I've done some research to get an understanding into the issue I want to ask about. Regrettably, I found out general descriptions of the mechanism and/or evidently biased explanations, which I've got no means to question. Please excuse me if I refer to a concept in a less than optimal terminology. I'm a bright guy but definitely not a scholar of economics.
Please note that I'm not asking for how fractional banking works in mathematical terms. I'm questioning the sanity of it. Well, not questioning - rather not grasping how it differs from hiding the lack of funds.
The traditional approach
Alice owns X units of currency but doesn't use them. Bob comes by and asks to borrow it for a period of one unit of time. As a reward, he promises to return 5% higher amount. Carol comes by and makes the same request with the difference that he promises 10% return on the investment.
Alice considers the chances of the money being paid back in full including the interest as corresponding to the pay-off (e.g. Bob pays up 1.05 X with the probability of 95% and in any other case he's good for nada, zero, ziltch). Alice regards the offers and realizes that there are three options (partial investment of X units isn't of interests).
- Keep the money in the mattress (0 risk, 0% gain).
- Present the money to Bob (5% risk, 5% gain).
- Present the money to Carol (10% risk, 10% gain).
Here, Alice might ask himself if the inflation forces him to invest into anything, if there's any slightest difference in correlation (5% gain but 5.01% risk) etc. But that's not the aim of the question.
The mechanics of the above is obvious to me. The bigger the risk (time the money invested), the bigger the gain. If at loss, only the amount being risked is lost. I.e. only the money risked to get the gain is being risked to getting lost. This part I view as sane and self-controlled.
The banking approach
Suppose there's this typical bank, Bank of Scandinavia. As far I've understood the regulations, it's allowed to lend more money than it actually possesses, as long as it doesn't go bananas. The government of Scandinavia decided that the bananas level starts at 50%, meaning that if BS owns 10 X units, they can lend out 20 X without being considered unstable.
This part puzzles me, because the gain of the bank is being generated based on equal parts of the money risked to getting lost and some money that doesn't even exists.
It's my understanding that the stimulation of the economy is far greater using this approach. I also hear that the wealth created this way is sustainable, at least if we keep the bananas level fairly modest.
As far my research went to its conclusion (and by that I mean that I got tired of googling and watching suspected cartoons on YouTube claiming to reveal the ugly truth), I've learned that some governments set the bananas level to 10% (meaning that BS could lend out 100 X). In fact, during a period, there was the level of 3% in US and it was frown upon as too restrictive.
Is it correct to regard the lending set-up as unhealthy, bound to implode and cause mayhem (at an extremely low risk, which in practice guarantees that such won't take place)?
Or is there a regulatory system covering either the tiny-whiney risky part or, alternatively, a means to recreate and pay back the part of the lost money that wasn't really there? Are there other gains to this set-up except boosting the economy (at incrementally larger risk)?