How Safe is Your Money? Fractional Reserve Banking and Other Threats

“You’re thinking of this place all wrong… as if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.” —George Bailey, It’s a Wonderful Life

These famous lines from Frank Capra’s holiday classic, It’s a Wonderful Life, have been used to explain how banking works, though the details don’t exactly reflect current realities. Today, we WISH that our banks were as conservative as George Bailey’s fictional Building and Loan. If John could only borrow what Sally had originally deposited, there would be less risk!

Fractional Reserve Banking 101

Investopedia defines fractional banking as “a banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal.” But banks don’t simply loan out 90% of what they have taken in, they create money through credit, or (defined another way) debt. And for better or worse, this unsecured “money” comprises a large part of our economy.

In recent years, reserve requirements have been only 3 -10% at most banks. That means a bank can lend John 10 or even 33 times or more what Sally has deposited. But in March of 2020, the Federal Reserve Board announced it had “reduced it’s reserve requirement ratios to zero percent effective March 26, 2020.” This action eliminated reserve requirements for banks and other depository institutions.

What does this mean? When a bank issues a credit card or lends money to a mortgagee, the borrower’s qualifications (and the bank’s reserves) allow the bank to literally manufacture money out of thin air. No printing press needed. No reserves required.

So what gives money its value? Certainly not the paper it’s printed on. It’s also not backed by “the gold standard,” as was once the case. Its value is the worth that people agree the currency represents. The value is derived from the confidence that a society has in the institutions and governments that back the currency. In Frank Capra’s movie, the townspeople’s confidence in George Bailey stopped the bank run. 

Worry Increases Over Bank Safety

When home and stock values started sliding into the abyss in 2008 and 2009, what stopped people from running to the bank to withdraw their funds? It was because the accounts were “FDIC insured.” To bolster confidence, the FDIC threw more chips into the poker game, increasing insurance on savings accounts from $100k to $250k in 2008, and temporarily guaranteeing unlimited funds in checking accounts. People felt reassured that their money was in a secure place—in a bank insured by the Government of the United States.

There was only one problem: this confidence wasn’t backed with real assets, but with a poker-faced bluff. As one blogger asserted, “If you think your bank deposits are “insured” or “safe” because of FDIC protection, you’re totally irrational.”

Ike Devji, an asset protection attorney stated, “many professionals I deal with, including a former bank president, have described that limit as a placebo. They believe the FDIC would actually be insolvent in the event of a major run on the banks. The limit was increased to $250,000… to prevent such a run.”

But the change in FDIC guarantees should neither assure nor worry us – we should already be VERY concerned. U.S. bank deposits have swelled to an all-time high. The most recent estimate we found was $17.12 trillion in September 2020, according to ycharts. How much of that $17 trillion is covered by FDIC reserves? Only about two percent. According to a recent FDIC statement, the reserve ratio for the fund that insures deposits in banks would remain at 2% in 2021, in spite of increasing economic risks.

Then there are the derivatives. Yes, like the derivatives that crashed the world economy in the subprime mortgage crisis. Warren Buffett calls them “financial weapons of mass destruction,” and he’s correct. Derivatives such as credit-swap defaults, the toxic assets built on failing mortgages, brought down Lehman Brothers in a matter of weeks.

Major “too big to fail” banks have hundreds of trillions in derivatives… more than the entire global economy. To understand the enormous size and risk of the derivatives market, see the illustrations at Demonocracy’s “Derivatives: the Unregulated Global Casino for Banks” and Visual Capitalist’s “All of the World’s Money and Markets in One Visualization.”

By any objective analysis, the banking system has become essentially an illiquid Ponzi scheme run by the Federal Reserve, which shares more in common with Bernie Madoff (or a poker player) than George Bailey.

A Safe Place to Store Your Cash?

Bank “bail-ins”? Some people fear that what happened in Cypress could happen here. Eight years ago, when major Cypress banks collapsed, they were “bailed in” by creditors, including unsuspecting depositors with more than 100,000 euros. Could that happen here in the US–could depositors be made liable for a bank’s failures? It seems the stage is set for that possibility, according to this Investopedia article: “Why Bank Bail-Ins Will Be the New Bailouts.”

Creditors? There are additional challenges and threats when saving at a bank. We have seen bank accounts drained when a....

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