Fractional Reserve Banking
So... now we understand deposit and loan banking and we know they were allowed to merge, we arrive at the modern version of the system - known as fractional reserve banking. This is where the reserves a bank holds are only a fraction of the value of the deposit receipts it issues. Importantly the commercial banks are allowed to create money out of thin air via deposit multiplication and charge interest on it. It's a little complicated to get your head around at first and that helps to obfuscate the fraud but actually it's fiendishly simple.
Let's walk through how it works...
A central bank or government usually sets the legal requirements for this process. History has shown that a 10% reserve ratio requirement is usually sufficient to keep the system from collapsing; 10% is usually enough to pay out nervous depositors without causing a bank run. So, for the purposes of ease I will use 10%.
Step 1: Customer X opens an account with the bank and deposits £100. The bank must keep 10% on deposit, so it keeps £10 and lends out £90 to customer Y and the money is deposited in their account.
Under traditional loan banking with 100% reserves, Customer X would have only £10 left to be withdrawn in their account because they lent the other £90 to customer Y. However, under fractional reserve banking, money can be both on deposit and out on loan at the same time. Can you imagine any other business being allowed to do that - merge both sides of the balance sheet!? So customer X's bank account balance would stay at £100 and customer Y's balance would be £90. The money supply has grown from £100 to £190.
Step 2: The bank then keeps 10% of customer Y's balance on deposit, and lends out 90% to customer Z, which happens to be £81, bringing the total money supply up to £271 and the process repeats. When the bank is fully loaned up, the amount of money in circulation is nearly ten times the original deposit.
To see that more clearly, have a look at the following table showing the transactions:
| Deposit Number | Amount Deposited | Lent Out | Reserves |
| 1 | £100.00 | £90.00 | £10.00 |
| 2 | £90.00 | £81.00 | £9.00 |
| 3 | £81.00 | £72.90 | £8.10 |
| 4 | £72.90 | £65.61 | £7.29 |
| 5 | £65.61 | £59.05 | £6.56 |
| ... | ... | ... | ... |
| Totals: | £999.99 | £899.99 | £100 |
As you can see, by the end of the process the money supply has increased nearly tenfold. All of the customers think their money is on deposit waiting to be withdrawn or spent.
The bank charges interest on the loans it makes and charges a higher interest to borrowers than it pays to lenders. They get to keep the difference, what's called the spread.
So let's examine the scenario of lending £100 to a bank at 3% and the bank lending to mortgage holders at 7%:
Normal loan banking: the bank would pay you £3 for having £100 encumbered for 1 year. They earn £7 by lending that £100 to someone else. The banked earned £4. At no times does the money supply change. There is always £100 - it has simply been saved and then put to use by someone willing to pay to borrow it. The interest the bank earned and paid part of to you came from elsewhere in the economy.
Fractional reserve banking: the bank charges interest on the money it conjures out of nothing! As the loans get repaid, the phantom money is destroyed and the money supply shrinks. In normal times, banks aim to be fully loaned up, so new loans are made to ensure this is the case. So imagine your £100 deposit to the bank. The bank takes the original £100 and lends £900 into existence, charging mortage borrowers 7% on that money. Every year they pay £3 in interest to you, but they receive £630 in interest for the use of the money your original deposit allowed them to create out of thin air!! That means if you could theoretically get a banking charter you could make 630% interest on your money.
Most people don't realise that when they deposit money at a bank, the bank is not keeping it safe for them - they're actually lending their money to the bank. It becomes a liability of the bank and there is a risk of it not being paid back. This arrangement is actually hidden in plain sight - the interest gives it away! You would have to pay them to keep it safe, but instead they pay you to lend it to them. And boy do they pay poorly...
Chronology?
The process detailed above shows the theory but in reality it doesn't require the process to be so formal. As long as loans are made and the bank holds adequate reserves they are within the legal requirements so the chronology can run in reverse. There's no need to receive deposits and then loan them out. They can make loans and then look for deposits to meet the reserve requirements. If they fall short, they can borrow from other commercial banks or the central bank themselves. Now here is a fascinating and disturbing thing. Most people genuinely and rightly think they are borrowing existing money; the bank and/or its customers are lending it to them. But in fact, you create the money you are borrowing when you sign for the loan and your posessions are the collateral against it. If you default on the loan and fail to pay back the money you yourself created, money the banks benefit from, they are entitled to take your stuff away. Fascinating because hardly any person taking loans out knows this, and disturbing because so many people who do know think it's perfectly acceptable.
So, why does it matter?
If the central bank can just step in these days and rescue failing banks, why should it matter to us?
Fractional reserve lending is legal counterfeiting and should be outlawed for precisely the reason counterfeiting is illegal. Creating new money doesn't increase wealth, it just means there are now more units representing the same wealth. For example if you double the supply of money, there are now twice as many claims on wealth but no new actual wealth, so each claim is effectively worth half as much.
The bank is creating new money that chases the existing supply of goods and services causing their prices to rise. That's one of the important characteristics about a medium of exchange - increasing its supply doesn't benefit anyone but the people creating it. More goods and services make us all wealthier, more exchange media simply means the each unit now represents less of the total wealth of the world. Detlev Schlicter says it best in his book "Paper Money Collapse":
"Money is valued because of what you can buy with it. If an individual has more money, that individual can buy more goods and services. But if society overall has more money, meaning that society has a bigger quantity of the money substance, society is not richer. It has more of the medium with which to exchange things but it has not more things to exchange."
The people borrowing the money are paying interest which they themselves must first obtain by swapping their productive effort for currency that already exists. The banks are earning money for nothing, and fractional reserve banking is transferring wealth via purchasing power from all holders of money to the counterfeiters.
When a failure occurs and a central bank steps in, where do they get the money for the bailout? Well, they either lend it from someone else or, as is much more likely they simply create it out of thin air (as described in central banking), further expanding the money supply and thus worsening the robbery. Everybody who didn't have their money in the failed bank have just had some of their purchasing power stolen to bail out the banks creditors first and depositors second.
Secondly, banks are lending more money than the market has saved. This causes all sorts of imbalances. As we'll see later, the coordination over time of savings and investment is very important to the health of an economy. The price to lend money - the interest rate - is paramount in coordinating the best use of our scarce resources. Creating new money influences and manipulates this signal. Elastic money systems are not self-regulating like fixed money supplies, and so they cause huge booms and busts due to malinvestments and their eventual demise when reality finally catches up.
Additional Reading
Interactive Fractional Reserve Calculator
Wikipedia article on fractional reserve banking