Weaknesses of Fractional Reserve Lending

There are some negative features in this system.

  1. It is not stable. The banks say your money is safe and it is your money, so is available to you, but that is not fully true. Banks lend out a sizable amount, so do not have all of your money available to you. The government does not have direct control over the money they issue, but can implement some rules to somewhat manage the money.                                  Say one of the banks makes a bad investment, or worse, some money is embezzled, so now they cannot pay out the money you ask for.  You do not have faith in the bank anymore, you read about it in the newspaper and other people start to demand their money, too. Even though the other banks are solid, people start to question those and start taking out money from there as well. That is where the FDIC comes in. It is a government agency which steps in and provides insurance to banks. The money a bank client asks for, will ultimately be provided through this insurance policy.
  2. Bad incentives. Because the bank is insured by this FDIC policy, the customer is not too concerned with how the bank invests its money, so there is no accountability necessary toward the customer, as to whether the bank is making good loans or bad loans.             Banks can issue sub-prime loans to people who cannot really afford that house. It is not just the sub-prime loans that cause financial problems, but more so the ease with which the banks “offer” all kinds of incentives so people will buy whether it is wise or not.
  3. Lending money. The banking system has a lot of control over the money. When the economy is doing well the banks will distribute more money into the lending supply. The opposite is true as well: when the economy is weak it can turn into a recession. Businesses will ask for less money in the form of loans, etc. But in a recession the economy really needs more money so people will buy more again. The Federal government will print more money. However, that is only half of the equation, when in fact, the banks provide less lending, being scared because of the recession. In reality, when you want to get more money into circulation the opposite is happening. When there is a boom and you want to slow down the economy, the opposite is also happening. Because of the boom, more money is entering the market place. To temper an overheated economy, the government can sell more securities and take the money it receives for them, out of circulation.

This is not some law of economics. It is a system, but not the only system, although the most common in many countries.

Sal really explains this very well with a diagram in The Monetary System class of the Khan Academy:


My challenge to you:    Take time to study this diagram, and see if you can explain it to a friend!