Fractional system

What Is Fractional Reserve Banking?

Fractional reserve banking is a banking system in which commercial banks hold only a fraction of their deposits as reserves and are permitted to lend out the remainder. This system is a core component of modern banking systems and plays a significant role in money supply and credit creation within an economy. The practice allows banks to facilitate more lending than the actual cash they hold, thereby expanding the amount of money in circulation.

History and Origin

The origins of fractional reserve banking can be traced back to the early days of goldsmiths. Historically, people deposited gold with goldsmiths for safekeeping, receiving paper receipts in return. Goldsmiths noticed that depositors rarely withdrew all their gold at once. This observation led them to realize they could lend out a portion of the deposited gold, earning interest, while still retaining enough to meet typical withdrawal demands. These receipts, backed by only a fraction of the gold, effectively became a form of currency.

As banking evolved, governments and central banks began to formalize and regulate this practice. In the United States, the Federal Reserve Act of 1913 established the Federal Reserve System, which formalized a system of reserve requirements for member banks, laying the groundwork for the modern fractional reserve banking system. The Federal Open Market Committee (FOMC) oversees the nation's monetary policy, including aspects related to bank reserves.

Key Takeaways

• Fractional reserve banking enables banks to lend a portion of customer deposits, creating new money in the economy.
• It is fundamental to modern banking systems and the process of credit expansion.
• Central banks regulate this system through tools like reserve requirements and interest rates.
• While it supports economic growth by facilitating lending, it also carries risks such as potential bank run and contributes to inflation.
• Deposit insurance and central bank oversight are crucial safeguards in this system.

Formula and Calculation

The core mechanism of fractional reserve banking can be illustrated by the money multiplier formula, which estimates the maximum potential expansion of the money supply resulting from an initial deposit.

Where:

• ( M ) = Money Multiplier
• ( RR ) = Reserve Requirement Ratio (the fraction of deposits banks must hold as reserves)

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

This indicates that for every dollar of new reserves introduced into the banking system, the total money supply could potentially expand by ten dollars through the process of lending and redepositing.

Interpreting the Fractional Reserve Banking System

The fractional reserve banking system is interpreted as a dynamic engine for economic activity, primarily through its capacity for credit creation. When banks lend out a significant portion of their deposits, they increase the total money supply beyond the physical currency in circulation. This expanded money supply can stimulate investment, consumption, and overall economic growth.

However, the interpretation also acknowledges the inherent reliance on public confidence. For the system to function smoothly, depositors must trust that their funds are safe and accessible, even though only a fraction is held in reserve. This trust is bolstered by regulatory frameworks and mechanisms like deposit insurance.

Hypothetical Example

Consider a new deposit of $1,000 made into Bank A. Assume a reserve requirement ratio of 10%.

1. Initial Deposit: You deposit $1,000 into Bank A. Bank A's reserves and deposits both increase by $1,000.
2. Required Reserves: Bank A must hold 10% of $1,000, which is $100, as required reserves.
3. Excess Reserves and Lending: Bank A now has $900 in excess reserves ($1,000 - $100). It can lend out this $900 to a borrower. This loan creates a new deposit of $900 in the borrower's account, perhaps at Bank B.
4. Second Round: Bank B receives the $900 deposit. It keeps 10% ($90) as required reserves and lends out the remaining $810.
5. Subsequent Rounds: This process continues. The $810 loan becomes a deposit at Bank C, which then holds 10% and lends out the rest, and so on.

Each time a loan is made, a new deposit is created, expanding the money supply far beyond the initial $1,000 cash deposit. The total theoretical increase in the money supply from the initial $1,000 deposit, with a 10% reserve ratio, could be up to $10,000.

Practical Applications

Fractional reserve banking is the foundation of nearly every modern banking system globally. Its practical applications are pervasive in finance:

• Monetary Policy: Central banks utilize fractional reserve banking to implement monetary policy. By adjusting the reserve requirement ratio, engaging in open market operations, and setting the discount rate, a central bank can influence the amount of money banks have available for lending, thereby affecting interest rates and the overall money supply.³ The International Monetary Fund (IMF) emphasizes that central banks are crucial institutions that manage a country's currency and control the money supply.²
• Credit Creation: This system facilitates the extension of credit, which is vital for economic activity. Businesses can secure loans for investment, individuals can finance homes and education, and governments can fund public projects.
• Liquidity Management: Banks manage their liquidity carefully within this system, balancing the need to lend for profit with the need to maintain sufficient reserves to meet withdrawal demands.
• Financial Market Operations: The daily operations of interbank lending markets, where banks lend excess reserves to each other, are a direct consequence of the fractional reserve model.

Limitations and Criticisms

While fractional reserve banking offers significant benefits, it is not without limitations and criticisms:

• Risk of Bank Runs: A primary vulnerability of the system is the potential for a bank run. If a large number of depositors simultaneously attempt to withdraw their funds, a bank holding only a fraction of those deposits in reserve may become insolvent, even if its assets are sound long-term. Historically, bank runs have led to widespread panic and financial crises.
• Financial Stability Concerns: Critics argue that the system inherently introduces systemic risk because a failure in one bank can ripple through the entire financial system due to interconnectedness.
• Moral Hazard: The existence of deposit insurance and the role of the central bank as a lender of last resort, while providing crucial stability, can also create a moral hazard. This means banks might take on excessive risks, knowing that the government or central bank will likely intervene to prevent a complete collapse. Deposit insurance, established during the Great Depression, has significantly reduced bank runs by guaranteeing a portion of deposits.¹
• Contribution to Inflation and Economic Cycles: Some economists argue that the system's ability to expand the money supply excessively can contribute to inflationary pressures. Additionally, the boom-and-bust cycles observed in economies are sometimes attributed, in part, to the expansive nature of credit creation in a fractional reserve system.

Fractional Reserve Banking vs. Full-Reserve Banking

Fractional reserve banking differs fundamentally from full-reserve banking, primarily in the amount of customer deposits that banks are required to hold in reserve.

The confusion between the two often arises from the misconception that banks simply lend out money they already possess. In fractional reserve banking, banks create new money when they make loans, as the loan amount is credited as a new deposit. In contrast, under a full-reserve system, a bank would only lend out funds that were explicitly saved as time deposits or raised as capital, meaning it would not create new money in the process of lending.

FAQs

What is the primary purpose of fractional reserve banking?

The primary purpose is to facilitate credit creation and expand the money supply, thereby stimulating economic growth by making more funds available for investment and consumption than otherwise possible with only physical currency.

How does a central bank influence fractional reserve banking?

A central bank influences fractional reserve banking through monetary policy tools, such as setting reserve requirements (though these are less common now in some major economies), adjusting interest rates, and conducting open market operations to manage the amount of reserves in the banking system.

Can fractional reserve banking lead to a financial crisis?

While the system is designed to be robust with regulatory oversight, it carries an inherent risk of bank runs and can contribute to financial instability if not managed prudently. Safeguards like deposit insurance and the role of the central bank as a lender of last resort are critical in mitigating these risks.