Free Money for Banks: How Fractional Reserve Banking Works
Exploring the Mechanism and Consequences of Fractional Reserve Banking.
Welcome to Vaseekaran's newsletter! In this edition, we dive deep into the mechanism of fractional reserve banking, a process that allows banks to lend out a percentage of the deposits they hold. We'll explain how it works, and explore the potential consequences that can occur if it fails. We'll also take a closer look at the current situation in the crypto market, where this mechanism is failing and leading to a lack of trust and confidence among users. This is a must-read for anyone looking to gain a better understanding of the financial system and how it can potentially impact our money and investments. Don't miss out on this informative and thought-provoking article!
Fractional Reverse Banking.
To get a better grasp on this, we need to learn about Fractional Reverse Banking. In a system called "fractional reserve banking," only a part of the money deposited in the bank needs to be available to be taken out. Banks only need to keep a certain amount of cash on hand, and the money you deposit can be used to give loans. Fractional reserves help the economy grow by making it easier to lend money.
Cash Reserve Ratio and Statutory Liquidity Ratio
In India, the Reserve Bank of India requires banks to keep a certain amount of their deposits as reserves (RBI). The Cash Reserve Ratio is the name for this number (CRR). At the moment, the CRR is 4%. This means that for every Rs 100 that is put into a bank, the bank must keep Rs 4 as reserves with the RBI and can lend out the other Rs 96. It’s the money they deposit to the RBI. Banks are also required to keep 18% of their deposits as a statutory liquidity ratio (SLR). That’s the amount they have to keep with the bank to maintain liquidity. So, banks can lend out about 78% of the money that is put in them. Depending on the RBI's monetary policy, these ratios may change.
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Let me give you an example. If Kumar puts 1 lakh rupees (100,000 rupees) into his bank account, the bank is legally allowed to lend out about 78% of that deposit. This means that the bank could lend another person or business 78,000 rupees. Take a customer of the bank, let's call him Shankar. He borrows 78,000 rupees in order to start a small business. Shankar's bank account is credited by the bank. Shankar keeps that money in his bank account until the business needs it. 78% of that deposit, or 61,620 rupees, can now be lent out by the bank. This will go on forever.
This process of lending can go on forever as long as the bank keeps getting new money in the form of deposits and loans. When a loan is paid back, the bank can use some of the money to make another loan. This creates a cycle of lending and borrowing that keeps the economy going.
The potential for a disaster
Now that we know how it works, let’s go further. This process can go on forever, which means that the amount of money in the economy grows with each deposit. This is how the banking system works, but it also brings up some important points. If you could, in theory, break people's trust in a bank as a whole and get enough people to pull out all of their money at once, the bank would fail and have to be bailed out.
You might ask, What is a bailout?
In simple terms, when a bank is facing financial difficulties and is unable to meet its obligations, the government or central bank may step in to provide financial support. This can include injecting money into the bank, taking over the bank's operations, or even merging it with another bank. The goal is to stabilize the bank and prevent its failure from causing a widespread economic crisis.
There have been a few instances of bank bailouts in India in recent history.
IDBI Bank: In 2019, the Indian government bailed out IDBI Bank, which had high non-performing assets (NPAs). The government injected capital and cut its stake from 80.96% to 46%.
YES Bank: In 2020, India's private sector bank YES Bank was near collapse due to high NPAs and low capital. The RBI rescued the company with a capital infusion from SBI and other investors and a new board.
Lakshmi Vilas Bank: In 2020, the RBI restricted the bank's operations and announced a merger with DBS Bank India due to high NPAs and liquidity issues.
Reasons for the loss of trust and confidence.
There are several reasons why customers may lose trust and confidence in a bank.
Poor customer service
Now, if any of the above things happened, except for negative publicity, it was the bank's fault. If bad financial management, fraud in the bank, not securing systems against cyber attacks, and bad customer service caused customers to lose faith in the bank and cause it to fail, they are to blame. Not bad publicity, though. It's easy for any organisation to get bad press these days. Social media has made it easier than ever for information to spread quickly.
Destroying a bank.
You might think that if a bank's competitor wants to take it down, all they have to do is spread false rumours about it. In theory, if one bank wants to destroy another bank, it can spread false rumours about the other bank through the news, social media, and other channels. Social media has made it easier than ever for information to spread quickly, and rumours or false information about a bank's financial stability can cause depositors to lose faith in the bank. If enough people believe this and take their money out of the bank at the same time, it can cause a bank run and maybe even cause the bank to fail. If a bank run causes it to run out of cash, it might not be able to pay its depositors and borrowers. But this doesn't happen because it would hurt the economy as a whole and hurt other banks as well, including the one that planned the attack. We also have the RBI to keep this kind of attack from happening.
Fractional Reserve Banking in Crypto
Now, let's look at why fractional reserve banking isn't working in the crypto market right now and what that means for the crypto market. Unlike traditional banks, decentralised platforms like exchanges don't have a central authority that decides how much money can be borrowed or lent. Because of this, many exchanges have been lending out more money than they have on hand, which has made users less trusting and confident.
The recent failure of the cryptocurrency exchange FTX is a great example of this. Bianance is another cryptocurrency exchange that competes with FTX. It destroyed FTX by selling all of the FTX tokens it had, which caused the price of FTX to drop by a lot. It caused more people to sell FTX tokens, which made the price drop even more. Until FTX couldn't pay the people who sold their tokens back to them with money. I'm not going to talk about the details. It's a big deal in the history of digital currencies. You can learn more about FTX by looking it up on Google. The crypto market has been hurt by this failure in a big way. Many users have lost faith in how safe these platforms are, which has led to less trading and a drop in the value of cryptocurrencies. Also, it has caused some cryptocurrency exchanges to go out of business because they couldn't pay their users. It's important to remember that this failure shows how the crypto market needs more rules and oversight to protect investors' money and keep crypto platforms from going down.
I want to end this article by telling you how to protect yourself if your bank goes bankrupt. You shouldn't put all of your money in one bank. Open bank accounts at several different banks and split your money among them. If one bank has problems, having your money in more than one bank can help keep your money safe. This is called diversifying your money. This way of spreading your money out can protect your savings and investments if one of the banks you have chosen has money problems.