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How Does Banking Work?

MEDIA / Newsletters / 2014 / June - How Does Banking Work?

How Does Banking Work?

Most people still think that banks are places where your money is kept safe. But how does banking work? The last couple of years has made us realise that Western banks are not as rock solid as we thought. How did it get this way?

How did we get here?

Governments, as always, are ready to protect us. They will make sure that our deposits are safe, by clamping down on unscrupulous profit seeking financiers, clamping down on tax havens who jeopardise the “financial integrity” of the global economic system. Any problems of course were caused by unregulated free enterprise they tell us.

Of course, governments are ready to help out. They do this in the only way they ever can: by ever more draconian regulation and even nationalisation is back in vogue after having been made unpopular by the communist regimes of old. And as always, the problems that the new rules and regulations pretend to solve were caused by other government edicts in the first place.

To explain this we’ll need to backtrack a few steps and retrace how banking arose and what needs it sought to satisfy and how it subsequently developed into the system we have today. In the process we’ll define some seemingly broadly understood concepts in an attempt to clarify their meaning and how the banking system currently works.

What is a Bank?

Understanding what a bank does is complicated by the fact that the word “bank” comprises several different functions and operations.

Loan Banking

On the one hand a bank can be considered an institution that makes loans: it lends out it assets against a rate of interest. There is a certain risk of course in this practice since if the borrower goes bankrupt a loss is incurred.

A loan bank can itself be financed by loans as well. The lenders extend loans to the bank for a certain period of time in order to receive an interest rate on their loans and the bank with its specialised knowledge and business contacts is able to lend out these funds more profitably. As any other business the loan bank can go bust if it makes investment decisions that turn out for the worse.

Note that the loan bank doesn’t create new money: the person who lends to the bank doesn’t have his money at the same time as the bank has it, and the bank doesn’t have money at the same time as its borrower has it.

Deposit banking

Then there is deposit banking. In this role the bank is nothing more than a business specialised in keeping your property safe: a warehouse. You bring your property – eg. gold coins – to the bank, and receive receipts in return. These warehouse receipts (a.k.a. bank notes) state that the money (the gold in the warehouse) is repayable on demand of the bearer.

Alternatively you can open a current account with the bank (a demand deposit account), which is essentially just a record the bank keeps of how much of the gold in the bank’s vault is yours. To show what it keeps in stock for you it issues bank statements to the depositor.

Using these receipts (or transferring current account units) in the exchange of goods is more convenient than exchanging the actual gold; however the recipient of the warehouse receipt will only want to accept the receipt as a substitute for the actual gold if he really believes the money is there. The bank needs to guard its reputation meticulously. Again, no new money is created. The only thing that happens is that money changes shape. The gold nugget which could previously be used to buy a car is now deposited in the bank and cannot be used. The current account balance with the bank is instead used to pay for the car: the current account balance is transferred to the seller of the car.

"Backed" receipts

To emphasise the point that the assets deposited in the bank against which the bearer receipts are issued are actually present this practice is called 100% reserve deposit banking, in contradiction to fractional reserve banking.

Warehouses operate on a 100% backing basis. The core business of a warehouse operator is the business of keeping the possessions of its depositors safe and in good condition. The warehouse doesn’t become the owner unless it is also in the business of trading or speculating in these goods or issuing futures on them (i.e the right to buy back against a specific price at a particular time). This principle is generally recognised by the courts.

What is the difference between operating a money warehouse with gold stored in it and issuing bearer receipts, and a bank?

Well there used to be none. But case law has developed in the 19th century England (notably Carr v Carr 1811) where issuing a warehouse receipt that is redeemable on demand by an institution that is considered a bank it is not considered fraud. In all other cases (such as a grain warehouse) this practice is still considered fraud.

Fractional Reserve Banking

What is fractional reserve banking? Consider the following scenario: it so happens that the deposit bank notices that after its reputation for reliability has been established that actual demand for delivery of gold by depositors is low and quite predictable.

