Fractional Reserve Banking Explained: What It Is, How It Works, and Examples
Summary:
Fractional reserve banking is a system that allows banks to lend out a portion of the deposits they receive while keeping only a fraction in reserve. This enables banks to create loans and expand the economy. However, it also comes with risks like bank runs if too many customers demand their money at the same time. In this article, we’ll dive deep into how fractional reserve banking works, its impact on the economy, the regulations governing it, and the advantages and disadvantages of the system. You’ll also learn about how fractional reserve banking compares to other systems like 100% reserve banking.
Fractional reserve banking is the backbone of modern financial systems. It allows banks to lend out a portion of their customers’ deposits while maintaining a fraction in reserve. By doing so, banks play a pivotal role in expanding the economy, providing credit, and fostering investment. In this article, we’ll explain how fractional reserve banking works, its role in the global economy, the potential risks, and why it’s an essential part of our financial infrastructure.
We will explore the process in depth, the historical context, the advantages and disadvantages, and provide answers to frequently asked questions to ensure you have a full understanding of this system.
What is fractional reserve banking?
Fractional reserve banking is a system in which banks are only required to keep a fraction of their deposits on hand. This allows them to use the remaining portion for loans and other investments. For example, if a bank receives $1,000 in deposits and has a reserve requirement of 10%, it only needs to keep $100 in reserve, while it can lend out or invest the other $900.
Key components of fractional reserve banking
- Reserves: The portion of deposits banks are required to keep on hand. These reserves ensure that banks can meet withdrawal requests from customers.
- Loans: The funds that banks lend out, which are generated from the deposits they receive. Loans are a primary source of revenue for banks as they earn interest on them.
- Reserve requirement: The specific percentage of deposits that banks are required to hold in reserve. This is set by central banks, such as the Federal Reserve in the U.S.
How it works in practice
When you deposit money into your bank account, the bank uses most of that money to create loans for other customers. Only a fraction of the deposit is kept in reserve in case you or other customers want to make withdrawals. For example:
- You deposit $1,000 into your savings account.
- The bank keeps $100 in reserve (assuming a 10% reserve requirement) and lends $900 to a borrower.
- The borrower uses the loan, and eventually, that $900 will be deposited into another bank, which can lend out 90% of that amount as well.
This cycle creates what is known as the money multiplier effect, increasing the overall supply of money in the economy.
History of fractional reserve banking
Fractional reserve banking has ancient roots, tracing back to medieval Europe. Goldsmiths issued promissory notes representing the gold they held in storage. Over time, these notes began circulating as a form of currency, and goldsmiths realized they could issue more notes than the gold they physically had, as long as not all customers came to withdraw their gold at the same time.
Evolution in the United States
In the U.S., the formalization of fractional reserve banking began with the National Bank Act of 1863, which required banks to keep reserves. This system was further developed with the creation of the Federal Reserve in 1913, which established standardized reserve requirements for banks.
Over the decades, the Federal Reserve adjusted these reserve requirements based on economic conditions. In 2020, the Federal Reserve reduced the reserve requirement ratio to 0% for all depository institutions due to economic pressures from the COVID-19 pandemic, signaling a significant shift in banking policy.
How fractional reserve banking works today
Fractional reserve banking today is heavily regulated and relies on central banks to set and adjust reserve requirements. The Federal Reserve, for example, plays a crucial role in managing these requirements to ensure financial stability and support economic growth.
The role of central banks
- Setting reserve requirements: They determine the minimum reserves that banks must hold, which affects how much money banks can lend.
- Controlling the money supply: By adjusting reserve requirements, central banks can influence the overall money supply in the economy. Lowering the reserve requirement allows banks to lend more, expanding the money supply. Increasing it has the opposite effect.
- Regulating interest rates: Central banks set key interest rates, like the federal funds rate, which influences how much it costs for banks to borrow from each other.
An example of the fractional reserve system in action
Imagine that Bank A receives $10,000 in deposits. With a reserve requirement of 10%, it must keep $1,000 in reserve but can lend out the remaining $9,000. That $9,000 is loaned to a business owner, who uses it to pay for goods. The recipient of that payment deposits the $9,000 in their bank, Bank B, which then lends out 90% of it (or $8,100), and so on.
This process creates a multiplier effect, where an initial deposit results in a much larger expansion of the total money supply.
Fractional reserve banking vs. 100% reserve banking
In contrast to fractional reserve banking, 100% reserve banking requires banks to keep all customer deposits on hand at all times. Under this system, banks cannot lend out any portion of their deposits, and they would only be able to issue loans based on separate investment capital.
Key differences
- Lending: Fractional reserve banking allows for significant lending, while 100% reserve banking restricts lending to funds raised through other means, such as equity or bonds.
- Money creation: In fractional reserve banking, the money supply can be expanded through lending. In 100% reserve banking, the money supply would be far more limited, reducing economic growth potential.
- Risk: 100% reserve banking eliminates the risk of bank runs, as all deposits are available for withdrawal. However, it also reduces the liquidity that drives modern economies.
Examples of fractional reserve banking in action
Example 1: Mortgage lending and economic growth
Let’s say a customer, Sarah, deposits $50,000 into her savings account at her local bank, Bank A. The reserve requirement is 10%, so the bank is required to keep $5,000 in reserve but can lend out the remaining $45,000. A second customer, John, applies for a mortgage loan, and Bank A uses Sarah’s deposit as part of the lending pool.
