Once upon a time, money was physical. Maybe it was gold, maybe it was silver, or maybe it was paper notes. Regardless, it was physical. And that meant that there was value in keeping your money somewhere safe. Say, down at the vault.
The vault owner could charge you for keeping your physical money safe. Eventually, however, he learned to lend your money out and earn some interest. And you eventually learned to ask for a share of that interest.
There’s an issue here, which is that if he lends too much out, you might come asking for your money and he might not have it. Thus the notion of reserves — an amount of your money that the bank keeps on hand in case you come asking to withdraw. The reserve is fractional because he only keeps a fraction of your deposit amount on hand.
Keeping a fraction of deposits on hand kind of works, most of the time, but if depositors get spooked, say, and they all want their money at the same time, the system still breaks down. That’s why we have FDIC insurance in the US: the government steps in if there’s a run on a bank.
And they all lived happily ever after.
Stepping out of history now, we find ourselves in 2020 with a system that was designed around physical money that needed to be kept safe in a vault; and yet our money is anything but.
Money is a number in a computer now, with your name attached to it. It sounds so simple, but we keep up pretenses like it’s something else that needs to be safeguarded in a vault.
And we continue to perpetuate the unstable system of fractional reserve banking, when there’s no need. People could keep their money in the bank, and decide if and when they want to loan it out (say, as a CD) or invest it. There would be no need for FDIC insurance, and the financial system would be that much more stable.