Understanding How Fractional Reserve Banking Affects Banks

Fractional reserve banking is a fundamental aspect of modern banking systems. It allows banks to lend out a significant portion of deposits they receive, rather than holding them in reserve.

Banks are required to keep a small percentage of deposits in reserve, but they can lend out the remaining amount. This is typically around 10% of deposits, but can vary depending on the country and regulatory environment.

Lending out deposits generates interest income for banks, which is a key source of revenue. This interest income is typically higher than the interest rate paid to depositors, making fractional reserve banking a profitable business model.

Banks use the money they lend out to make new loans, which in turn creates new deposits.

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The concept of fractional banking has a rich history that dates back to the gold trading era. It emerged with the realization that not all people needed their deposits at the same time.

In this era, people deposited their silver and gold coins at goldsmiths, who gave them promissory notes. These notes were later accepted as a means of exchange and used in commercial transactions.

The goldsmiths realized that not all savers would withdraw their deposits at the same time, so they started using the deposits to issue loans and bills at high interest, in addition to the storage fee charged to the deposits.

Sweden was the first country to establish a central bank in 1668, and other countries followed suit.

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Banks create new money by issuing loans to borrowers, crediting their accounts with the loan amount, and increasing the money supply.

Commercial banks are required to hold only a fraction of customer deposits as reserves, typically 10%, and may use the rest to make loans. This is known as the reserve requirement.

The bank lends out the majority of deposits, say $90 out of $100, to an entrepreneur to buy a factory. The old owner of the factory then deposits the $90 into a bank account, where it is split again, with 10% held in reserve and the rest lent out.

The lower the reserves a bank keeps, the more money circulates in the economy, but the less likely it is to withstand a bank run.

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Fractional-reserve banking allows banks to provide credit, which represents immediate liquidity to borrowers.

Banks also provide longer-term loans and act as financial intermediaries for those funds, essentially "borrowing short and lending long".

This process expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.

Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions, reducing the risk of bankruptcy.

A well-regulated fractional-reserve bank system can be used by the central bank to influence the money supply and interest rates.

Influencing interest rates is an important part of monetary policy used by central banks to promote macroeconomic stability.

Historically, central banks have changed reserve requirements to influence the money supply, but this is rarely used today.

In the US, the Federal Reserve eliminated reserve requirements entirely in 2020, instead preferring to use changes in the interest rate paid on reserves to influence the broader interest rate level in the economy.

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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.

Banks are required to hold only a portion of the money deposited with them as reserves, known as the reserve requirement. This allows them to act as intermediaries between borrowers and savers by giving loans to borrowers and providing immediate liquidity to depositors who want to make withdrawals.

The reserve requirement can be set by the central bank and is typically around 10% of customer deposits. For example, if a person deposits $1,000 in a bank account, the bank may hold $100 in reserve and lend out the other $900.

The money creation process is also affected by the currency drain ratio and the safety reserve ratio. The currency drain ratio refers to the propensity of the public to hold banknotes rather than deposit them with a commercial bank.

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The safety reserve ratio, also known as excess reserves, is the amount of reserves held by commercial banks beyond the legal requirement. This can be influenced by the central bank's monetary policy, such as paying interest on reserve balances.

Here's a breakdown of the money creation process:

This process is known as the money multiplier, and it allows banks to create new money by lending out a portion of the deposits they hold. However, it also increases the risk that a bank cannot meet its depositor withdrawals, which is why central banks regulate the banking system to ensure stability.

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Fractional reserve banking works because each bank is legally allowed to issue credit up to a specified multiple of its reserves. This means that banks don't need to hold all of their deposits in reserve, freeing up capital for lending.

However, this system can be fragile, as relatively few depositors demand payment at any given time. Banks maintain a buffer of reserves to cover cash withdrawals and other demands for funds.

But during a bank run or financial crisis, demands for withdrawal can exceed the bank's funding buffer. This can force the bank to raise additional reserves to avoid defaulting on its obligations.

