Fractional-Reserve Banking Explained Simply

Fractional-reserve banking is a system where banks keep only a fraction of deposits in reserve and lend out the rest. This means that banks create new money by making loans.

Banks are required to keep a minimum amount of deposits in reserve, known as the reserve requirement. For example, if a bank has a reserve requirement of 10%, it means that it must keep at least 10% of deposits in reserve and can lend out the remaining 90%.

Think of it like a water tank - the reserve requirement is like the minimum amount of water that must be left in the tank, and the rest of the water can be used to fill other tanks.

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Fractional-reserve banking is a system where only a fraction of bank deposits are required to be available for withdrawal. Banks keep a specific amount of cash on hand and create loans from the money you deposit.

In the past, goldsmiths would issue promissory notes, which were later used as a means of exchange, and used deposited gold to issue loans with interest. This is where fractional banking was born.

Banks are required to hold reserves, but the amount varies. In 1917, the reserve ratio was set at 13%, 10%, and 7% for different types of banks. The Federal Reserve sets the reserve requirement as one of the tools for guiding monetary policy.

For example, if you deposit $1,000 in a bank account, the bank might be required to keep only 10% of that, or $100, as reserves. They can then lend out the other $900.

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Fractional-reserve banking has its roots in the past, where goldsmiths would issue promissory notes to people who deposited their gold and silver coins with them.

These notes gained acceptance as a medium of exchange for commercial transactions and became an early form of circulating paper money.

The goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills.

This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them.

The Swedish Riksbank was the world's first central bank, created in 1668, and many nations followed suit in the late 1600s to establish central banks.

Central banks were given the legal power to set a reserve requirement, and to specify the form in which such assets were required to be held.

The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today.

In the U.S., the National Bank Act was passed in 1863 to require banks to keep reserves on hand to protect depositor funds from being used in risky investments.

Reserve requirements for banks under the Federal Reserve Act were set at 13%, 10%, and 7% in 1917.

On March 26, 2020, the 10% and 3% required reserve ratios against net transaction deposits were reduced to 0% for all banks, essentially removing the reserve requirements altogether.

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This was replaced with Interest on Reserve Balances (IORB), or interest paid on reserves the banks hold as an incentive rather than a requirement.

Goldsmiths used the deposited gold to issue loans with interest, and fractional banking was born.

Banks with fewer than $16.3 million in assets were not required to hold reserves, while those with more than $124.2 million in assets had a 10% reserve requirement.

The concept of fractional banking emerged during the gold trading era, with the realization that not all people needed their deposits at the same time.

If the noteholders lost faith in the goldsmiths, they would withdraw all their coins and other deposits simultaneously, putting the goldsmiths at risk of insolvency.

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Fractional reserve banking is a system where only a fraction of bank deposits are required to be available for withdrawal. Banks keep a specific amount of cash on hand and create loans from the money you deposit.

The reserve requirement is a key component of fractional reserve banking, allowing banks to act as intermediaries between borrowers and savers. Banks are required to hold a certain percentage of deposits as reserves, such as 10% of $1,000, which is $100.

This system came into place as a solution to problems during the Great Depression, when depositors made many withdrawals, leading to bank runs. The government introduced reserve requirements to help protect depositors' funds from being invested in risky investments.

Banks use customer deposits to make new loans and award interest on the deposits made by their customers. The reserves are held as balances in the bank's account at the central bank or as currency in the bank.

The Federal Reserve sets the reserve requirement as one of the tools for guiding monetary policy.

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Banks create money by lending it to customers, and this process is known as fractional-reserve banking. This means that banks are required to hold only a fraction of customer deposits as reserves and may use the rest of the deposits to award loans to borrowers.

The money creation process is affected by the currency drain ratio, which is the propensity of the public to hold banknotes rather than deposit them with a commercial bank. This ratio can influence the money supply by affecting the amount of deposits that banks can lend out.

Banks create new money when they issue loans, which increases the money supply. For example, when a person borrows a $100,000 mortgage loan, the bank credits the borrower's account with money equal to the size of the mortgage loan instead of giving them currency amounting to the value of the loan.

Here's a step-by-step example of how banks create money:

The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. The money multiplier is calculated using the formula: m = 1/R, where m is the money multiplier and R is the reserve requirement.

