Fractional Reserves

8/18/2019 Fractional Reserves

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Abstract

This paper seeks to delve the question of whether banks can create money out of nothing.

The banking crisis has resurrected interest in this issue, but it had remained unsettled. It is

a general observation that banks create money out of nothing, implying that the actual

money in circulation and the money shown in the accounts of all account holders of an

economy, collectively is not the same. Five hypotheses are formed in this study to be tested

against the responses on selected, qualified professionals in banking industry.

1.0 Introduction

With the world economy teetering on the edge of disaster there has been a great deal of

discussion of late about high finance, and the financial practices of various high-level

institutions within the global economy. Fractional eserve !anking "ystem is an

increasingly enthralling area amongst the academicians, bankers or even the committee of

I#F. $nder this system, money can be created or formed out of nothingness.

1.1 Money

#oney is any item or verifiable record that is generally accepted as payment for goods and

services and repayment of debts in a particular country or socio-economic conte%t ofett,

'(()*.

1.1.1 Functions of Money

The main functions of money are distinguished as+ &* a medium of e%change, &'* a unit of

account, &* a store of value and &* a standard of deferred payment. In essence, any item

or verifiable record that fulfills these functions can be considered money.

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http://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Standard_of_deferred_paymenthttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Standard_of_deferred_paymenthttp://en.wikipedia.org/wiki/Payment


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1.1.2 Money in Modern Economy

#oney is pivotal to the formation and functionality of the modern economy. #oney in the

modern economy is merely a special form of I/$, or in the language of economic

accounts, a financial asset.

"ource+ 0ewis 1irkham

2ccording to positivemoney.org, the money banks create is merely the electronic deposit

money that flashes up on the screen when one checks his or her balance at an 2T#. It is

actual, tangible paper money that one can feel or touch. Instead, it is digital money or

virtual money rather than hard cash. This raised the question as to whether deposits from

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customers are consisted of ((3 hard cash. In the light of this, the following hypothesis is

tested+

4+ !anks do not have to wait for the deposits to come in before they can issue the loan to

their customers.

4'+ 5eposits from 6ustomers recorded under liability in the bank statement of financial

position does not consist ((3 of cash from their customers.

1.1.4 Fiat Money

2ccording to #ichael &'(*, fiat or 7paper8 money is money that is not convertible to any

other asset &such as gold or other commodities*. /n the fact that fiat money is accepted by

everyone in the economy as the medium of e%change, albeit the bank is in debt to the

holder of its money, that debt can only be repaid in more fiat money. In essence, fiat money

is not backed by gold reserves. Fiat money offers advantages over linking money to gold

when it comes to managing the economy. With fiat money, changes in the demand for

money by the public can be matched by changes in the amount of money available to them.

When the amount of money is linked to a commodity, such as gold, this places a limit on

how much money there can be, since there is a limit to how much gold can be mined

ichael, '(*. #ost countries abandoned or abolished the gold standard since 9

onwards, which allow them to regain control over the money in the economy. /n the basis

of this, the following hypotheses were formed+

4+ inggit #alaysia is not backed by the gold reserve.

4+ inggit #alaysia is a fiat money.

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1.4 Fractional Reserve Bankin !ystem "FRB#

2ccording to 0eary &'((9*, the term :fractional reserve; is derived from the fact that a

bank8s :reserve account; is only required to be a fraction of total amount of money which

the bank is legally authoriotes*. !anks cannot print money, but they can e%pand credit, which then can be redeemed

for money. In #alaysia, the current statutory reserve ratio &"* as at #arch '((9 is 3

of the deposit as set out by !ank >egara. This reserve represents the amount bankers are to

maintain in order to fulfill the withdrawal needs of its customers. 2ccording to the

illustration by the postulation of 2rfah et al. &'('*, the process of F! works as such+

. 2, has an account with a 5raco !ank and deposited #(((( today for safe keeping.

'. ! applied for a loan from the 5raco !ank.

. The bank by law, set out by bank >egara, on statutory reserve ratio &"*, can loan out

99 percent of the deposit, hence 5raco !ank grant loan of # 99(( to ! who also deposit

same to ?rego bank and ?rego bank loans out # 9@( to #rs. 4awa who deposits to

another bank for e%ample 6ilco !ank.