A bank can raise funds by borrowing in the interbank lending market or from the central bank, selling assets, or calling in short-term loans. If creditors lose confidence in the bank, they'll try to redeem their deposits before others do, creating a self-fulfilling prophecy of a bank run.

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The banking process is a key part of fractional reserve banking, where banks take deposits and lend them out to other customers.

Banks split deposits into reserves and loans, typically keeping a small percentage in reserve and lending out the rest. For example, if you deposit $100, the bank might hold $10 in reserve and lend out $90 to an entrepreneur.

The bank's decision on how much to lend out is crucial, as it determines the amount of money circulating in the economy. The lower the reserves, the more money circulates, but the bank also risks a bank run if too many depositors withdraw funds at once.

A bank run occurs when depositors lose confidence in the bank's ability to meet their withdrawals, leading to a rapid depletion of reserves. This can happen if the bank lends out too much or makes poor investment decisions.

In a fractional reserve system, banks can exist and serve their communities by providing loans to entrepreneurs and earning interest on deposits. However, this comes with the risk of a bank run or bad investments causing the bank to go bankrupt.

Banks aim to keep a balance between lending out enough money to drive economic growth and maintaining sufficient reserves to prevent a bank run. The interest rate paid to depositors is meant to compensate for the risks involved in lending and banking.

Fractional reserve banking is a system where banks keep only a fraction of their deposits as reserves, allowing them to lend out the remaining amount and create new money through loans.

The amount of reserves a bank keeps is crucial for the stability of the banking system, and if they lend out too much or make poor investment decisions, they risk going bust.

A bank's reserves can be thought of as a safety net, holding 10% of deposits aside for unexpected withdrawals, as seen in the example where a bank lends out $90 of a $100 deposit and keeps $10 in reserve.

The money multiplier is a theoretical concept that demonstrates the maximum amount of money that could be created by commercial banks for a given amount of base money and reserve ratio, but in practice, central banks focus on setting target interest rates to satisfy their monetary policy goals.

This system allows banks to create new money through loans, which can be deposited again, further amplifying the money supply, but it also means that the balance between reserves and loans is crucial for the stability of the banking system.

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The money multiplier is a key concept in banking theory that explains how banks create new money through lending. It's a simple yet powerful idea that has a significant impact on the economy.

The money multiplier is the inverse of the reserve requirement, which is the percentage of deposits that banks must hold in reserve. In countries where the central bank imposes a reserve requirement, the money multiplier is defined as m = 1/R.

For example, if the reserve requirement is 10%, the money multiplier would be m = 1/0.1 = 10. This means that for every dollar of base money, banks can create up to $10 of new money through lending.

Here's a breakdown of the money multiplier formula:

m = 1/R

Where:

For instance, if the reserve requirement is 20%, the money multiplier would be m = 1/0.2 = 5.

This means that for every dollar of base money, banks can create up to $5 of new money through lending.

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.

The money multiplier is a crucial concept in understanding how banks create new money and how it affects the economy.

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Austrian School economists such as Jesús Huerta de Soto and Murray Rothbard have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized.

According to them, not only does money creation cause macroeconomic instability (based on the Austrian Business Cycle Theory), but it is a form of embezzlement or financial fraud.

US Politician Ron Paul has also criticized fractional-reserve banking based on Austrian School arguments, echoing the concerns of Huerta de Soto and Rothbard.

This criticism suggests that the influence of powerful rich bankers on corrupt governments around the world has led to the legalization of financial fraud.

However, the criticism is not entirely accurate, as fractional-reserve banking can be used to expand the economy when done properly.

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Austrian School economists like Jesús Huerta de Soto and Murray Rothbard have been vocal critics of fractional reserve banking, calling for its outlawing and criminalization. They argue that money creation causes macroeconomic instability and is a form of embezzlement or financial fraud.

US Politician Ron Paul has also criticized fractional reserve banking based on Austrian School arguments. However, this criticism is only partly true.