- Initial deposit: Sarah deposits $50,000 in her savings account.
- Reserves held: Bank A sets aside 10%, or $5,000, to comply with the reserve requirement.
- Loan issued: Bank A lends out $45,000 of Sarah’s deposit to John for his mortgage.
- Impact on the economy: John uses the $45,000 loan to purchase a home, contributing to the housing market. The seller of the home, in turn, deposits the money into another bank (Bank B), which can now lend out 90% of that deposit, continuing the cycle.
This example illustrates how fractional reserve banking helps stimulate lending, particularly for significant investments like home purchases. The loan benefits both the individual and the broader economy by promoting activity in the housing and construction sectors.
Example 2: Business expansion with bank loans
Consider a small business owner, Mike, who runs a growing coffee shop. He applies for a business loan of $100,000 to open a second location. His bank, Bank C, uses fractional reserve banking to facilitate this loan.
- Initial deposit: Customers deposit a total of $200,000 into Bank C.
- Reserves held: With a 10% reserve requirement, Bank C keeps $20,000 in reserve.
- Loan issued: Bank C uses the remaining $180,000 to issue business loans, including $100,000 to Mike.
- Economic impact: Mike’s loan enables him to open a new coffee shop, creating jobs and increasing local economic activity. His employees, in turn, deposit their wages into Bank D, allowing that bank to make further loans.
This example highlights how fractional reserve banking provides capital for business expansion, which is essential for job creation and economic development.
How the money multiplier effect influences economic growth
One of the core benefits of fractional reserve banking is the money multiplier effect. This concept refers to how an initial deposit can be loaned out multiple times, thereby multiplying the amount of money circulating in the economy. The effect is crucial in promoting growth and ensuring that businesses and consumers have access to credit.
When banks loan out the majority of deposits while keeping only a small fraction in reserve, they enable more money to flow into the economy. This, in turn, spurs investment, consumer spending, and business expansion. The size of the money multiplier depends on the reserve requirement; lower reserve requirements result in a higher multiplier effect, as more money is available for lending.
However, the money multiplier can also contribute to inflationary pressures. As more money enters circulation, there may be an excess supply of currency chasing the same amount of goods and services. Central banks carefully monitor the money multiplier and adjust reserve requirements and interest rates to prevent inflation from spiraling out of control.
For instance, in times of economic contraction, central banks may lower reserve requirements to stimulate lending. Conversely, in periods of rapid growth, they may increase reserves to slow down the money supply and prevent overheating.
How central banks manage liquidity risk in fractional reserve systems
While fractional reserve banking boosts economic growth by allowing banks to lend more, it also introduces liquidity risks. Liquidity risk occurs when a bank cannot meet its short-term obligations, particularly if too many customers try to withdraw their deposits at once. Central banks play a crucial role in managing this risk to ensure financial stability.
One of the key tools central banks use to mitigate liquidity risk is the discount window, a facility where banks can borrow money in times of short-term cash shortages. This provides banks with a safety net, allowing them to meet withdrawal demands even if they don’t have enough cash on hand. However, borrowing from the central bank usually comes with a higher interest rate, incentivizing banks to first seek funds from other banks or the open market before resorting to the discount window.
Another important mechanism is deposit insurance, which protects consumers by guaranteeing their deposits up to a certain amount. In the U.S., for example, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor per bank. This insurance reduces the likelihood of bank runs, as customers feel more secure that their money is protected, even if a bank faces temporary liquidity issues.
Additionally, central banks continuously monitor the health of the banking system. They conduct stress tests to ensure that banks can withstand various economic scenarios, such as recessions or financial crises. These tests help regulators identify vulnerabilities and take preemptive measures to avoid systemic failures.
Conclusion
Fractional reserve banking is a critical component of modern financial systems, enabling banks to lend more and promote economic growth. While it provides significant benefits, such as increasing the money supply and supporting investment, it also comes with risks like bank runs and overextension of credit. Understanding how this system works and its impact on the economy helps consumers and policymakers make informed decisions about financial stability and economic policy.
Frequently asked questions
What is the reserve requirement today?
As of March 2020, the Federal Reserve has reduced the reserve requirement ratio to 0%. This means that banks are not required to hold any portion of their deposits in reserve, but they are incentivized to do so through interest on reserves.
How does fractional reserve banking expand the money supply?
Fractional reserve banking expands the money supply through the lending process. When a bank lends out a portion of deposits, the borrower typically spends that money, which then gets deposited into another bank. This cycle of lending and depositing increases the total amount of money in the economy.
What are the risks of fractional reserve banking?
The primary risks of fractional reserve banking include vulnerability to bank runs, where too many customers try to withdraw their money at the same time, and the risk of overextending credit, which can lead to inflation or financial bubbles.
Key takeaways
- Fractional reserve banking allows banks to lend out a portion of customer deposits, promoting economic growth.
- The money multiplier effect expands the money supply, enabling more lending and investment.
- This system is vulnerable to bank runs, but deposit insurance and central bank regulation mitigate some of the risks.
- Understanding the advantages and risks of fractional reserve banking is key for consumers and policymakers.
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