In the aftermath of the forced confiscation of bank accounts in Cyprus, the question that clients ask me most is, “could it happen here?” “Here” is wherever the client lives or invests, and could be the United States, Canada, Australia, New Zealand, Switzerland, or any other country. The answer is yes. This result stems from the nature of our modern financial system, built as it is on the flawed foundation of a poorly-understood concept called “fractional reserve banking.”

In the Middle Ages if you had gold, silver, or jewelry you didn’t want to store at home, you could take it to a secured warehouse or a goldsmith to store it. You gave the warehouse-keeper a sealed bag of coins and received a receipt for it. The warehouse-keeper didn’t lend out your valuables; he only kept them secure, in return for a fee. As long as no one (including the warehouse-keeper) stole your valuables, your wealth was secure. Such safekeeping arrangements remain popular today in bonded warehouses throughout the world.

Not all depositors, however, insisted on receiving the same bag of valuables back from the warehouse-keeper. They were satisfied to receive back equivalent value. Depositors could now use the receipts warehouse-keepers issued as a medium of exchange.

Warehouse-keepers understood that not every receipt would likely be redeemed simultaneously. They began lending out some fraction of the valuables stored in exchange for interest payments. In this manner, warehouse keepers and goldsmiths evolved into interest-paying fractional-reserve banks.

Fractional Reserve Banking: It’s Not Your Money…You Only Think It Is!, 5/2/13

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