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. The process would be on-going and perpetual. From the #(((( deposited by 2, it

created a great deal &#99((Am9@(* out of thin air by the commercial @ banks. "o,

under this system, an original deposit of #(,((( for e%ample, enables the banking

sector to increase deposits to ma%imum amount of #((, (((, &which is #, (((

divided by the reserve requirement of (.(*.

Withal to that, 2rfah et al. &'(* also argued that F! is practiced by virtually all

conventional and Islamic banks in #alaysia. In the light of this, the following hypothesis is

formed+

4B+ 2ll banks in #alaysia practices Fractional eserve !anking "ystem

2.0 Researc$ Met$odoloy

6hapter ' outlines the research method that is being used in the study. esearch method is

the way to which the data are collected for the research proCect. The methodology pertains

to the means, approaches or ways adopted in the conduct of the research and acquisition of

information. This chapter layout includes the design of the research style, identification of

methodology of data collection and sample profiling. Withal to that, it confers the method

of data analysis that will be used in the postulation.

2.1 Researc$ %esin

The approach pertaining to this research is qualitative research, whereby a focused group

interview is adopted through the use of purposive sampling.

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2.2.1 &rimary %ata

2ccording to Dikmund &'((*, primary data is collected purposely for the assignment.

$nder the conte%t of this study, (3 of primary source of data were collected through

survey method via questionnaire. This goes by the virtue that questionnaire survey method

was the preferred method of conduct by a certain selected or predetermined respondents

qualified to participate in the study. Euestionnaire is a research survey practice utili


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2.' %escri(tive Analysis

5escriptive analysis is the process of transforming raw data into a form that would provide

the ease of understanding and interpreting in reflecting the statistical information.

5escriptive analysis statistics are contributed via frequencies, measure of central

tendencies and dispersions. /n the basis of the postulation by !urns and !ush &'((), pg.

'*, the descriptive analysis is used to depict the variables in a data matri%. It is

comprised of statistics that are linked with frequency analysis that aids in summari


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'.0 Analysis ) Findins

6hapter provides a detailed and thorough deliberation of the outcomes of the study on

the basis of open-ended responses and statistical analysis of the data obtained. This chapter

includes an individual respondent profiling, overview of statistical analysis and analysis of

the maCor findings.

'.1 Individual Res(ondent &rofilin

Res(ondent 1* Face+to+Face Intervie,

!ection A *a. 2ge

b. Eualification #aster in

Finance

c. Gears in "ervice 9

d. ob osition

anagerial J >on #anagerial*

#anagerial

e. 2ccounting $nderstanding

&!achelor, rofessional*

!achelor

f. eligious !ackground

&2ttending eligious "chool,!elieve in ?od, "piritualist, 2theist*

!elieve in god

!ection B *

a* 5escribe how banks &from both 6onventional and Islamic* make a double entry whenK

i. 2 customer is depositing cash in the bank

5ebit !ank

6redit 6ustomer

ii. 2nother customer is receiving a loan from the bank

5ebit 6ustomer6redit !ank

iii. 2 customer is paying part of the loan to the bank

5ebit !ank

6redit 6ustomer

b* Is it true that the banks do not have to wait for the deposits to come in before they can

issue the loan to their customersL &GesJ>o*

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>o. This particular !ank manager claims that the have to adhere to the !># rule that their

loan out amount to ma%imum @B3 to 9(3 of the total available deposit. If one particular

branch does not have adequate deposits, the 4E treasury will request that deposits from other

branches be transferred to the needing branch

c* Is it true that the :5eposits from 6ustomers; recorded under 0iability in the bank "tatement of Financial osition, consisted of ((3 cash from their customersL &GesJ>o*

Ges but as per mentioned earlier, only @B to 9B3 are allowed to be loaned out.

d* Is inggit #alaysia backed by the gold reserveL &GesJ>o*

>o. The manager suggested that 5inar is such currency that is backed by ?old eserves

e* Is inggit #alaysia a fiat moneyL &GesJ>o*

Ges, due to the fact that currency is not backed by a physical commodity &?old in this case*,

the value of fiat money is derived from the relationship between supply and demand rather

than the value of the material that the money is made of.

f* 5oes your bank practices Fractional eserve !anking systemL &GesJ>o*

Ges. The manager was initially hesitant to admit, but agreed at the end.


