Definition
Fractional Reserve Banking is a banking system where only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. This allows banks to use the rest of the deposit to make loans and thereby earn profits. The fraction that is required to be kept is determined by the central bank, which is known as the reserve requirement.
Key Takeaways
- Fractional Reserve Banking is a system in which only a fraction of bank deposits are backed by actual cash-on-hand, available for withdrawal. This allows banks to use the rest of the funds to provide loans and invest in various ways to make more income.
- This banking system expands the money supply of a country. By lending more than they hold, banks in a fractional reserve system generate more money, which supports economic growth but can also lead to inflation if not properly regulated.
- The risk associated with Fractional Reserve Banking is the possibility of a bank run, where a large number of customers demand to withdraw their money at the same time, which could exceed the bank’s liquid assets. This is why banks in many countries are required to have deposit insurance to protect depositors and prevent bank runs.
Importance
Fractional Reserve Banking is a crucial concept in the financial sector as it forms the backbone of the global banking system. This system allows banks to lend more money than they hold in reserves, promoting economic growth by facilitating more loans, credit, and capital for businesses and individuals.
It also empowers banks to earn more money through the interest on loans. By determining the reserve requirement, Fractional Reserve Banking influences liquidity and money supply, thus affecting inflation rates, economic health, and monetary policy.
However, it also means that banks might not have enough cash on hand to meet all the withdrawal demands during times of financial uncertainties, leading to potential bank runs. Therefore, while accelerating economic activity, it also indicates an inherent risk in our banking system.
Explanation
The primary purpose of Fractional Reserve Banking is to maintain liquidity and foster financial stability in the economy while promoting growth. To elaborate, banks only keep a fraction of the deposits as reserves (cash stored in the bank vault or deposited with the central bank) and typically lend out the majority of the deposits received from account holders.
This injects more money into the economy, promoting spending and business investment, which consequently stimulates economic growth. The process of fractional reserve banking is also crucial for creating money.
When banks lend money out, they essentially create new money. This is because in the borrower’s perspective, they have more money to spend (the loan they just received). Meanwhile, the original depositor’s account balance also remains the same, theoretically meaning an overall increase in money in the economy.
This leads to money multiplication, further injecting liquidity into the economy. Nonetheless, risks are involved as too much money created can lead to inflation, and thus, central banks regulate the minimum level of reserves to ensure a balance.
Examples of Fractional Reserve Banking
Commercial Banks: Commercial banks operate under a fractional reserve banking model. When customers deposit their money into a bank account, the bank does not keep all of the money. Instead, it keeps a fraction (as determined by national banking regulations) and lends out the rest to other customers or invests in financial ventures, with the expectation of generating more returns.
Federal Reserve System (U.S.A): The central banking system of the United States, also known as the Fed, is another example of fractional reserve banking. The Fed sets a minimum reserve requirement for all other banks, meaning it determines what fraction of customer deposits banks are required to keep on reserve. This system allows the Fed to control the supply of money in the economy.
Credit Creation: The credit creation process by the banks is an example of the Fractional Reserve Banking system. When a bank extends a loan, it does not lend out its reserves or other customers’ deposits, but instead it “creates” the loan by making an entry into its books. In essence, banks are able to create new money through loans because they’re only required to hold a fraction of their customers’ deposits on reserve. For instance, if a bank has a reserve ratio of 10%, it can lend out 90% of the deposits it receives, effectively creating more money circulating in the economy.
Fractional Reserve Banking FAQs
What is Fractional Reserve Banking?
Fractional Reserve Banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to expand the economy by freeing capital for lending.
How does Fractional Reserve Banking work?
In the Fractional Reserve Banking system, banks keep only a fraction of their deposits in reserve as cash. The rest of the money is used to give out loans. When a bank gives out a loan, it does not physically hand out cash; instead, it deposits the loan amount in the borrower’s bank account. This creates new money in the system.
What is the Reserve Requirement in Fractional Reserve Banking?
The Reserve Requirement is the minimum amount of funds a bank must hold in reserve against deposit liabilities. Reserve requirements set by central banks affect the amount of loans that a bank can distribute.
What are the Pros and Cons of Fractional Reserve Banking?
Pros include economic expansion due to increased lending and borrowing, stability in the banking system, and better liquidity for banks. Cons include the risk of a bank run if customers lose faith in the bank’s ability to pay, and inflation due to creation of new money.
What happens during a bank run?
A bank run occurs when a large number of customers withdraw their deposits simultaneously due to fears of the bank’s insolvency. In Fractional Reserve Banking, banks do not have enough cash in reserve to cover all deposits, so they might face insolvency during a bank run.
Related Entrepreneurship Terms
- Reserve Requirement
- Central Bank
- Deposit Multiplier
- Liquid Assets
- Bank Run
Sources for More Information
- Federal Reserve System: The official website of the U.S. Federal Reserve provides ample resources on different aspects of banking and finance including fractional reserve banking.
- Investopedia: This is a comprehensive source of financial information and explains Fractional Reserve Banking in a clear and understandable manner.
- Khan Academy: Provides educational materials on a variety of topics, including banking and money. The topic of Fractional Reserve Banking is explained in layman’s terms.
- The Economist: This is a leading source of analysis on international business and world affairs, they provide insightful reads on a variety of economic topics like Fractional Reserve Banking.
