WHAT IS FRACTIONAL RESERVE BANKING AND WHY IT'S IMPORTANT
Amidst our discussion about divestment, it is helpful to understand the banking system and some of the relevant mechanisms of money. This explainer will cover the basics of the fractional reserve banking system and how divestment not only refers to your investments, but your checking account as well. This is just one part of the very complex banking and finance industry, but will hopefully provide useful context.
Fractional Reserve Banking
When you deposit money into your checking account, the bank gives you the ability to withdraw it at any time. However, the bank does not keep all of your deposit on hand in anticipation of withdrawal. Instead, it only has to keep some of the deposit and is free to use the rest. This is fractional reserve banking.
The reserve ratio is the proportion (typically 10%) of your deposit the bank must hold as reserves which can be readily withdrawn. For example, if you deposit $1000 the bank must hold $100 in reserves. (Of course this is scaled to the entire banking system and banks must hold 10% of all deposits they receive.)
So what happens to the other 90% of your deposit? The banks are free to lend out this money. Returning to our example, $900 of your $1000 could be loaned out. (There are other things banks can do instead of lending, but we’ll focus on lending for now since it is the most common example.)
Lending is meant to promote economic expansion, the idea being: more money is available to those who will use it to grow business, fund their projects, invest, etc. Why do banks lend? Most importantly to them, they make money from loans.
The notion of reserves can be very unintuitive at first and a common question is “how can banks promise withdrawal if only 10% of deposits are held as reserves?” Essentially, the entire system hinges on the assumption that not everyone will withdraw all of their funds at the same time or at least faster than the rate at which the banks can liquidate the loans back into reserves. This assumption has failed in the past when sentiment about a bank’s ability to provide owed deposits falters and a bank run occurs. A bank run is when people rush to withdraw their deposits at the same time and the banks don’t have the reserves and can’t give everyone their money. Bank runs can be significantly financially destructive and there have been prominent examples in the past and recently. However, modern policy and deposit insurance (provided in Canada by the Canadian government via the Canada Deposit Insurance Corporation) has helped to mitigate the damage and risk of bank runs. Crudely, as long as you and I don’t both try and withdraw our deposits at the same time, the reserves from my deposits can fund your withdrawals and vice versa.
Divestment is the call to ensure the loans banks make with our deposits are toward sustainable projects and are not funding fossil fuels. Deposit insurance protects depositors from losing their money because of poor loaning on behalf of the banks. While important, an unintended consequence of this is that banks no longer have economic incentive to loan in ways to keep and attract clients by loaning responsibly. Banks profit off our money—if enough of their clients threaten to withdraw their funds, it may reinstate the pressure for them to lend and operate responsibly which includes divesting from fossil fuels.
Credit Unions are alternatives to commercial banks, although they still operate in a fractional reserve banking system. Credit unions are functionally very similar to commercial banks but may offer less services. However, joining a credit union means you become a part owner. This gives you voting rights on the operation of the credit union. As such, credit unions often don’t loan (or very little) to fossil fuel companies and with your voting rights, you can influence divestment.
This is for educational purposes only and is not financial advice. Please inform financial decisions based on your personal goals and own research. It is important to understand how your money moves and its influence. Hopefully this helped provide a better sense of the fractional reserve banking system and how divestment fits into all of it. If you have any further questions, please don’t hesitate to get in touch.
- Josh Der