Why then, the bank considers, would it not be okay if it removes some of the gold; perhaps selling it for extra profit? Would it be violating its duty to safeguard the assets of the holders of warehouse receipts/ current account holders and to deliver gold upon demand? Well, yes current law does consider it fraud by the warehouse operators, but not for the warehouse operators called banks.

You could make a case though that there is no fraud until you default on your promise. The default would then occur when the account holders suspect that there are more units in circulation than there is gold in the bank and they suspect others might be inclined to take delivery of the gold: a bank run occurs.If the dough is missing it is not simply a case of entrepreneurial miscalculation by the bank as in the case of default on an outstanding loan, but a case of fraud.

Liquidity Ratio

Instead of selling part of the gold the deposit bank might issue new warehouse receipts without receiving anything. The bank in this case is using something which is not theirs to make a loan and make money on it by receiving interest. The net effect though is exactly the same as selling the gold: the warehouse receipts are not fully backed any longer by the gold stored in its vault. The percentage of deposits stored divided by the demand deposit receipts (or current account balances) issued is the liquidity ratio of a bank. A 100% reserve bank therefore has a liquidity ratio of 100%.

An interesting current day example of a money warehouse is Tradeflow. This a system introduced by Dubai Multi Commodities City for issuing electronic receipts in return for depositing valuables (gold, precious stones, etc). These warehouse receipts in return can be used for payment or as security for trade finance. More about Tradeflow here.

What keeps deposit banks from issuing an unlimited number of warehouse receipts? Even if the law considers it legal, limits are imposed by the fact that a bank run might ensue as well as the existence of other banks. Other banks also take deposits. And if I have a bank account with bank A and pay Mr B who holds a bank account with bank B, then bank A will have to transfer the gold to bank B. Bank B is not likely to just leave it there with bank A, because if it is into fractional reserve banking it can use this physical gold to issue more receipts while keeping the liquidity ratio the same.


The result of fractional reserve banking is expansion of the money supply which is another term for inflation. More money in circulation means, all other factors being equal, that prices will increase because there is more currency chasing the same amount of goods.

Prices will not increase instantaneously across the whole economy. Instead the first recipients of the newly created money benefit from the purchasing power of the old money. So they gain in wealth. The losers are those who receive the new money last: those in rural areas far away from the world of high finance and government offices. The price of goods will have been bid up by the time the new money reaches them and they would have had to pay these inflated prices with old money. Inflation hurts the savers, the insured, and the people on fixed incomes.

Monopoly on Money Creation

Whileas every bank would covet the power to print new money and use it as if it were earned, the problem as set out above are the limitations that markets impose. Now, what if you would have the monopoly to issue bank notes in a specific geographic area, you would be able to eliminate or cartelise the competing banks, you would be able to vastly increase the money supply and you would be the first to get the newly printed money.

Since only a government has a monopoly of force in a particular area only it is able to launch such a system. Hence in 1694 the world’s first central bank, the Bank of England, was launched to help the English government finance a large deficit (it purchased government debt). The nice thing about printing money for the government is that it is much less painful than taxation and it goes virtually unnoticed. With taxation it is clear who the culprit is but with newly printed money in circulation nobody quite knows what happened, or point a finger at anyone. It is just that most things are more expensive than before. If a finger is going to be pointed, it is at the capitalist, or the speculator, which in turn comes in convenient for the government to extend their reach and divert attention from their own failings. The introduction of central banking was a master stroke.

The Power Distributed

So how was this new system going to work? Although rolled out in various stages, the eventual result was that banks could no longer keep gold deposits and issue their own currency. Instead only the Central Bank would keep the gold deposits and issue warehouse receipts (bank notes)/ current account balances to the banks. The banks would in turn use these deposit accounts to issue deposit accounts, denominated in the Central Bank’s currency, to the public.

