Fractional Reserves

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 Reserve Banking System is an
increasingly enthralling area amongst the academicians, bankers or even the committee of
IMF. Under this system, money can be created or formed out of nothingness.
1.1 Money
Money 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 context (Mofett,
2006).
1.1.1
Functions of Money
The main functions of money are distinguished as: (1) a medium of exchange, (2) a unit of
account, (3) a store of value and (4) a standard of deferred payment. In essence, any item
or verifiable record that fulfills these functions can be considered money.
1
1.1.2
Money in Modern Economy
Money is pivotal to the formation and functionality of the modern economy. Money in the
modern economy is merely a special form of IOU, or in the language of economic
accounts, a financial asset.
Source: Lewis Kirkham

According 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 ATM. 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
2
customers are consisted of 100% hard cash. In the light of this, the following hypothesis is
tested:
H1: Banks do not have to wait for the deposits to come in before they can issue the loan to
their customers.
H2: Deposits from Customers recorded under liability in the bank statement of financial
position does not consist 100% of cash from their customers.
1.1.4 Fiat Money
According to Michael (2014), fiat or paper money is money that is not convertible to any
other asset (such as gold or other commodities). On the fact that fiat money is accepted by
everyone in the economy as the medium of exchange, 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
(Michael, 2014). Most countries abandoned or abolished the gold standard since 1931
onwards, which allow them to regain control over the money in the economy. On the basis
of this, the following hypotheses were formed:
H3: Ringgit Malaysia is not backed by the gold reserve.
H4: Ringgit Malaysia is a fiat money.
1.4
Fractional Reserve Banking System (FRB)
According to Leary (2009), the term fractional reserve is derived from the fact that a
banks reserve account is only required to be a fraction of total amount of money which
the bank is legally authorized to create, lend or spend. Banks expand the money supply by
being able to lend out multiples of the funds they have in their reserve account. This
implies that by all legal means a banker, under a 10% reserve requirement, can loan out ten
times the amount in reserve, creating 90% of the loan from thin air. According to Meera &
Larbani (2009), the process of money creation assumes 2 forms namely paper notes and
coins known as state money and accounting and electronic entries (monies) created by
banks as money through FRB. Only the Central Bank can print money (Federal Reserve
Notes). Banks cannot print money, but they can expand credit, which then can be redeemed
for money. In Malaysia, the current statutory reserve ratio (SRR) as at March 2009 is 1%
of the deposit as set out by Bank Negara. This reserve represents the amount bankers are to
maintain in order to fulfill the withdrawal needs of its customers. According to the
illustration by the postulation of Arfah et al. (2012), the process of FRB works as such:
1. A, has an account with a Draco Bank and deposited RM10000 today for safe keeping.
2. B applied for a loan from the Draco Bank.
3. The bank by law, set out by bank Negara, on statutory reserve ratio (SRR), can loan out
99 percent of the deposit, hence Draco Bank grant loan of RM 9900 to B who also deposit
same to Grego bank and Grego bank loans out RM 9801 to Mrs. Hawa who deposits to
another bank for example Cilco Bank.
4. The process would be on-going and perpetual. From the RM10000 deposited by A, it
created a great deal (RM9900+Rm9801) out of thin air by the commercial 8 banks. So,
under this system, an original deposit of RM10,000 for example, enables the banking
sector to increase deposits to maximum amount of RM100, 000, (which is RM1, 000
divided by the reserve requirement of 0.01).
Withal to that, Arfah et al. (2014) also argued that FRB is practiced by virtually all
conventional and Islamic banks in Malaysia. In the light of this, the following hypothesis is
formed:
H5: All banks in Malaysia practices Fractional Reserve Banking System
2.0
Research Methodology
Chapter 2 outlines the research method that is being used in the study. Research method is
the way to which the data are collected for the research project. 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
Research Design
The approach pertaining to this research is qualitative research, whereby a focused group
interview is adopted through the use of purposive sampling.
2.2.1
Primary Data
According to Zikmund (2003), primary data is collected purposely for the assignment.
Under the context of this study, 40% 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. Questionnaire is a research survey practice utilizing a
set of questions targeted to a noteworthy figure of subjects as a means of obtaining
information from the respondents for a study (Malhotra & Peterson, 2004). This method
ensures standardization of compatibility across interviewers, increase speed, and facilitates
data processing.
2.2
Data Analysis
Under the settings of this study, Statistical Product and Service Solutions or in abbreviation
(SPSS) version 20 is used as the tool for data analysis. Data are tabulated into SPSS and
the frequencies of Yes and No are analyzed on the basis of custom tables featured under
SPSS. Results of data will be tested against the hypothesis and constructs developed in
introduction. Due to the fact that this is a qualitative research, it may be a predicament to
establish scale measurements such as confidence interval and p-value. Instead, the
acceptance of hypothesis will be based on the percentile of 0.7 or greater pursuant to the
frequency in each given response pertaining to every single hypothesis tested upon
(Zikmund, 2003).
2.3
Descriptive Analysis
Descriptive 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.
Descriptive analysis statistics are contributed via frequencies, measure of central
tendencies and dispersions. On the basis of the postulation by Burns and Bush (2006, pg.
424), the descriptive analysis is used to depict the variables in a data matrix. It is
comprised of statistics that are linked with frequency analysis that aids in summarizing the
information displayed in the frequency table (Aaker et al., 2007 p. 438). Fundamentally,
descriptive analysis involves the calculation of the descriptive summary statistics, precisely
on the mean or percentages (Aaker et al., 2007 p. 436). The sample mean reflects the
average number, gained by dividing the sum of responses to that question by the sample
size (Aaker et al., 2007 p. 438). The mean, range and percentage are used to measure and
describe the statistical summary in this study. The objective of descriptive analysis boils
down to the ability to provide accurate, simple and meaningful figures by summarizing
both the dependent and independent variables in a given large set of data.
3.0
Analysis & Findings
Chapter 3 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 major findings.
3.1
Individual Respondent Profiling
Respondent 1: Face-to-Face Interview

