorities in England long ago acted to counter the dangers posed to the health of an economy in which numerous private issuers of paper money were active. Under the 1844 Bank Charter Act, the right to issue most kinds of paper money was restricted to the Bank of England. Unfortunately, the Act did nothing to prohibit the growing reliance of bankers upon the newly developing cheque and account statement system. Once more, public confidence was essential to the successful operation of the new system. Where once the public felt sure of its ability to convert receipts into gold, it had now to be persuaded that the figures printed on bank account statements could be withdrawn as state money if required.

The check and account system can be analysed most easily if we assume that there is only one bank operating in the economy. Imagine that this bank has several customers of which A and B are two. Both A and B start with a zero balance on their current accounts. Customer A now gives customer B a cheque of £100 in payment for goods, and customer B deposits this cheque with the bank. The banker credits account B with £100 and debits account A with the same amount. B is now in credit and A in overdraft to the amount of £100 and the goods have been paid for. The amount of new (bank) money in existence is the £100 in customer B's account.

Notice that one group of bank customers must always be in debt to an amount that equals existing bank money supply. Notice also that if A now repays his overdraft by depositing a cheque of £100 drawn on Customer B, then the bank money transferred from B to A simply vanishes. Bank money stands in complete contrast to state money. Gold coins and even modern paper money are never destroyed in the act of repaying a loan.

In Malaysia during June 1997 the total amount of state money (i.e. notes and coins) in existence was approximately RM19 billion, yet the total amount of money separately available in demand deposit accounts exceeded RM43 billion to give a total 'M1' money supply of RM62 billion. These figures, Bank Negara's own, clearly show the extent of money manufacture by banks in the modern world. It also explains why it is that if everyone went to withdraw their money from their bank in cash on the same day, then the banking system would collapse.

Of the interest charged on bank money, some is paid to depositors and the rest belongs to the bankers. The amount of the bankers' profit is therefore largely determined by a) the difference between the interest rate paid to depositors and that charged to borrowers, the 'interest spread', and b) the amount of money manufactured. The actual level of interest rates is often immaterial in influencing either of these variables.

To the extent that Malaysia's banking system is constructed on the same principles of banking that have ruled in Europe for some three hundred years, then foreigners are to blame for the Ringgit crisis. But this argument aside, the causes of the Ringgit devaluation are far closer to Kuala Lumpur than any Western city. Malaysian banks have expanded the supply of Ringgits on a massive scale in recent years. Between June 1996 and June 1997 for example, the authorities manufactured an extra RM1 billion of notes and coins whilst the banks manufactured more than RM7 billion of new money in the form of demand deposits. With this flood of new bank money comes the risk that each Ringgit will eventually be valued less highly, by both Malaysians and foreigners. Of course, foreign banks play the same game with foreign currencies. Therefore, to a large degree, it is the relative extent to which the game is played across the world that influences currency exchange rates in the long run.

Whilst an individual can be arrested for manufacturing money in his own home, the commercial banking system is given the full protection of the law in doing precisely the same thing. Financial stability cannot be built upon such injustice. A genuine Islamic banking system could change all of this. Its impact would be felt at the very heart of the monetary system since the usury that I have described above would vanish. But alas, the modern Islamic banking experiment is little more than conventional banking with the labels changed. The designers of the system have largely failed to identify the true nature of modern banking. The result is an array of Malaysian Islamic banking products that show no obvious difference to that offered by the interest-based system. These products are introduced to the public with implausible justifications by bankers who have every reason to maintain the status quo. Others who campaign sincerely for Islamic banking can often be trapped in the mind set of a Western financial degree course, brought up on a diet of financial textbooks that usually reflect the thinking of non Muslims.

A community that has practised usury for centuries, and which therefore understands it better than those whose religion prohibits it, should be studied first and criticised second. Those who argue against the usurers without understanding the true nature of usury will probably lose their argument, as did the Church, as have countless politicians and ordinary men throughout history.


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