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In countries where the central bank does not impose a reserve requirement, such as the United States, Canada, and the United Kingdom, the theoretical money multiplier is undefined, having a denominator of zero. This means that banks can create as much money as they want without being limited by reserve requirements.

Here's a table showing how the money multiplier works:

Note that the money multiplier is a theoretical concept and is not always reached in practice. Banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, which can limit the money creation process.

In fractional-reserve banking, banks operate by holding a fraction of deposits in reserve, while lending out the rest. This allows them to generate income from interest payments on loans.

The reserve requirement is set by the central bank, and it determines the minimum percentage of deposits that banks must hold in reserve. For example, if the reserve requirement is 10%, a bank with $100 in deposits must hold $10 in reserve.

Banks use the deposited funds to make loans to customers, which can be in the form of mortgages, credit cards, or personal loans. The interest earned on these loans is a significant source of income for banks.

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Fractional-reserve banking allows banks to provide credit, which represents immediate liquidity to borrowers. This is a crucial function of commercial banking, enabling people to access money they need for various purposes.

Banks provide longer-term loans and act as financial intermediaries for those funds. They essentially help bridge the gap between those who have money to lend and those who need it.

Fractional-reserve banking expands the money supply of the economy, but it also increases the risk that a bank cannot meet its depositor withdrawals. This is a trade-off that banks must navigate carefully.

Modern central banking has made it possible for banks to practice fractional-reserve banking with reduced risk of bankruptcy through inter-bank business transactions. This has made the system more stable and efficient.

According to macroeconomic theory, a well-regulated fractional-reserve bank system can be used by the central bank to influence the money supply and interest rates. This is a powerful tool for promoting macroeconomic stability.

Historically, central banks have changed reserve requirements to influence the money supply and interest rates. However, this approach is no longer commonly used, as seen in the US where the Federal Reserve eliminated reserve requirements entirely in 2020.

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Bank liquidity management is crucial for banks to avoid defaulting on their obligations. To maintain a minimal reserve ratio, banks set a target and respond when the actual ratio falls below it.

Banks respond to a low reserve ratio by selling or redeeming other assets, securitizing illiquid assets, restricting investment in new loans, borrowing funds, issuing additional capital instruments, or reducing dividends. This is essential to maintain confidence in the bank's creditworthiness and prevent a bank run.

Banks maintain a stock of low-cost and reliable sources of liquidity, such as demand deposits with other banks, high-quality marketable debt securities, and committed lines of credit with other banks. These sources are managed with targets to ensure the bank's liquidity needs are met.

The cash reserve ratio is a key financial ratio used to analyze a bank's liquidity, calculated by dividing cash reserves by demand deposits. For example, ANZ National Bank Limited had a cash reserve ratio of 11.81% as of 30 September 2017. This ratio indicates the bank's ability to meet its short-term liquidity needs.

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Banks also use maturity analysis to manage their liquidity, dividing assets and liabilities into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months', etc. This analysis highlights large future net outflows of cash and enables the bank to respond before they occur.

Here are some key terms related to bank liquidity management:

Central banks have been created to address the problems associated with fractional-reserve banking, including the possibility of bank runs.

To prevent bank runs, central banks have implemented various measures, such as centralized clearing of payments and central bank lending to member banks.

Minimum required reserve ratios (RRRs) are one of the measures used to regulate fractional-reserve banking. This means that banks are required to hold a certain percentage of their deposits in reserve, rather than lending them out.

Minimum capital ratios are also used to regulate fractional-reserve banking, requiring banks to hold a certain amount of capital to cover potential losses.

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Here are some of the measures used to regulate fractional-reserve banking:

Central banks have been created to address the problems of bank runs, which can occur when depositors suddenly demand their money back, exceeding the bank's funding buffer. This can lead to a crisis, as the bank is forced to raise additional reserves or default on its obligations.

In most legal systems, a bank deposit is not a bailment, meaning the funds deposited are no longer the property of the customer. The customer receives an asset called a deposit account, which is a liability on the bank's balance sheet.

Regulatory auditing and government-administered deposit insurance are designed to prevent bank runs, but these measures have their limitations. For example, deposit insurance is often seen as a swindle, as it insures an institution that is inherently insolvent.

A bank can raise funds from additional borrowings, selling assets, or calling in short-term loans, but during a bank run, demands for withdrawal can exceed the bank's funding buffer. This is why central banks have been created to address these problems.