Section A :
a.
Age
b.
Qualification
c.
d.
e.
f.
44
Master
in
Finance
19
Managerial
Years in Service
Job Position
(Managerial / Non Managerial)
Accounting Understanding
Bachelor
(Bachelor, Professional)
Religious Background
Believe in god
(Attending
Religious
School,
Believe in God, Spiritualist, Atheist)
Section B :
a) Describe how banks (from both Conventional and Islamic) make a double entry when;
i.
A customer is depositing cash in the bank
Debit Bank
Credit Customer
ii. Another customer is receiving a loan from the bank
Debit Customer
Credit Bank
iii. A customer is paying part of the loan to the bank
Debit Bank
Credit Customer
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 customers? (Yes/No)
8
No. This particular Bank manager claims that the have to adhere to the BNM rule that their
loan out amount to maximum 85% to 90% of the total available deposit. If one particular
branch does not have adequate deposits, the HQ treasury will request that deposits from other
branches be transferred to the needing branch
c) Is it true that the Deposits from Customers recorded under Liability in the bank
Statement of Financial Position, consisted of 100% cash from their customers? (Yes/No)
Yes but as per mentioned earlier, only 85 to 95% are allowed to be loaned out.
d) Is Ringgit Malaysia backed by the gold reserve? (Yes/No)
No. The manager suggested that Dinar is such currency that is backed by Gold Reserves
e) Is Ringgit Malaysia a fiat money? (Yes/No)
Yes, due to the fact that currency is not backed by a physical commodity (Gold 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) Does your bank practices Fractional Reserve Banking system? (Yes/No)
Yes. The manager was initially hesitant to admit, but agreed at the end.

