Checking Accounts and Bernie Madoff

Ronnie writes in:

I’m curious what your thoughts are on fractional reserve banking. It seems to me that this method of banking is a high risk form of financial management on the part of the banks. The difference (sort of) between Maddoff and FRB seems only different by institution: as long as there is more money coming in it doesn’t matter that a small percentage is going out. This system seems based entirely on debt, which is not ideal for a country, I wouldn’t think.

What Ronnie is really asking about is fractional reserve banking, which is the standard practice of pretty much every bank in the modern world.

What’s Fractional Reserve Banking? It’s easiest to illustrate fractional reserve banking by giving an example.

Let’s say a new bank opens up in town and you’re the first person to open an account there. You deposit $100. Then, another person stops in seeking a loan of $80. The bank gives the person that loan, leaving only $20 in their reserves. Of course, the interest rate they’re paying you on your account is low – say, 2% – and the interest rate they’re charging on the loan is likely higher – say, 6%. At the end of the year, they’ll earn $4.80 in interest on their loan to the customer, and then pay you $2 in interest on your deposit, keeping $2.80 for themselves.

Now, if you were to decide that you wanted your full balance back, the bank would obviously be in trouble. They wouldn’t have the money to give back to you, and thus they’d go bankrupt (and you’d have to rely on FDIC insurance).

What actually happens is that a bank has a lot of depositors. Let’s say 1,000 people all deposit $100 in the account, then the bank lends out $80 to a different group of 1,000 people. This would leave $20,000 in their coffers. Thus, even if 150 of the original depositors came in and asked for their money back, the bank would be completely fine.

Fractional reserve banking simply means that a bank is only required to keep a fraction of their deposits on hand – they’re allowed to lend out the rest to people who want to borrow money.

Understanding Fractional Reserve Banking

The Benefits

Without this system, it would be almost impossible to borrow money for any purpose. Loans would basically only exist between individuals – you wouldn’t be able to just go to a bank to borrow money for a car, a home, or to start a business.

At the same time, the idea of a checking or savings account as we know them would go away. We would have to pay a sharp fee for such services – or else keep all of our money at home.

The Risks

The biggest risk in such a system is the potential for bank runs. If the bank is making poor decisions with the money they’re lending out (or investing), then people who hold accounts at that bank might get nervous and start demanding their money in droves. If enough people tried to withdraw their money at once, the bank would eventually not have enough to pay the depositors and would go out of business. This happened with the Northern Rock bank in 2007 and with IndyMac and Washington Mutual in 2008 – in both cases, the bank showed signs of holding a lot of bad investments, causing depositors to start clearing out their accounts very quickly, driving the banks out of business.

My Take

On one level, I do understand Ronnie’s comparison of fractional reserve banking to the Ponzi scheme perpetuated by Bernie Madoff – both of them relied on a continual flow of deposits and both collapse if the deposits stop flowing.

The difference between the two is simple, though: Madoff’s scheme could not earn money without new depositors constantly entering the system. He needed new investors so that he could keep paying old ones – and that meant that it was inevitably going to fail.

This system, though, can work forever provided that a large number of depositors don’t demand all of their money at once. Since the rate of interest the banks pay to checking and savings accounts is lower than the rate of interest the banks charge borrowers, the system also earns money in perpetuity, something that Madoff’s scheme doesn’t do.

In short, I think fractional reserve banking is something of a necessary evil, given the benefits (individuals are able to borrow money, banking services are free and often earn depositors some interest).

Still Unsure?

Some people are still left feeling pretty uncomfortable when they learn about fractional reserve banking. If you’re left feeling this way, keep two things in mind:

Your checking and savings accounts are insured by the FDIC

Currently, that insurance is for up to $250,000 – it’s scheduled to drop back to $100,000 at the end of 2009, but that may change. Make sure your account is insured (if it’s in an American bank, it probably is) and hold on to your bank statements, as those may be the proof you need to get your money if your bank were to fail.

You shouldn’t have all of your eggs in one basket

I would personally feel concerned if my account balances were pushing the FDIC limit. Instead, I would be investing some of that money in real estate, stocks, government bonds, or other things – the money will work much better for you there.

Trent Hamm
Trent Hamm
Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

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