When we think of a bank, we usually think of a massive stone building with a huge vault with thick walls made from hardened steel. Banks need a secure place to store all the money and gold from depositors.
As a child, when I first learned about banks and savings accounts, I thought that the bank kept all the money inside its vault. I was surprised when my father explained that most of the depositors’ money is not in the vault, but is loaned out to the bank’s customers. Banks are allowed to lend some fraction of the deposits, maybe 90%, in a system called fractional reserve banking.
So what are the origins of this fractional reserve banking system?
Back during the middle ages, one profession was the goldsmith. A goldsmith is a metalworker who specializes in working with gold and other precious metals. These craftsmen would fashion jewelry and other things out of gold. Naturally a goldsmith would have on hand some supply of gold, and a means to store it safely against theft.
At that time, gold was also used for minting coins for currency. So people like merchants would have a stock of gold that represented some portion of their personal wealth. The rest of their wealth might be in land and in their business. People would leave their gold with the goldsmith because he had the facility to safeguard it, i.e. some kind of secure vault.
After awhile, the goldsmith might have, let’s say, 1000 of ounces of gold sitting in his vault. He notices that every day some people make deposits and others make withdrawals, but never all the gold at once. The amount varies everyday, but he notices that the net withdrawal ( deposits minus withdrawals) is never more than 5% of the gold in his vault. The remaining 95% of the gold just sits there collecting dust. The goldsmith probably keeps careful records so he can determine this.
The goldsmith also owns his own gold as part of his personal fortune, which he lends out to others at interest. One day, a merchant stops by wanting to borrow gold. Unfortunately, our goldsmith, who bears an uncanny resemblance to Zero Mostel, has already loaned out all his gold inventory. Oh, but how he hates turning away business. After the merchant leaves, his apprentice, played by Gene Wilder, says that there is lots of gold in the vault.
“Ah, but that is not our gold, it belongs to the customer’s who are paying us to store it for them” replies the goldsmith.
The wheels start turning. Suddenly he has a moment of inspiration! He gets the idea of not only lending out his own gold, but lending out everyone else’s gold that just sits there. He has determined that there is never a need for more than 5% of the gold on any day. So he concludes that he can keep a reserve of 10%, which gives him a margin of safety, and he can lend out 90%. He will collect interest, plus the fee for storing other people’s gold. It’s brilliant! The birth of modern banking.
The smaller his gold reserve, the more profit he will enjoy. But a smaller reserve is also riskier, because he may not have enough gold to cover all the day’s withdrawals. Conversely, more gold reserves gives a greater margin of safety, but less profit. So the goldsmith banker has to strike a balance between safety and profit.
Of course, the goldsmith doesn’t tell anyone he is doing this, so he can keep the profits for himself. Maybe he paints some wooden disks to look like gold coins, or has bags full of lead shot, so it looks like all the gold is still there. But 90% of it is loaned out. He does this for many years and gets rich by doing this.
Then one day, something happens. Perhaps there is news of an invading army approaching and everyone wants to withdraw their gold all at the same time. But the goldsmith doesn’t have it all, 90% is loaned out. His luck has run out. There is a run on his bank which always ends badly for all parties. The angry mob storms his place of business, smashes the windows and burns down the building. Then they drag him out and burn him at the stake. Or maybe, they just hang him.
Of course once everyone had figured out that bankers got so rich by lending out other people’s gold, they now want a cut. They demand to be paid if the banker wants to use their gold, i.e. banks must offer to pay interest for the use of your money.
So you can see how the fractional reserve banking system we know today started out, which was steeped in dishonestly and greed. And the same kind of dishonesty goes on today, just in different forms. For instance, worthless assets like sub-prime mortgages are disguised to look something valuable. Instead of using gold paint, they get a bogus AAA rating from a rating agency. But it’s the same crooked business. Nether leopards nor bankers change their spots.
