This was the beginning of the Fractional Reserve System that is the basis of how the banking system works today. What this means is that it is perfectly legal for banks to lend money they don’t have as long as they work within specified limits.

When the Bank of England initiated this system in 1694, the ratio allowed was 2:1. In other words, if a bank held £1,000 in deposits, it could lend £2,000 on the back of this.

This created what is known as “fiat money.” Fiat money means that, for money to come into existence, the government simply prints some pieces of paper with nothing to back them up and declares that they are legal tender.

The word “fiat” comes from Latin and means an “arbitrary decree or pronouncement,” so this does not exactly give you lots of confidence. In fact, these days, most fiat money does not even exist in paper form; it is simply created on computer screens.

Over the years, the fractional reserve ratio has become a lot more generous to the banks. In the USA, the ratio between lending and deposits is now typically 9:1. Around the world, the amount banks are required to hold in reserve can be even lower than 10%. In some cases, there is no limit on it at all. In the UK, there are no formal limits but a voluntary system is in place.

The overall effect is that banks are virtually free to simply

create money out of thin air provided they work within the

system and the limits laid down by governments.

In the USA, for example, it is estimated that less than 5% of the money supply actually exists as physical currency. Most simply exists on computer screens.

The following example gives an idea of how this works in practice. It shows how the banking system takes one deposit of just over £1,000 and turns it into loans worth almost £100,000 without any additional assets to back it up.

EXAMPLE

HOW BANKS TURN a £1,000 DEPOSIT INTO £100,000 OF LOANS

Joe goes to the bank because he wants a loan of £10,000 to buy a car

The bank he goes to is actually a new one and it doesn’t even have any depositors yet. However, the bank’s owners have deposited £1,112 of their own money with the central bank.

Under the fractional reserve system, they are allowed to lend nine times the amount they have on deposit, so they can lend Joe his £10,000. They effectively invent the money by creating it in their computer systems and they credit it to his account.

When he has been credited with the money, Joe writes a cheque for £10,000 to buy the car from Jill.

Jill now deposits the £10,000 cheque in her bank account.

Now Jill’s bank has a new £10,000 that they can use for lending. However, they have to follow the fractional reserve requirement of 1:9 so they can lend £9,000 of it.

Once they lend that £9,000 to someone else, it gets paid into that person’s bank account and becomes the basis for a possible new loan of £8,100 (9 x £9,000).

The process continues until, on the back of the original £1,112 deposited by the bank’s owners, it is possible to lend almost £100,000.

In theory the situation described in the example could all happen within one bank. However, even when the money is deposited with several banks, it is all happening within the same system.

So, as a result of this process, we have almost £100,000 of debt created entirely on the back of one small deposit.

The only real assets involved in this process are the ones being traded as a result of the loans, such as cars and houses. Meanwhile, the banks are profiting from interest on all these loans.

In practice, the banks will also have taken in some deposits from customers and will be paying out some interest to them—but naturally at much lower levels of interest than they are charging their borrowers.

Most people believe that when they borrow £10,000 from their bank, the bank has raised £10,000 to cover that. In fact, if the bank has raised £10,000, it could be using this to lend almost £100,000.

When they are allowed to charge interest on money they have created out of thin air, it’s hardly surprising that banks make so much money. Later, we’ll look in more detail at how banks make huge profits out of the interest they charge.

Later in this book I’ll be showing you how to use a concept called “gearing” to copy the banks and turn your own £10,000 of cash into £100,000 asset. I’ll show you how that principle can help you build your wealth much faster than would otherwise be possible.

WEALTH WORKOUT 4: FINANCIAL FREEDOM

List at least ten things you would do if you were financially free and had enough passive income to cover all your costs.

For example, identify where you would live or what type of business you would set up or how you would spend your time.

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27. How Banks Create Money Out of Thin Air