Fractional reserve banking

3 key takeaways

• Fractional reserve banking allows banks to keep a fraction of deposits in reserve while lending out the rest, thus expanding the money supply and promoting economic activity.
• This system requires banks to maintain a minimum reserve ratio, which is set by central banks to ensure liquidity and stability within the banking system.
• While fractional reserve banking supports economic growth, it also carries risks such as bank runs and financial instability, which central banks mitigate through regulation and oversight.

What is fractional reserve banking?

Fractional reserve banking is a system in which banks hold a fraction of their customers’ deposits in reserve and lend out the remainder. This reserve is a small percentage of the bank’s total deposits, known as the reserve ratio. The reserve is kept either as cash in the bank or as deposits with the central bank. By lending out the majority of their deposits, banks can earn interest, support economic activities, and expand the overall money supply in the economy.

Importance of fractional reserve banking

Money creation: By lending out deposits, banks create new money, increasing the total money supply in the economy. This process, known as the money multiplier effect, helps fuel economic growth and development.

Credit availability: Fractional reserve banking facilitates access to credit for individuals and businesses, enabling investments, consumption, and economic expansion.

Economic stability: Central banks use reserve requirements to control the amount of money banks can create, helping to manage inflation, stabilize the economy, and ensure the banking system’s liquidity.

How fractional reserve banking works

1. Deposits: Customers deposit money in a bank, which the bank holds in reserve.
2. Reserves: The bank keeps a fraction of the deposits as reserves, either as cash or as deposits with the central bank.
3. Lending: The bank lends out the remaining portion of the deposits to borrowers, such as individuals or businesses.
4. Money creation: The lent-out money is deposited in other banks, which then keep a fraction in reserve and lend out the rest, creating new money in the process.
5. Reserve ratio: The central bank sets a minimum reserve ratio, ensuring banks maintain enough reserves to meet withdrawal demands and maintain liquidity.

Example of fractional reserve banking

Suppose the reserve ratio is 10%. If a customer deposits $1,000 in a bank, the bank is required to keep $100 (10%) in reserve and can lend out $900. The $900 loaned out will be deposited in another bank, which will keep $90 (10%) in reserve and lend out $810. This process continues, creating new money and expanding the money supply.

Advantages of fractional reserve banking

Economic growth: By creating new money and providing credit, fractional reserve banking supports economic growth and development.

Liquidity: Banks maintain enough reserves to meet withdrawal demands, ensuring liquidity in the banking system.

Efficiency: Banks can earn interest on loans, which helps them operate profitably and provide financial services to customers.

Disadvantages of fractional reserve banking

Bank runs: If many depositors withdraw their money simultaneously, banks may face liquidity issues, leading to bank runs and potential failures.

Financial instability: Excessive lending and money

creation can lead to inflation and financial bubbles, increasing the risk of economic instability.

Credit risk: Lending out deposits exposes banks to credit risk, as borrowers may default on their loans, potentially leading to losses for the bank.

Managing risks in fractional reserve banking

Central bank regulation: Central banks set reserve requirements and monitor banks’ activities to ensure they maintain adequate reserves and operate within safe lending limits.

Deposit insurance: Governments often provide deposit insurance to protect depositors’ funds and maintain confidence in the banking system, reducing the risk of bank runs.

Prudential supervision: Regulatory authorities conduct regular supervision and audits of banks to ensure they adhere to sound banking practices and maintain financial stability.

Related topics

To further understand the concept and implications of fractional reserve banking, consider exploring these related topics:

• Central Banking: The role and functions of central banks in regulating and overseeing the banking system, including setting reserve requirements.
• Monetary Policy: The process by which central banks manage the money supply and interest rates to achieve economic objectives such as controlling inflation and promoting growth.
• Bank Runs: A situation where a large number of depositors withdraw their funds from a bank simultaneously, leading to potential liquidity issues and bank failures.
• Credit Creation: The process by which banks create new money through lending activities, expanding the overall money supply.
• Financial Stability: The measures and policies implemented to maintain stability in the financial system and prevent crises.

Fractional reserve banking is a fundamental aspect of modern banking systems, enabling the creation of money and the provision of credit, which are essential for economic growth and development. Exploring these related topics can provide a deeper understanding of the mechanisms and implications of fractional reserve banking in the broader financial system.