Money | Fractional Reserve Banking

Imagine that we are on an island and I’m a banker; it’s not that far fetched. There are 50 people on the island and we use bottle tops as money. I’m borrowing this idea from a finance writer because it’s simple.  Banking and monetary systems aren’t simple however; so bear with me. 

There are two banks on the island, I run one and my mate on the other side of the island runs the other bank. We both have roughly 1,000 bottle tops in each bank. The islanders want a better standard of living and so look to us to make the economy work.

We need more food and cheap food so when someone says he can catch lots of fish, if he had a boat; it seems like a good idea. My mate in the other bank tells him to order one from the boat builder and I lend the boat builder 100 BT (bottle tops) for supplies to build the boat. The boat builder starts to buy timber and materials from the other islanders and so everyone is better off. I don’t give the boat builder bottle tops of course, I give him a cheque or give him IOU. The bottle tops stay in my bank, although he might withdraw a few. When the fisherman gets his 150 BT loan to buy the boat that cheque goes to the boat builder who comes to deposit it in my bank. Now you might think I have to pay that 150 BT to my mate in the other bank; not so. I give him an IOU, he’s a banker and would rather have 5% interest on the 150 BT. So I loan out 100 BT to the boat builder and my mate loans out 150 BT to the fisherman and the only bottle tops to actually leave our banks is the few the boat builder withdraws to buy sundries. This is cool; I might pay myself a bonus!

What can go wrong you might be asking yourself, we can create money by issuing cheques, IOU’s and bonds and only need to actually use bottle tops when someone needs to make a small withdrawal. If we can get them to use cheques and automatic payments those will be a fraction of what we lend out and get interest on. We only have 1,000 bottle tops each but we can lend out 10,000 bottle tops at 20% interest! That is 2,000 bottle tops a year in interest and we only had 1,000 bottle tops to start with. This is cool, I deserve a bigger bonus!

It was all going so well, I had a luxury yacht on order and the boat builder had never had it so good. Then it all started to go wrong. This guy came from a neighbouring island and asked my mate in the other bank if he could borrow money to buy a boat. This seemed great, it would be more work for the boat builder. The boat builder  put the price of my luxury yacht up! Then after the boat was delivered to the other island we found it was going to be used for tourism; we don’t have that many tourists. The guy can’t pay the money back and my mate in the other bank is short of funds as a result. He wants to borrow from my bank! People are worried and taking their bottle tops out of his bank and putting them in mine. This is OK, but some people are holding bottle tops in their pockets, that is a disaster for banking. I am not lending to that other bank, how can he pay me back? They could start withdrawing money from my bank!

 

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