Fractional reserve banking

What Is Fractional Reserve Banking?

Fractional reserve banking is a banking system in which financial institutions hold only a fraction of their customers' deposits in reserves and lend out the remainder. This practice, central to modern monetary economics, allows banks to facilitate credit creation and expand the money supply within an economy. The concept hinges on the understanding that not all depositors will simultaneously withdraw their funds, enabling banks to utilize a significant portion of deposited funds for loans and investments. Today, most global financial systems operate under a fractional reserve banking model.

History and Origin

The roots of fractional reserve banking can be traced back to medieval Europe, specifically to goldsmiths and money changers. Initially, individuals would deposit their gold and other valuables with goldsmiths for safekeeping, receiving promissory notes or receipts in return. These notes, which represented claims on the deposited gold, gradually became accepted as a form of currency in commercial transactions.²⁶,

Over time, goldsmiths observed that not all depositors would redeem their notes simultaneously. This realization led them to begin lending out a portion of the gold they held in their vaults, earning interest rates on these loans.²⁵,²⁴ This pivotal shift transformed goldsmiths from passive custodians into early bankers, laying the groundwork for the fractional reserve system. The practice of fractional reserve banking further developed with the establishment of central banks, such as the Bank of England in the late 17th century and the Federal Reserve in the United States in 1913, which introduced regulatory frameworks like reserve requirements to oversee financial stability.²³,,²²

Key Takeaways

• Fractional reserve banking allows banks to hold only a portion of customer deposits in reserve, lending out the rest.
• This system facilitates credit creation, which is crucial for stimulating economic growth and expanding the money supply.²¹,²⁰
• Central banks play a key role in regulating fractional reserve banking through monetary policy tools such as reserve requirements and interest rates.¹⁹,¹⁸
• While promoting economic activity, fractional reserve banking carries inherent risks, notably the potential for bank runs if many depositors attempt to withdraw funds simultaneously.
• Despite its risks, it is the predominant banking system globally, balancing the need for liquidity with opportunities for credit expansion.¹⁷

Formula and Calculation

In a fractional reserve banking system, the potential expansion of the money supply can be illustrated using the money multiplier. This theoretical concept estimates the maximum amount of money that can be created by an initial deposit, assuming banks lend out all excess reserves.

The formula for the simple money multiplier is:

Where:

• (M) = Money Multiplier
• (RR) = Reserve Ratio (the fraction of deposits banks are required to hold as reserves)

For example, if the reserve requirement ((RR)) is 10% (0.10), the money multiplier ((M)) would be:

This indicates that an initial deposit could theoretically lead to a tenfold expansion of the money supply through successive rounds of lending and redepositing within the banking system. It's important to note that this is a simplified model and real-world money creation is influenced by various factors, including banks' willingness to lend and borrowers' demand for loans.

Interpreting Fractional Reserve Banking

Fractional reserve banking is interpreted as a dynamic mechanism that transforms static deposits into active capital, essential for driving economic activity. The system allows banks to serve as financial intermediaries, connecting savers with borrowers and facilitating the efficient allocation of funds.¹⁶

A lower reserve requirement or higher money multiplier implies greater potential for credit creation and expansion of the money supply. Conversely, a higher reserve ratio limits this expansion. Understanding fractional reserve banking is crucial for comprehending how monetary policy influences economic conditions, as central banks can adjust reserve ratios and other tools to influence lending behavior and economic growth. The system operates on the premise of public confidence in the financial system; if confidence erodes, it can lead to instability.¹⁵

Hypothetical Example

Imagine Sarah deposits $1,000 into her checking account at Bank A. If the reserve requirement is 10%, Bank A is required to hold $100 in reserves and can lend out the remaining $900.

1. Initial Deposit: Sarah deposits $1,000 into Bank A.
2. Bank A Lending: Bank A keeps $100 and lends $900 to John, who uses it to buy new equipment from ABC Supplies.
3. Redeposit: ABC Supplies deposits the $900 into its account at Bank B.
4. Bank B Lending: Bank B keeps 10% ($90) as reserves and lends the remaining $810 to Lisa for a small business expansion.
5. Further Cycles: Lisa spends the $810, which then gets deposited into another bank, and the process continues.

In this simplified example, the initial $1,000 deposit has led to $900 (from Bank A) plus $810 (from Bank B) and so on, in new loans, effectively expanding the total money available in the economy beyond the initial deposit. This illustrates how fractional reserve banking contributes to the expansion of the money supply.

