Banks use deposited money to provide loans, and in reality, not all of that money remains in the bank. Discover the hidden principles of the banking system, which originated with goldsmiths!
The Money You Borrow Isn’t Actually in the Bank
The “reserve requirement” means that banks must keep only 10% of total deposits on hand, while the rest can be lent out. However, for this to work, another condition must be met: “People don’t all withdraw their deposits from the bank at the same time.” Let’s hear from Jeffrey Myron, a professor of economics at Harvard University.
“If everyone decided to withdraw all their deposits on the same day, the bank would go bankrupt. That’s because the money the bank actually holds falls far short of 100% of the total deposits. This is what happens during a financial crisis. People who have deposited money in various financial institutions all try to withdraw their funds at once. But banks and other financial institutions don’t actually hold all that money. It’s invested across various sectors of the economy. So if everyone tries to withdraw their deposits all at once, the financial institution collapses.”
Let’s look at an example. Suppose Bank A has $10 million in deposits. There are 10 account holders, each of whom has deposited $1 million with the bank. In accordance with the reserve requirement ratio, the bank has kept only $1 million of the $10 million on hand and has lent out the remaining $9 million. This is based on the experience that people who deposit $1 million do not withdraw the entire amount at once, but rather withdraw and use money within a range of about $100,000. It is also based on the assumption that the 10 depositors will not all rush to the bank at once to withdraw their $1 million each, totaling $10 million. However, suppose one day all 10 people come to the bank to withdraw their deposits. With only $1 million in cash on hand, the bank has no money to give to the remaining 9 people and eventually goes bankrupt. This is called a “bank run.”
In theory, if “everyone” who has deposited money in a bank were to withdraw their funds “all at once,” the bank would go bankrupt immediately. A bank run is arguably the scenario banks fear most. However, banks typically do not worry about bank runs in normal times because such events rarely occur unless the bank is in a state of severe insolvency. Therefore, whenever incidents like the collapse of Lehman Brothers during the 2008 U.S. financial crisis or the suspension of operations at Korean savings banks in 2011 occur, it is not surprising that the greed and lack of ethics within the financial sector—which triggers crises by selling various risky loan products—are cited as problems.
The Story of a Goldsmith Who Became a Banker
This becomes even clearer when we look at the story of British goldsmiths, who can be considered the forerunners of modern banking. Canadian economist Charles Nelson discusses this story in detail in his book *Macroeconomics*. Let’s hear about the origins of banking from Ellen Brown, president of the Institute for a Public Bank in the U.S.
“It originated in 17th-century England, when people entrusted their gold to goldsmiths for safekeeping. They began issuing paper receipts. They later became bankers. These receipts came to be known as ‘banknotes.’ They served as receipts for the gold entrusted to them. Both those who wanted to borrow gold and those who had deposited it preferred these paper receipts because they were easy to carry and eliminated the risk of theft.”
This was a common occurrence in 17th-century British cities.
Back then, there was no such thing as currency as we know it today. In other words, it was an era when gold itself was money. However, gold was not only heavy to carry around but also inconvenient. So, people minted coins made from melted gold—that is, “gold coins”—and these began to circulate as common currency. But since gold is so valuable, there were concerns about keeping it at home or carrying it around all the time. Eventually, people began renting safes from goldsmiths to store their gold. This was because goldsmiths possessed large, sturdy safes, and their shops were considered the safest places in town for storing gold.
When people brought their gold to the goldsmith, the goldsmith would issue a receipt and promise to return the gold at any time upon presentation of the receipt. Of course, the goldsmith also charged a certain amount as a storage fee. However, from that point on, people began exchanging the gold receipts instead of the gold itself. Not only were the receipts much lighter and easier to carry than gold, but they could also be exchanged back for gold coins at any time by presenting them to the goldsmith. For a time, the gold receipts served as currency.
But from the goldsmith’s perspective, the situation seemed to be taking a strange turn. And finally, he realized something.
“People aren’t coming to claim all the gold coins they deposited at once. Nor are large groups of people flocking in all at once!”
From that point on, the goldsmith began to exercise his “ingenuity.” He decided to lend out the gold coins people had deposited with him to others and collect interest. He reasoned that as long as the loans were repaid, the depositors would never notice, and he could make money almost for free. In this way, the goldsmith was able to lend out the gold coins, secretly collect interest, and amass a substantial profit.