Now you have two tier money creation: first the central bank engages in fractional reserve banking and then the banks engage in fractional reserve banking. Holders of bank notes could now only redeem their Central Bank notes in gold from the Central Bank. This is called the classical gold standard. From now the form of warehouse receipt issued by a bank to the public would be important. Banks could now only expand the money supply by issuing demand deposits; not by issuing bank notes since that was the monopoly of the central bank. If a depositor was to convert his current account balance into bank notes that would have a contractionary effect, since his bank would have to draw down its reserves with the Central Bank.

This cartelisation of the banking sector under the authority of the Central Bank made it possible to largely do away with the limitations on money creation that the market would set in a competitive free banking system. The first restriction was the bank run. Bank runs could be countered by the Central Bank acting as lender of the last resort should a bank run into trouble. But more importantly it could regulate and direct the speed of the increase in money supply of the banks. The problem with account holders taking their deposits to other banks would be countered by ensuring that banks would expand their money supply at approximately the same rate. The most important tool in its toolbox here is that the Central Bank can increase the reserve the banks hold jointly with the Central Bank, so that in a way the incentive of banks to decrease their Central Bank reserves is countered. It can increase these bank reserves by buying assets, any asset. This is called quantitative easing.

Quantitative Easing

With quantitative easing the Central Bank pays for its asset in its own newly issued currency notes. The seller deposits this in a bank. The bank deposits the money with the Central Bank and voila its reserves have gone up (or put otherwise: its liquidity ratio has improved). Now it can issue further demand deposits as long as its minimum reserve ratio with the Central Bank is maintained.

Then, suddenly as cash hungry many Western governments were getting ready for World War I they told the holders of Central Bank notes that now these were no longer redeemable in gold. Even the existing vast expansionary powers the Central Banks already possessed were not sufficient. The gold standard had to go now too. Subsequently the paper notes in circulation were relegated to a position of fiat money; which value was only protected by the will of a government to restrict the amount of money in circulation. Without a Central Bank in place Britain (and other countries) would never been able to go off a gold standard and fight this war on the scale and for the duration it has been fought.

Bretton Woods

After the Second World War, a system similar to a classical gold standard was established by the Bretton Woods Agreements. Under this system the US Federal Reserve bank was to play the role of central bank of the central banks. The Fed would keep the gold and the other central banks would hold their reserves in the form of US dollar bills. They could take delivery by exchanging $35 for one ounce of gold. In 1971 the Fed played the same trick on them as they had played on their own population by suddenly abolishing the convertibility of the US dollar reserves into gold.

In today’s world, banks that take deposits in government currency accounts, back the claims of their current account holders with deposits they themselves keep with other banks. Smaller banks keep their deposits with bigger banks. These bigger banks are often called system banks and considered too-big-to-fail. They are considered too big to fail because if they would, then not only their account holders would lose their deposit but also the account holders with the smaller banks that keep their own deposits with these system banks. The system banks in turn keep their deposits with the central banks. And the system banks themselves can they really get in trouble? Only to the extent that a central bank is not willing to indefinitely inflate the money supply and act as lender of the last resort for these banks or to the extent that the population en masse would convert their deposit accounts into cash.

And the central banks, do they still hold gold? They might hold something or almost nothing. But why they hold it is anyone’s guess. Gordon Brown didn’t think there was a need when he famously sold of most of Britain’s gold reserve just before the gold rally started in 2000. Conceivably the only reason is because they at least remotely anticipate a global collapse of a banking system based on fiat alone. One scenario in which that could happen is if account holders en masse would insist holding their money in bank notes. That last threat is now in the process of being eliminated too. Across Europe in various countries cash transactions above a certain amount are already prohibited and some, like – always progressive – Sweden, are considering the idea to abolish cash altogether. Another scenario would be that if people again -en masse – would convert their fiat currency holdings into gold or other precious metals that are seen as holding intrinsic value and can serve as a medium of exchange.

Although it took a bit more than three centuries; in hindsight you couldn’t have thought up a scheme better suited to the needs of ever expanding governments seeking ever expanding powers.

With many thanks to Murray Rothbard’s book “The Case Against the Fed” published by the Mises Institute. How does banking work? You can download it here:

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