!ection A *

a. 2ge 9

b. Eualification !achelor inFinance

c. Gears in "ervice )

d. ob osition


>on-

#anagerial



!achelor


&2ttending eligious "chool,

!elieve in ?od, " piritualist, 2theist*

!elieve in god

!ection B *



5ebit !ank

6redit 6ustomer


5ebit 6ustomer

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6redit !ank


5ebit !ank

6redit 6ustomer



Ges

c* Is it true that the :5eposits from 6ustomers; recorded under 0iability in the bank

"tatement of Financial osition, consisted of ((3 cash from their customersL &GesJ>o*

Ges


>o.

e* Is inggit #alaysia a fiat moneyL &GesJ>o*Ges


Ges.

Res(ondent '* Face+to+Face Intervie,

!ection A *a. 2ge 'B

b. Eualification !achelor in

Finance

c. Gears in "ervice

d. ob osition


>on-

#anagerial



!achelor



!elieve in ?od, "piritualist, 2theist*

!elieve in god

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!ection B *



5ebit !ank

6redit 6ustomer


5ebit 6ustomer

6redit !ank


5ebit !ank

6redit 6ustomer



True to a certain e%tent. This is due to the virtue that the bank can leverage more than a single

source of liability. 4owever, they have to abide to the minimum ratio under the governance of

Tier ratio and by authority J regulation of !>#.



Ges, however it is arguable. >owadays, everything is digital. It can be said that ((3 of the

deposits are digital money. It can be argued that it is not ((3 hard cash. It is true for virtual

cash but not true for hard cash.


>o, since the abolishment of !retton Woods system.


Ges. 5oesn8t have a tangible backing, hence fiat. 2ll paper currency are fiat money.


Ges. There will be statutory reserve requirement. I believe it is 3 for customer deposit, rest

can be loaned.


!ection A *

a. 2ge @

b. Eualification 2"62

c. Gears in "ervice 9

d. ob osition


#anagerial

e. 2ccounting $nderstanding !achelor

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!elieve in god

!ection B *



5ebit !ank

6redit 6ustomer


5ebit 6ustomer

6redit !ank


5ebit !ank 6redit 6ustomer



True. !anks didn8t use the deposits to issue loan, and according to the rules set by I5#,

bank cannot circulate customers deposit money.



Ges, if you are talking from accounting perspective point of view. 4owever, most transaction

nowadays is virtual so it may not be ((3 hard cash.


>o, it is a fiat money.


Ges.


Ges.

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Res(ondent -* Face+to+Face Intervie,

!ection A *a. 2ge )

b. Eualification !achelor in

Finance

c. Gears in "ervice

d. ob osition


#anagerial



!achelor




!elieve in god

uslim*

!ection B *



5ebit !ank

6redit 6ustomer


5ebit 6ustomer6redit !ank


5ebit !ank

6redit 6ustomer



Ges. It comes to the direct balance sheet equation, 2 M 0 A /N. !esides liability, bank can

fund through equity through tier , hybrid, issuing shares etc. 5eposit is not the only source

of funds for banks to loan to customers. "o, deposit is not so significant.



>o. In theory yes, but under digital banking system not ((3 hard cash is involved.


artly, hence no.

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Ges. >ot Cust inggit #alaysia, other currencies are too. !ecause gold supply is limited.


Ges.

Res(ondent * Email / (en+Ended uestionnaire Intervie, Intervie,

Section A :

a. years old

b. !!2 &4ons*

Finance

c. B years

d. N%ecutive

e. !achelor f.

!ection B *


i. 5ebit !ank

6redit 6ustomer

ii. 6redit !ank

5ebit 0oan 6ustomer

iii. 6redit 6ustomer

5ebit !ank


issue the loan to their customersL

Ges


"tatement of Financial osition, consisted of ((3 cash from their customersL Yes

d* Is inggit #alaysia backed by the gold reserveLGes

e* Is inggit #alaysia a fiat moneyL

Ges

f* 5oes your bank practices Fractional eserve !anking systemL

Ges

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!ection A *a. H years old

b. 5egree

c. ' years

d. N%ecutive

e. !achelor

f.