Practical Applications

Fractional reserve banking is fundamental to the functioning of modern economies and has several practical applications:

• Monetary Policy: Central banks utilize fractional reserve banking as a primary lever for monetary policy. By adjusting reserve requirements or influencing interest rates, they can control the overall money supply and credit creation in the economy to achieve macroeconomic objectives like controlling inflation or stimulating economic growth. For instance, in March 2020, the Federal Reserve reduced reserve requirements to zero for all depository institutions to support the flow of credit to households and businesses.
• Financial Intermediation: Banks act as intermediaries, channeling funds from savers (depositors) to borrowers (individuals and businesses). This process facilitates investment and consumption, which are vital for economic expansion.¹⁴,¹³
• Liquidity Provision: While banks lend out a fraction of deposits, they maintain sufficient reserves and access to short-term borrowing markets to meet typical withdrawal demands, ensuring that depositors have access to their funds when needed.¹²

Limitations and Criticisms

Despite its widespread adoption, fractional reserve banking faces several limitations and criticisms:

• Risk of Bank Runs: The most significant inherent risk of fractional reserve banking is the vulnerability to bank runs. If a large number of depositors lose confidence in a bank's solvency and attempt to withdraw their deposits simultaneously, the bank may not have sufficient liquidity to meet all demands, potentially leading to its collapse., This risk is mitigated by government-administered deposit insurance and the role of central banks as lenders of last resort.
• Inherent Instability: Critics argue that the system is inherently unstable because it creates money "out of thin air" through lending, making the money supply susceptible to fluctuations in lending practices and borrower demand. Some economists assert that this process can contribute to economic booms and busts.¹¹,¹⁰
• Ethical Concerns: Some critics, particularly those from certain schools of economic thought, raise ethical concerns, arguing that fractional reserve banking constitutes a form of fraud because banks lend money that technically belongs to depositors, implying two claims on the same asset.⁹,⁸ However, proponents argue that depositors enter into a contractual agreement where they lend their money to the bank, and the bank, in turn, is obligated to return an equivalent sum on demand, thus negating claims of fraud.⁷
• Preferential Treatment: Academic papers highlight concerns about taxpayer-backed deposit insurance and bailouts, arguing that they provide preferential treatment to banks compared to other lenders and can lead to a misallocation of resources.⁶

Fractional Reserve Banking vs. Full-Reserve Banking

Fractional reserve banking and full-reserve banking represent two distinct models for how banks manage customer deposits. The primary difference lies in the amount of funds banks are required to hold in reserves against their deposit liabilities.

The confusion between the two often arises from the perception of what constitutes "money" and how it is created. In a fractional reserve system, commercial banks play a direct role in creating new money supply when they issue loans. In contrast, a full-reserve system would largely remove this ability from commercial banks, restricting money creation primarily to the central banks or governmental authorities.³

FAQs

How does fractional reserve banking expand the money supply?

Fractional reserve banking expands the money supply through a process known as the money multiplier. When a bank receives a deposit, it keeps a fraction as reserves and lends out the rest. The lent money is then typically deposited into another bank, which in turn lends out a portion, continuing the cycle. Each new loan effectively creates new money in the form of new deposits within the banking system.

What is the role of the central bank in fractional reserve banking?

Central banks play a crucial role in regulating and overseeing fractional reserve banking. They set reserve requirements (though many have reduced them to zero), implement monetary policy to influence interest rates and the money supply, and act as a lender of last resort to provide liquidity to banks during times of crisis, thereby preventing bank runs and maintaining financial stability.,²

Is fractional reserve banking safe for depositors?

While fractional reserve banking inherently carries the risk of bank runs, various safeguards are in place in modern financial systems to protect depositors. These include deposit insurance schemes (like FDIC insurance in the U.S.), robust bank regulations, and the role of the central bank as a provider of emergency liquidity. These measures aim to instill confidence and prevent widespread panic withdrawals.

Why do most countries use fractional reserve banking?

Most countries use fractional reserve banking because it efficiently facilitates credit creation, which is essential for stimulating investment, consumption, and overall economic growth. It allows for a more dynamic allocation of capital compared to a full-reserve banking system, which would severely limit the amount of money available for lending and could stunt economic development.,¹