Modern banking is based on a confidence trick. The confidence trick is known today as fractional reserve banking.
The original confidence trick is easy to understand. It could only have arisen because ‘commodity money’ was used. Commodity money means that the value of the coin is determined by what it is made from, such as gold or silver. This is in contrast with today, where our bank-notes and coins are worthless of them-selves, but are money, because they are deemed by Government to be money.
In the era of commodity money, it was dangerous as well as inconvenient to carry a lot of heavy gold and silver coins, pretty much as it would be today. People preferred to deposit their gold or silver coins with goldsmiths for safe keeping. The goldsmiths issued receipts or ‘promissory notes’ for the amount of gold coins that were deposited with them. A promissory note is what it says, a promise to pay. It is a receipt promising to pay real gold or silver coins. Promissory notes were much easier and safer to carry around than gold or silver coins, which meant they became very popular. You deposited your gold or silver coins, and one can imagine that in the eyes of the depositor, they were located on a particular shelf in the vault. In exchange, the depositor got a receipt, a promissory note, which stated he was the owner.
The invention of ‘to the bearer’ promissory notes was an enormous boost for the goldsmiths. They became goldsmith-bankers. They realized that few people ever came back to cash them in at any one time, meaning that the gold and silver coins were stored in their vault for a few years at a time, with no identifiable owner, because the receipts were made ‘to the bearer’, and not to a named individual.
The goldsmith-bankers were smart, and decided they could make a lot more money, if they created additional promissory notes, than they had money deposited. The goldsmith-bankers issued these additional promissory notes to borrowers, and in return obtained real gold coins, when the loans were re-paid with interest.
To understand this fully, just say that a goldsmith-banker had £1,000 in gold coins on deposit from John Smith for safekeeping. The goldsmith-banker issues John Smith a promissory note for £1,000. Now say Fred Brown comes by and wants to borrow £1,000. The goldsmith-banker issues another promissory note for £1,000 to Fred Brown and charges him say 5% interest. A year later, Fred Brown repays the goldsmith-banker for the promissory note of £1,000 plus 5% interest, with £1,050 in gold coins. The goldsmith-banker has made £1,050 in real gold coins, real money for his promissory note backed by nothing and what’s more he can still charge John Smith interest for safeguarding his £1,000.
In this way, it is not too hard to imagine that over time the banker would own most of the gold coins in his vault! At some point the goldsmith-bankers stopped charging people to guard their money, and then paid them interest for storing it, because they were making so much money, by lending it out many times over, by issuing these additional promissory notes.
Take the example of a goldsmith-banker who issues five promissory notes, but with only one backed by gold. Say Fred Brown deposits £1,000 in gold coins for one year and is paid 3% interest. One receipt goes to Fred Brown for his deposit of £1,000. The receipt to Fred Brown is backed by the real gold coins that he deposited for safe-keeping. The other four receipts are promissory notes conjured up out of nothing, by a stroke of a pen. Keeping this as simple as possible let’s assume that within one year the debtors have to repay the banker and the banker has to repay Fred Brown.
At the end of the year the banker makes £50 in interest for each receipt and £4,000 in principal. This means that with four additional receipts he ontains £200 per year in interest and £4,000 in principal but only has to pay £30 in interest to John Smith.
Interest charged to borrowers £200
Gross Profit £4,200
Less interest paid to John Smith -£30
Net Profit £4,170
On £1,000 of real gold coins deposited with the goldsmith-banker for safe-keeping, he could make over four times as much in pure profit in just one year by issuing five promissory notes, but with only one backed by real gold. In this way goldsmith-bankers made an enormous amount of money very quickly.
Fractional Reserve Banking
Over time the goldsmith-bankers codified this practice of limiting the total amount of promissory notes that they issued, to a specified multiple of the gold they had in reserve. If the goldsmith-banker had £1,000 in gold coins as the fractional reserve, and issued five promissory notes for £1,000, making £5,000 in total, the fractional reserve ratio would be 20%; If he issued ten separate promissory notes for £1,000, making £10,000 in total, the fractional reserve ratio would be 10%.
Once you understand this ancient confidence trick, you understand fractional reserve banking.