Section A :
a.
Age
b.
Qualification
c.
d.
e.
f.
39
Bachelor
in
Finance
16
NonManagerial
Bachelor
Years in Service
Job Position
Believe in god
(Attending
Religious
School,
Section B :
i.
Debit Bank
Credit Customer
Debit Customer
9
iii.
Credit Bank
A customer is paying part of the loan to the bank
Debit Bank
Credit Customer
Yes
Yes
No.
Yes
Yes.

Section A :
a.
Age
b.
Qualification
c.
d.
e.
f.
25
Bachelor
in
Finance
3
NonManagerial
Bachelor
Years in Service
Job Position
Believe in god
(Attending
Religious
School,
10
Section B :
i.
Debit Bank
Credit Customer
Debit Customer
Credit Bank
Debit Bank
Credit Customer
True to a certain extent. This is due to the virtue that the bank can leverage more than a single
source of liability. However, they have to abide to the minimum ratio under the governance of
Tier 1 ratio and by authority / regulation of BNM.
Yes, however it is arguable. Nowadays, everything is digital. It can be said that 100% of the
deposits are digital money. It can be argued that it is not 100% hard cash. It is true for virtual
cash but not true for hard cash.
No, since the abolishment of Bretton Woods system.
Yes. Doesnt have a tangible backing, hence fiat. All paper currency are fiat money.
Yes. There will be statutory reserve requirement. I believe it is 3% for customer deposit, rest
can be loaned.

Section A :
a.
Age
b.
Qualification
c.
Years in Service
d.
Job Position
e.
38
ASCPA
9
Managerial
Bachelor
11
f.
Believe in god
(Attending
Religious
School,
Section B :
i.
Debit Bank
Credit Customer
Debit Customer
Credit Bank
Debit Bank
Credit Customer
True. Banks didnt use the deposits to issue loan, and according to the rules set by PIDM,
bank cannot circulate customers deposit money.
Yes, if you are talking from accounting perspective point of view. However, most transaction
nowadays is virtual so it may not be 100% hard cash.
No, it is a fiat money.
Yes.
Yes.
12

Section A :
a.
Age
b.
Qualification
c.
d.
e.
f.
36
Bachelor
in
Finance
14
Managerial
Years in Service
Job Position
Bachelor
Believe in god
(Attending
Religious
School, (Muslim)
Section B :
i.
Debit Bank
Credit Customer
Debit Customer
Credit Bank
Debit Bank
Credit Customer
Yes. It comes to the direct balance sheet equation, A = L + OE. Besides liability, bank can
fund through equity through tier 1, hybrid, issuing shares etc. Deposit is not the only source
of funds for banks to loan to customers. So, deposit is not so significant.
No. In theory yes, but under digital banking system not 100% hard cash is involved.
Partly, hence no.
13

Yes. Not just Ringgit Malaysia, other currencies are too. Because gold supply is limited.
Yes.
Respondent 6: Email / Open-Ended Questionnaire Interview Interview

Section A :
a.
b.
c.
d.
e.
f.
31 years old
BBA
(Hons)
Finance
5 years
Executive
Bachelor
Section B :
i.
Debit Bank
Credit Customer
ii. Credit Bank
Debit Loan Customer
iii. Credit Customer
Debit Bank
issue the loan to their customers?
Yes
Statement of Financial Position, consisted of 100% cash from their customers?
Yes
d) Is Ringgit Malaysia backed by the gold reserve?

Yes
e) Is Ringgit Malaysia a fiat money?
Yes
f) Does your bank practices Fractional Reserve Banking system?
Yes
14