Fractional reserve banking can either be used to expand the economy or, when governments and central banks use it as players, it becomes a corrupt criminal enterprise that redistributes the money supply from producers of economic goods to a criminal cabal.

The criticism of a cabal's use of fractional reserve banking is in order, and central banks should be restrained and restructured to only play a role in genuine productive economic activity.

A bank simply adds another option for someone holding money other than keeping it in their mattress by storing money in a bank. By storing money in a bank, the depositor should earn a return on their money of a few percent a year, which compensates for the small risk that the bank may fail and the money may be gone.

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The bank might fail because they make bad investments and do not earn enough money to pay back their depositors. If enough depositors come at once asking for their money that the bank doesn’t have enough money to pay them all, we call this a bank run.

A bank run occurring during the Great Depression. Fractional reserve banking inherently involves the risk of bank runs because there will always be more money marked on the accounts than there is in the vault.

Let’s say we’re in a small town, where each of the 50 citizens has deposited $1,000 in the bank. The bank then has $50,000, and they lend out 90% of it or $45,000 and keep $5,000 in reserve.

If half the town comes down to the bank to withdraw their money, the bank now needs to come up with $25,000, with only $3,000 in reserve. This is a ‘run on the bank’ and it can happen any time the bank keeps less than 100% of deposits in reserve.

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Banking regulation is essential to prevent bank runs and maintain public confidence. Central banks have been created worldwide to address these problems.

Sweden was the first country to establish a central bank in 1668, and other countries followed suit. The central banks were given the power to regulate commercial banks, set reserve requirements, and act as a lender of last resort.

In some jurisdictions, the central bank does not require reserves to be held during the day, while in others, like the United States, Canada, and the United Kingdom, there are no mandatory reserve requirements.

Here's a comparison of some jurisdictions' reserve requirements:

The capital requirement ratio acts to prevent an infinite amount of bank lending when there are no mandatory reserve requirements.

In a fractional-reserve banking system, each bank is legally authorized to issue credit up to a specified multiple of its reserves.

This means that the reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits.

Banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds, which works relatively smoothly most of the time.

However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, forcing the bank to raise additional reserves to avoid defaulting on its obligations.

A bank can raise funds from additional borrowings, by selling assets, or by calling in short-term loans, but if creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible.

This can create a self-fulfilling prophecy, where the fear of a bank run actually precipitates the crisis.

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The Federal Reserve eliminated the reserve requirement in March 2020, allowing US banks to lend out money infinitely.

This move has significant implications for the banking system and the economy. Banks are now under less pressure to maintain cash reserves.

In the European Union, central banks do not require reserves to be held during the day. This allows banks to use their money more freely.

The lack of reserve requirements can lead to a bank run, where depositors withdraw their funds and the bank runs out of money.

Central banks have been created to address the problems associated with bank runs, which are a possibility due to the nature of fractional-reserve banking.

Bank runs occur because depositors may suddenly demand their money back, leading to a liquidity crisis for the bank. This is why central banks play a crucial role in maintaining financial stability.

The creation of central banks has helped mitigate the risks associated with bank runs, allowing banks to operate with more confidence and stability.

Commercial banks are allowed to hold only a fraction of customer deposits as reserves and may use the rest of the deposits to give loans to borrowers.

This process is called fractional reserve banking, and it's how banks create money. By giving loans, banks accept promissory notes in exchange for credit that is deposited in the borrower's account in the bank.

For example, if someone 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.

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When a bank issues a loan, it creates new money, which increases the money supply. The old owner of the factory takes the $90 and puts it in a bank account as well, creating a chain reaction of deposits and loans.

The bank again keeps 10% aside for reserves, and lends out the remaining amount. This process can multiply the money in the system, but it also increases the risk of a bank run if too many depositors come to withdraw funds and the reserves run out.

A bank is a business, and if they do a bad job, they run out of money and fail. This is a huge problem for the system, as it can lead to instability and uncertainty in the economy.

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