!ection B *


i. 5ebit !ank 1redit 6ustomer

ii. 6redit !ank

5ebit 6ustomer


5ebit !ank



Ges.


"tatement of Financial osition, consisted of ((3 cash from their customersL

Ges.

d* Is inggit #alaysia backed by the gold reserveL

Ges.


Ges.

f* 5oes your bank practices Fractional eserve !anking systemLGes

Res(ondent 3* Email / (en+Ended uestionnaire Intervie, Intervie,

!ection A *

a. ') years old

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b. 5egree

c. years

d. /fficer

e. !achelor

f. Islam

!ection B *


i. 5ebit !ank

6redit 6ustomer

ii. 6redit !ank

5ebit 6ustomer


5ebit !ank



Ges



Ges


Ges


Ges


Ges


!ection A *

a. ( years old

b. #asters

c. B yearsd. 2ssistant

#anager

e. >J2

f.

!ection B *

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i. 6redit 0iability

ii. 6redit 0oan5ebit 2sset

iii. 5ebit 0oan

6redit 2sset



Ges, because of the fractional reserve system.



>o.


>o. /ur gold reserve had depleted over time.


Ges.


Ges and I think all bank in #alaysia practice Fractional eserve !anking.

Res(ondent 10* Email / (en+Ended uestionnaire Intervie, Intervie,

!ection A *a. B years old

b. !!2

c. ' years

d. #anager

e. !achelor

f. !elieve in ?od

!ection B *


i. #ay happen when line problem, st transaction not pick up. "taff re-key in again. !ut,

at the end of the day, both transaction picking by the system.

ii. "ame as above, normally happen during offlineJ line problem situation.

iii. 2s above



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#ay be true or not and depends on situation. The most important is customers B8cs.

6haracter, capacity, collateral, condition and concern sense.



Ges under liability but not ((3 from customers.


>o.


Ges. In fact, I believe all currencies in today8s world is fiat money.


Ges.

4.2 !tatistical Analysis

In terms of the double entry, all respondents provide unanimous answer that when someone

is depositing the cash, cash will be recorded on the asset &5ebit* while deposits will be

liability &6redit*. When someone is receiving a loan, bank would record the loan on debit

side and the cash on credit side. When someone pay back part of the loan to the bank, the

bank receives money and record it in their asset &5ebit* and reduce the liabilities of the

customer owe to the bank &6redit*.

4.2.1* Issuance of 5oan ,it$out 6aitin for %e(osits to 7ome In

Position

M NM

Count Count

B

N 1 0

Y 4 5

CN 2 0

Y 3 5

DN 5 2

Y 0 3

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E Y 5 5

F Y 5 5

/n the basis of the data obtained, it can be succinctly observed that 9(3 of the respondents

comprising of (3 managerial level whilst B(3 non-managerial level personnel in the

banking industry are aware that banks can issue loans without waiting for deposits to come

in. '(3 of the respondents provided further elaboration on the subCect matter that banks do

not rely on solely deposits to issue loan. The basic accounting equation hails down to 2sset

M 0iabilities A /wner Nquity. 5eposits are under the liabilities of the bank O the obligation

where the bank owes to its savers. The respondents stated that banks could go for other

alternatives of funding on the equity continuum, which include for instance issuance of

shares and bonds. 5eposits itself is insignificant for the issuance of loan. Whilst this does

not succinctly pin-point towards the fact that banks are creating money out of nothing, it

does however validate the fact there is no need for banks to wait for deposits to come in

prior to issuing a loan. The hypothesis &4(* that 7!anks does not have to wait for deposits

to come in to issue loan8 is thus accepted &9(3 P H(3*.

4.2.2* %e(osits from 7ustomers 7onsisted of 1008 7as$ Recorded under t$e

5iability !ection of Bank !tatement of Financial &osition

Position

M NM

Count Count

B

N 1 0

Y 4 5

CN 2 0

Y 3 5

DN 5 2

Y 0 3

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E Y 5 5

F Y 5 5

ursuant to the data obtained, @(3 of the respondents consisting of (3 managerial level

whilst B(3 non-managerial level personnel believed that deposits from customers

consisted of ((3 cash under the liability section of the bank statement of financial

position. 2mongst the @ respondents who suggested that the statement is true, of them