Section A :
a.
37 years old
b.
Degree
c.
12 years
d.
Executive
e.
Bachelor
f.
Section B :
i.
Debit Bank
Kredit Customer
ii. Credit Bank
Debit Customer
Debit Bank
Yes.
Yes.
Yes.
Yes.
Yes
Section A :
a.
26 years old
15
b.
Degree
c.
3 years
d.
Officer
e.
Bachelor
f.
Islam
Section B :
i.
Debit Bank
Credit Customer
ii. Credit Bank
Debit Customer
Debit Bank
Yes
Yes
Yes
Yes
Yes
Section A :
a.
30 years old
b.
Masters
c.
5 years
d.
Assistant
Manager
e.
N/A
f.
Section B :
16
i.
Credit Liability
ii. Credit Loan
Debit Asset
iii. Debit Loan
Credit Asset
Yes, because of the fractional reserve system.
No.
No. Our gold reserve had depleted over time.
Yes.
Yes and I think all bank in Malaysia practice Fractional Reserve Banking.
Section A :
a.
45 years old
b.
BBA
c.
23 years
d.
Manager
e.
Bachelor
f.
Believe in God
Section B :
i.
May happen when line problem, 1st transaction not pick up. Staff re-key in again. But,
at the end of the day, both transaction picking by the system.
ii. Same as above, normally happen during offline/ line problem situation.
iii. As above
17
May be true or not and depends on situation. The most important is customers 5cs.
Character, capacity, collateral, condition and concern sense.
Yes under liability but not 100% from customers.
No.
Yes. In fact, I believe all currencies in todays world is fiat money.
Yes.
4.2
Statistical 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 (Debit) while deposits will be
liability (Credit). 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 (Debit) and reduce the liabilities of the
customer owe to the bank (Credit).
4.2.1: Issuance of Loan without Waiting for Deposits to Come In
Position
C
D
NM
Count
Count
18
On the basis of the data obtained, it can be succinctly observed that 90% of the respondents
comprising of 40% managerial level whilst 50% non-managerial level personnel in the
banking industry are aware that banks can issue loans without waiting for deposits to come
in. 20% of the respondents provided further elaboration on the subject matter that banks do
not rely on solely deposits to issue loan. The basic accounting equation hails down to Asset
= Liabilities + Owner Equity. Deposits are under the liabilities of the bank 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. Deposits 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 (H0) that Banks does not have to wait for deposits
to come in to issue loan is thus accepted (90% > 70%).
4.2.2: Deposits from Customers Consisted of 100% Cash Recorded under the
Liability Section of Bank Statement of Financial Position
Position
C
D
NM
Count
Count
19
Pursuant to the data obtained, 80% of the respondents consisting of 30% managerial level
whilst 50% non-managerial level personnel believed that deposits from customers
consisted of 100% cash under the liability section of the bank statement of financial
position. Amongst the 8 respondents who suggested that the statement is true, 1of them
however did raise the fact that this statement is arguable. In terms of digital cash, it is true
that customers deposits make up 100% of the cash deposit but however in the scenario of
hard cash, it is absolutely not the case. The remaining 20% 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 todays world are however mostly virtual which
does not come in the form of hard cash. The hypothesis (H 0) that Deposits from
Customers recorded under liability in the bank statement of financial position does not
consist of 100% cash from their customers is therein rejected (20% < 70%). One 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.
20
4.2.3: Ringgit Malaysia is Backed by Gold Reserve
Position
M
NM
Count
Count
C
D
In accordance to the data obtained, it can be observed that 70% (50% managerial level
whilst 20% non-managerial level) of the respondents agreed that Ringgit Malaysia is not
backed by gold reserve. In fact, 1 respondent pointed out that Ringgit Malaysia is just
partially backed by its gold reserve. 30% out of these 70% respondents further suggested
that gold supplies are limited and ever since the abolishment of Bretton Woods pegging
against the gold system, all currencies in the world is not backed by gold reserve. Amongst
the remaining 30% who suggested that Ringgit Malaysia 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 explanatory of the response they provided.
Overall however, the hypothesis (H0) that Ringgit Malaysia is not backed by gold reserve is
accepted (70% = 70%).
21
4.2.4: Ringgit Malaysia is a Fiat Money