The FDIC, which insures commercial bank deposits, has less than one percent of the huge number of deposits it "insures." This raises questions about the effectiveness of deposit insurance in preventing bank runs.

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Central Banks are institutions that play a crucial role in regulating the financial system. They have been created to address the problems associated with bank runs, which can occur when depositors lose confidence in a bank's ability to meet their withdrawal demands.

Central banks have implemented various measures to prevent bank runs, including minimum required reserve ratios (RRRs) and minimum capital ratios. These measures are designed to ensure that banks maintain a sufficient level of reserves and capital to meet their obligations.

Some central banks also pay interest on deposits held by commercial banks, which can provide a source of liquidity for banks during times of financial stress. For example, the central bank may pay 2% interest on deposits, which can help to encourage commercial banks to hold more reserves.

In addition to regulating commercial banks, central banks also have the authority to provide emergency loans to distressed banks. This can help to prevent bank failures and maintain financial stability.

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Here are some key measures that central banks have implemented to regulate commercial banks:

In summary, central banks play a critical role in regulating the financial system and preventing bank runs. By implementing measures such as minimum required reserve ratios and minimum capital ratios, central banks can help to maintain financial stability and prevent bank failures.

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Commercial banks are required to hold only a fraction of customer deposits as reserves. This means they have the freedom to use the rest of the deposits to award loans to borrowers.

Banks issue loans by accepting promissory notes in exchange for credit that is deposited in the borrower's account in the bank. This is a key part of the process banks use to create money.

There are two main types of fractional-reserve banking: loan-based and deposit-based. Loan-based involves issuing loans to borrowers, while deposit-based involves using deposits to make loans to other customers.

Banks credit the borrower's account with money equal to the size of the mortgage loan instead of giving them currency amounting to the value of the loan. This is how banks create new money, which in return increases the money supply.

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Austrian School economists have criticized fractional-reserve banking, calling for it to be outlawed and criminalized. They argue that money creation causes macroeconomic instability and is a form of embezzlement or financial fraud.

Some critics also point out that fractional-reserve banking can lead to consumer panic and mass withdrawals, as seen in the Greek financial crisis of 2009 and the Great Depression in the US. In these instances, citizens flocked to banks to withdraw their funds, causing the banks to close their doors.

A key criticism of fractional-reserve banking is that there are insufficient funds for everyone to withdraw at once. However, this is generally not an issue because people won't need to remove all of their capital under most circumstances.

Austrian School economists have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized, labeling it as a form of embezzlement or financial fraud.

They argue that money creation causes macroeconomic instability, based on the Austrian Business Cycle Theory. This theory suggests that artificial money creation can lead to economic booms and busts.

US politician Ron Paul has also criticized fractional-reserve banking based on Austrian School arguments. He likely sees the flaws in the system firsthand, having witnessed the impact of monetary policy on the economy.

The main criticism of fractional reserve banking is that there are insufficient funds for everyone to withdraw at once. This is often cited as a major flaw in the system.

However, this is generally not an issue because people won't need to remove all of their capital under most circumstances. It's a rare occurrence, but it can happen, as seen in the Greek financial crisis of 2009.

Greece defaulted on its debts to the International Monetary Fund amidst a global financial crisis, causing citizens to flock to the banks to withdraw their funds. The banks were forced to close their doors to prevent a complete withdrawal of capital from a struggling system.

The National Bank Act of 1863 imposed 25% reserve requirements for U.S. banks under its charge, which may have helped mitigate such crises in the past.

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Consumer panic can cause mass withdrawals and lack of capital. This can happen when economic circumstances are uncertain, causing people to rush to their banks to withdraw their funds. As seen in the Greek financial crisis of 2015, citizens flocked to the banks to withdraw their money, forcing the banks to close their doors to prevent a complete withdrawal of capital.

A bank run can occur due to consumer panic, and a fractional reserve system keeps banks from being able to meet the demand for withdrawals because they don't physically have the funds. This was witnessed during the Great Depression in the U.S., when consumers rushed to banks to withdraw all of their funds, leading to the collapse of New York's Bank of the United States.

Too much lending can contribute to economic overheating, causing the economy to grow too fast. This can happen when banks lend more during periods of expansion, creating more money and increasing demand. As a result, producers begin producing more to meet demand, leading to a situation where the economy overheats.

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