Banking 101

Banks are a critical feature of the modern economy. But most people don't understand how modern banking actually works.

Spoiler Alert: It may shock you.

Here's Banking 101!

1/ First, a bit of history.

Most historians believe the earliest forms of banking began to appear around ~2000 BC in ancient India, Assyria, and Sumeria.

Ancient Greece and Rome expanded upon this legacy.

But banking transitioned into its more modern form in Renaissance Italy.

2/ In its most basic sense, the business of banking is very simple.

Take money from depositors (deposits), pay them interest. Lend money to borrowers (using deposits), receive interest.

As long as the interest received exceeds the interest paid, the bank is happy / profitable.

3/ Historically, banks would maintain sufficient "reserves" (cash/metals) to give depositors their money back on request.

This is prudent, but limits the ability to create credit and thus may stifle investment in an economy.

So called "fractional reserve banking" changed that.

4/ Fractional reserve banking allows banks to only maintain a fraction of deposits in their reserves.

If the reserve requirement is 10%, a bank with $100 in deposits only has to maintain $10 in reserves.

To illustrate the beauty (and the beast!) of this system, here's a story.

5/ Imagine you arrive in a new town in California during the gold rush.

You get off the train with $1,000 in your pocket (and boundless ambition!).

You head over to the new CA Savings Bank and deposit the money into a bank account.

You are happy.

6/ CA Savings has a 10% reserve ratio, meaning it has to maintain 10% of your deposit in its reserves.

It places $100 in its reserves and lends the remaining $900 to Judson Adam, who uses it to buy gold pans.

The gold pan seller, Josiah Smith, deposits the $900 into CA Savings.

7/ CA Savings places $90 (10% of $900) in reserves and lends the remaining $810 to Jeremiah Black, who uses it to buy wheelbarrows.

The wheelbarrow seller, Johnson Campbell, decides to keep the cash in his pocket.

Let's take a step back and look at what has happened here.

8/ Your original deposit of $1,000 at CA Savings started this chain, but there is now $2,710 of "cash" in circulation.

You: $1,000 at CA Savings
Josiah: $900 at CA Savings
Johnson: $810 in pocket

The fractional reserve banking model enabled the creation of credit/dollars.

9/ That is mostly a good thing.

Judson and Jeremiah received loans that allowed them to spend, invest in equipment, start businesses, hire, etc.

The fractional reserve system enabled credit creation, which in turn sparked growth.

So that is the beauty.

What about the beast?

10/ Say there is an earthquake. You get nervous, so you ask CA Savings for your $1,000 back.

Well, they only have $190 of it (10% reserves from the $1,900 in deposits received).

They have to call in their loans (and halt any new lending) to meet your withdrawal.

This is bad.

11/ If the bank is unable to call its loans to meet withdrawals, it may be insolvent. Panic ensues. Credit contracts. The economy slumps.

The system can quickly unravel.

This is a highly simplified example - closed system, very few depositors and loans - but the basics hold.

12/ So you see, the modern fractional reserve banking system is both beauty and beast.

It enables the creation of credit, which may drive investment and growth.

But it also opens the door to rapid contractions, which tend to be self-fulfilling as panic begets more panic.

13/ I was inspired to do this primer after reading a great thread from @coloradotravis. As he points out, the system relies on banks actually lending. If they aren't lending, dollars are dying.

Thanks to @RaoulGMI @SantiagoAuFund for sharing it! https://twitter.com/coloradotravis/status/1296853677253124096

14/ So that was Banking 101!

The intention of this was to hit on the VERY BASICS of modern banking. Stay tuned.

One could write an entire book on the nuances of this topic (and many people have!). I highly recommend following @RaoulGMI @SantiagoAuFund @coloradotravis for more.

15/ And for more educational threads on money, finance, and economics, check out my meta-thread below. Stay tuned for more! https://twitter.com/SahilBloom/status/1284583099775324161

As some have (correctly!) pointed out, this thread did not cover the complex realities of the modern banking system that muddy the waters a bit.

First off, thank you for encouraging active discourse!

Second, I will plan to hit on this in future threads. Stay tuned.