Position
M
NM
Count
Count
C
D
All respondents (100%) of both managerial and non-managerial level unanimously

responded that Ringgit Malaysia is indeed a fiat money. This is in congruence with the
literature review that all currencies in todays world are backed by faith instead of gold
reserves. This however, does contradict with the response of 30% respondents in the
previous construct that Ringgit Malaysia is backed by gold reserve. A possible reason
pertaining to such occurrence may be that the respondents might be suggesting that Ringgit
Malaysia is backed by gold reserves partially and BNM could only print money parallel or
proportionate to its gold reserve increment. The hypothesis (H 0) that Ringgit Malaysia is a
fiat money is therein accepted (100% > 70%).
22
4.2.5: Does your bank practices Fractional Reserve Banking System

Position
M
NM
Count
Count
C
D
All respondents (100%) of both managerial and non-managerial level unanimously

responded that banks in Malaysia 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 Reserve Banking System. It may
be generally inferred that virtually all the officers and managers in the banking sector are
aware that banks are practicing Fractional Reserve Banking System based on the sample
size. Thus, the hypothesis (H0) that All banks in Malaysia are practicing Fractional
Reserve Banking System is accepted (100% > 70%).
23
4.0: Summary of Analysis

Construct
H1: Banks does not have to wait for
Supported
deposits to come in to issue loan.
Yes
H2: Deposits from Customers recorded

under liability in the bank statement of
financial position does not consist of 100%
No
cash from their customers.

H3: Ringgit Malaysia is not backed by gold
reserve.
H4: Ringgit Malaysia is a fiat money
H5: All banks in Malaysia are practicing
Yes
Yes
Fractional Reserve Banking System.
Yes
Academically, this research contributes to the existing literature by the virtue of extending
and examining the on-going orthodoxy those banks create money out of nothing. Under the
results derived from this study, 4 out of 5 constructs of hypotheses are supported.
Hypothesis 2 is however not supported, which contradicts with existing literatures
postulated by positivemoney.org. As afore-conferred, it could be largely due to the fact that
respondents perceived the question from the vantage point of accounting entries instead of
looking into the notion of hard cash, which should have been the intended purpose of the
question. On the basis of summary of the analysis, it is plausible to infer that money is
created out of nothing by banks hinging on the fact that: (1) banks does not have to wait
for deposits to come in to issue loan suggesting that loans are only backed by a portion of
24
deposits under fractional reserve banking system and that banks can make 8 to 10 times
loan out of that deposit, (2) Ringgit Malaysia is not backed by gold reserve, (3) Ringgit
Malaysia is a fiat money and (4) all banks in Malaysia practice fractional reserve banking
system which essentially entails fractional deposit lending.
5.0
Conclusion
On an all-embracing vantage point, it can be concluded that banks actually creates money
by the practice of Fractional Reserve Banking System where banks are endowed the ability
to do fractional deposit lending. As 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.
25

Fractional Reserves

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fractional Reserves

Uploaded by

Copyright:

Available Formats

Abstract

Money in Modern Economy

Source: Lewis Kirkham

Fractional Reserve Banking System (FRB)

Analysis & Findings

Individual Respondent Profiling

Respondent 1: Face-to-Face Interview

Respondent 2: Face-to-Face Interview

Respondent 3: Face-to-Face Interview

Respondent 4: Face-to-Face Interview

Respondent 5: Face-to-Face Interview

e) Is Ringgit Malaysia a fiat money? (Yes/No)

Respondent 6: Email / Open-Ended Questionnaire Interview Interview

d) Is Ringgit Malaysia backed by the gold reserve?

Respondent 7: Email / Open-Ended Questionnaire Interview Interview

4.2.3: Ringgit Malaysia is Backed by Gold Reserve

4.2.4: Ringgit Malaysia is a Fiat Money

All respondents (100%) of both managerial and non-managerial level unanimously

4.2.5: Does your bank practices Fractional Reserve Banking System

All respondents (100%) of both managerial and non-managerial level unanimously

4.0: Summary of Analysis

deposits to come in to issue loan.

H2: Deposits from Customers recorded

cash from their customers.

Fractional Reserve Banking System.

You might also like