however did raise the fact that this statement is arguable. In terms of digital cash, it is true

that customers8 deposits make up ((3 of the cash deposit but however in the scenario of

hard cash, it is absolutely not the case. The remaining '(3 of the respondents who opined

the statement as being untrue suggested synonymous fact that while it holds true in

accounting point of view, transaction in today8s world are however mostly virtual which

does not come in the form of hard cash. The hypothesis &4(* that 75eposits from

6ustomers8 recorded under liability in the bank statement of financial position does not

consist of ((3 cash from their customers is therein reCected &'(3 Q H(3*. /ne possible

vindication behind the fact that most respondents suggested that this statement holds true

boils down to the misperception of the question of whether hard cash or digital cash is

involved in such scenario.

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4.2.'* Rinit Malaysia is Backed by 9old Reserve

Position

M NM

Count Count

B

N 1 0

Y 4 5

CN 2 0

Y 3 5

DN 5 2

Y 0 3

E Y 5 5

F Y 5 5

In accordance to the data obtained, it can be observed that H(3 &B(3 managerial level

whilst '(3 non-managerial level* of the respondents agreed that inggit #alaysia is not

backed by gold reserve. In fact, respondent pointed out that inggit #alaysia is Cust

partially backed by its gold reserve. (3 out of these H(3 respondents further suggested

that gold supplies are limited and ever since the abolishment of !retton Woods pegging

against the gold system, all currencies in the world is not backed by gold reserve. 2mongst

the remaining (3 who suggested that inggit #alaysia is backed by gold reserve, they

are observed to be entirely under non-managerial position. These respondents might not

have adequate knowledge in such area which is e%planatory of the response they provided.

/verall however, the hypothesis &4(* that inggit #alaysia is not backed by gold reserve is

accepted &H(3 M H(3*.

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4.2.4* Rinit Malaysia is a Fiat Money

Position

M NM

Count Count

B

N 1 0

Y 4 5

C N 2 0

Y 3 5

DN 5 2

Y 0 3

E Y 5 5

F Y 5 5

2ll respondents &((3* of both managerial and non-managerial level unanimously

responded that inggit #alaysia is indeed a fiat money. This is in congruence with the

literature review that all currencies in today8s world are backed by faith instead of gold

reserves. This however, does contradict with the response of (3 respondents in the

previous construct that inggit #alaysia is backed by gold reserve. 2 possible reason

pertaining to such occurrence may be that the respondents might be suggesting that inggit

#alaysia is backed by gold reserves partially and !># could only print money parallel or

proportionate to its gold reserve increment. The hypothesis &4(* that inggit #alaysia is a

fiat money is therein accepted &((3 P H(3*.

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4.2.-* %oes your bank (ractices Fractional Reserve Bankin !ystem

Position

M NM

Count Count

B

N 1 0

Y 4 5

C N 2 0

Y 3 5

DN 5 2

Y 0 3

E Y 5 5

F Y 5 5

2ll respondents &((3* of both managerial and non-managerial level unanimously

responded that banks in #alaysia do practice fractional reserve banking system. This is

deemed consistent with the findings under literature review that all banks regardless of

Islamic or conventional banks are practicing Fractional eserve !anking "ystem. It may

be generally inferred that virtually all the officers and managers in the banking sector are

aware that banks are practicing Fractional eserve !anking "ystem based on the sample

si


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4.0* !ummary of Analysis

7onstruct !u((orted

:1* !anks does not have to wait for

deposits to come in to issue loan. ;es

:2* 5eposits from 6ustomers8 recorded

under liability in the bank statement offinancial position does not consist of ((3

cash from their customers.


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deposits under fractional reserve banking system and that banks can make @ to ( times

loan out of that deposit, &'* inggit #alaysia is not backed by gold reserve, &* inggit

#alaysia is a fiat money and &* all banks in #alaysia practice fractional reserve banking

system which essentially entails fractional deposit lending.

-.0 7onclusion

/n an all-embracing vantage point, it can be concluded that banks actually creates money

by the practice of Fractional eserve !anking "ystem where banks are endowed the ability

to do fractional deposit lending. 2s a recap, it represents a system that merely a fraction of

bank deposits are hard cash-backed. This implies that banks can lend out many times more

than the deposits that they have with them.

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Fractional Reserves

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