However, this fact could not be hidden forever. People found it suspicious that the goldsmith was suddenly making so much money, and before long, they discovered that he was lining his pockets by lending out the gold coins they had entrusted to him and collecting interest. Eventually, the people flocked to the goldsmith to protest. But at this point, the goldsmith once again demonstrated his resourcefulness and made the following proposal instead.
“If I lend out your gold coins and collect interest, I’ll share a portion of it with you.”
People were tempted by this offer. Since they could make money without lifting a finger, it seemed like the best deal possible. But even then, the goldsmith had little to worry about. After all, he was making money by collecting interest on other people’s money. Then, the goldsmith’s greed began to grow. Upon reflection, he realized that no one actually knew how many gold coins were in his vault. Eventually, the goldsmith began issuing gold certificates at will, claiming to have gold coins that weren’t even in the vault. Of course, people had no idea that the goldsmith was “creating” money that didn’t exist in the vault.
This is a story told by Ellen Brown, director of the Institute for a Public Bank in the United States.
“Goldsmiths issued certificates worth ten times the amount of gold in their vaults. There were probably no one wiser than them. They knew that, on average, people would only come to claim 10% of the gold. This is the very foundation of the 10% reserve requirement. It’s still the case even today.”
Ultimately, goldsmiths were able to collect interest on gold coins that didn’t even exist, and before long, they transformed into bankers who had amassed immense wealth. Only then did people begin to suspect the goldsmiths, and some wealthy depositors withdrew all their gold coins. This is exactly what a “bank run” is.
However, while this bank run initially posed a major crisis for the bankers, it later became a golden opportunity for them to accumulate even greater wealth and transform into full-fledged banking institutions. It was none other than the British Royal Family that extended a “lifeline” at this time. At the time, the British Royal Family, which needed a large amount of gold coins due to prolonged wars, granted bankers “special authority to create fictitious money and conduct lending operations.” The term “Chartered,” commonly found in bank names, means “licensed” or “authorized.” In simpler terms, it means “they received a license from the government to print fictitious money.” At the time, the British monarchy permitted banks to lend up to about three times their gold reserves, and from that point on, a “secret relationship” between bankers and the government began. Let’s continue listening to Professor Geoffrey Ingham of the University of Cambridge discuss this secret relationship between the two.
“The Bank of England was established in the late 17th century. It received funding from London merchants. It was a deal between the London merchants and the king. The king needed to borrow money for war, and the merchants wanted war. They hoped that war would secure trade routes and expand their territories. That was the connection. So, ultimately, the bourgeois capitalist merchants and the state formed an alliance, and a deal was struck. This deal allowed the merchants to establish the Bank of England. They enjoyed privileges akin to a royal charter. So the merchants established the bank and contributed 2 million pounds in capital. In 1696, that was a truly enormous sum. And they lent this money to the king. It was merely a promise to repay the debt, but that became the bank’s asset. Based on this asset, the Bank of England issued 2 million pounds in new banknotes. The value of Bank of England banknotes is based on the king’s promise to repay this money. This is banking.”
Banks that make money with other people’s money
Through this process, a full-fledged bank was established, and following precedent, the bank was able to use the reserve requirement ratio to create money at will—up to the percentage authorized by the government—even without actual cash in its vaults. And this principle applies just as much to modern banks.
In fact, the business of banking is quite unique. Most businesses sell pre-made products or provide services. It goes without saying, but these are “things that exist”—manufactured goods or services that can be provided at any time. Surprisingly, however, banks sell “things that do not exist.” They make real money by inflating and exchanging virtual entities.
The following is a statement by Ellen Brown, director of the Institute for Public Banking.
“Banks do not lend out deposits. When you try to withdraw money from a bank, they don’t say, ‘Sorry, we just lent your deposit to someone else. Come back in 30 years to get it.’ Instead, banks claim, ‘We don’t necessarily need to hold actual money, but if you want it, we’ll give it to you immediately.’”
The reason banks can do this stems from the long-held assumption that “many people do not withdraw their deposits all at once.” John Steel Gordon, an American financial historian, puts it this way:
“What do banks do? They make money using other people’s money.”
Ultimately, banks are not companies that make money with their own capital; rather, they are companies that create money using other people’s money and survive by collecting interest. This is precisely why our society has become one that encourages debt. It is why we receive loan offers via text message several times a day and why banks send loan brochures everywhere. This is because banks generate new money only when customers take out loans.
