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Over the past couple weeks, I’ve been writing about the idea of being your own bank. The impetus behind blogging this was to put into writing a few things that I've been doing the last few years to gain more control over my own finances, and rely less on traditional financial institutions or banks. I believe this way of managing my own life has really benefited the way I think about money, and something I wanted to share with others as well.

In my first post, I explained that the primary function of banks was storage and lending. By storing assets, banks hold value that customers can use to exchange for other goods and services they desire. The most common thing stored for customers is fiat currency, which is really just a note backed by the government that created it. The second function, lending, allows bankers to do two things. First, it makes a profit for the bank, thus paying them for their managing duties. Second, it allows them to stay ahead of general economic inflation.

In my second post, I outlined the troubles of inflation, and why it isn't just a rise in price levels, but represents a loss of value over time for the money we earn. Banks used to help their customers stay ahead of inflation with high interest savings accounts. However, those days are long gone. If we’re going to become our own bank, we need to find storage services that are far better at helping us stay ahead of the curve of inflation.

This week’s post is about a key principle that allows banks to lend money as they do. It allows them to effectively put money to work, earning more money, which can then, of course, be used to earn even more. It has caused the world economy to boom and bust historically. It is called Fractional Reserve Banking.

The Fractional Reserve System

Fractional Reserve Banking is a pretty old idea. Basically, banks only have to keep a small portion of the currency deposited in them, as determined by whatever sovereign nation they exist under. Because of this, each deposit into the bank creates a multiplier effect on the value of each bank asset.

For example, if the reserve amount is 10%, a customer can deposit $100 at the bank, and the bank only needs to keep $10 on hand and loan the other $90. The bank then charges interest on the loan, so that the money returned would be greater than what was deposited. Loaned at 5%, the $90 comes back at $94.50, and the bank now has $104.50, from which they can lend $94.05. Keep in mind, the customer who made the deposit still has $100 available to them this whole time. So really, conceptually the bank now has $100 for that customer and $94.05 to loan to others. Thus, the functional liquidity added to the economy is now $194.05. With the fractional reserve system, they have increase liquidity through the each deposit.

This system is extremely effective in increasing the flow of money in an economic system. The problem lies in the responsibility and management of the bankers. Because most people don’t withdraw all of their money immediately from the bank, there’s a cushion of time where banks can lose from an unpaid loan without much concern. Since most banks are conservative, they tend to lend only to customers they trust to pay them back. However, as banks become bigger and bigger, their customer base grows larger than their ability to delineate between those who will and won’t pay their dues. And if they lend to more and more customers who don’t pay them back, they soon won’t be able to afford simultaneous withdrawals from other customers, thus dissolving the bank.

By becoming our own bank, we can avoid being affected by cycles of recession and inflation. But, if we want to be effective in the long run, we must exercise caution in our spending, so that our own reserves don’t run out.

Rethinking the System

The key concept we learn from fractional reserve banking is using the same dollar for multiple purposes. After all, banks are simply using any deposit for both that customer’s account and lending it to others. So, instead of thinking about the system as how much we can keep versus how much we are able to lend, we can think of it as being able to use the same asset for two or more simultaneous things.

Let’s say I put $100 dollars into a normal bank account. Also, let’s say the bank pays me an interest of 1% on it annually (we’re going to use simple interest to keep things easy). At the end of the year, that account would have $101. However, if I wanted to use it to purchase a $5 coffee, I need to take out money in order to do so. That means that the interest on that account would only grow it to $95.95. I haven’t just lost 5 dollars. I’ve lost $5.05. In fact, every purchase I make, I’ve not just lost the amount I paid, but also the interest that could have accumulated.

It gets worse. Remember (from my previous post) that inflation averages around 4% annually? This means that I’ve actually lost around $8 in total, which, in this case, is 8% of what I earned. When such losses compound across years, I’ve actually lost a lot of money!

But what if we could do both? What if we could take that $100 and use it to accrue interest and purchase coffee? Or use that same $100 to purchase coffee, earn more income, and beat inflation? In effect, we would have created our own ‘fractional reserve’ system.

The Collateralized Loan

The overall basic vehicle we can use to be our own bank is called the collateralized loan. The idea is simple. Rather than investing your money in a traditional bank account, which is really just an asset with high liquidity, we use it to purchase assets that we can use as collateral for loans. The assets should have an average value increase greater than the average inflation rate, which means by the time we pay off the loan, the asset itself has gained in value, helping to offset any loss we would have had otherwise.

There are a couple advantages to this approach. First, it liquidates an asset without destroying it. The money we loan to ourselves is at least a portion of that asset’s worth at the time of loan, and we can (most of the time) use that loan to do whatever we want, including purchasing more assets or lending to others. Second, since a loan is not a taxable event, we can use the entire loan for ourselves without worrying about owing any governmental authority.

Over the next few weeks, I’ll be writing about the products and services we can use to do this. I’ll explain and evaluate different systems and services that already exist, and see the positives and negatives of each approach.

A Sneak Peak

Here is a preview of what I’ll be talking about:

Precious Metals and Gold – Some of the oldest forms of currency comes from precious metals and, of course, gold. While no nation (as far as I know) uses the gold standard anymore, this is not necessarily a bad thing. What it’s done is turn these once legitimate currencies into assets that can be collateralized, and so now anyone can use them for banking.

Real Estate Investment and Ownership – Real estate is one of the oldest asset classes that allow you to become your own bank. Since it’s so old, the way to do this is actually pretty well known. I will be talking about how each banking function is fulfilled in a mortgaged property, and the pros and cons of doing it today.

Participating Whole Life Insurance – This asset class is surprisingly not talked about or used much. It’s perhaps due in part to the stigma attached to all kinds of insurance, from a legacy of scams and other things. Nevertheless, if leveraged correctly, Participating Whole Life Insurance is one of the most effective boons for anyone desiring to be their own bank.

Cryptocurrency – Although cryptocurrency is a very new asset class, if used and managed correctly, they can fulfill every single banking function I’ve written about. As more and more utility comes to this space in the next couple decades, this asset class could become one of the most important financial vehicles created in the past couple centuries. This is due to crypto’s ease of access, allowing it to become a bedrock on which anyone in the world can participate in the global economy, and so have the opportunity to enrich their own lives. However, because it still has a fairly nebulous future, much of what will be in this post will be speculative rather than fact-based.

Disclaimer: Please keep in mind that, while a lot of work and research has been done, everything which I talk about is still my own opinion. Do not conflate anything I write as financial advice. Also, I am not selling any goods or services related to what I’m talking about above. I won’t be telling you to buy a some package or deal in this series. I believe it’s imperative for everyone to do their own research so as to meet their own individual needs.

This list is what I’ve explored so far, and certainly doesn’t encompass all services and systems that allow us to be our own bank. Thus, I will add to this series as I find new or different products or services that achieve the same things, even after it is done.

After reviewing each of the things mentioned above, I will look at the avenues through which we can use our loans to make a profit, and so put money to work earning more money. Thus, we become our own bank.

So there you have it, the roadmap I’ve planned to be your own bank. See you in the next post!

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Header Image was taken from here.