What is Fractional Reserve Banking?
You may have heard the term fractional reserve banking, fractional-reserve banking, or fractional reserve system and wondered what it is. This article will explain what fractional reserve banking is, how it works, and its implications on the economy.
What is Fractional Reserve Banking?
Fractional reserve banking is a system in which commercial banks are required to maintain only a fraction of their deposits as reserve funds. These reserves, held in either cash or on deposit with the central bank, can be used as liquidity in the event of unexpected withdrawals or other bank default scenarios.
Under a fractional reserve banking system, banks have a legal right and obligation to lend, on top of the amount of money they actually physically hold. This presents banks with the ability to create money effectively out of thin air – money which can be used to finance investments and economic activity.
To better understand what fractional reserve banking is, it is important to note the differences between fractional and full reserve banking.
Difference Between Fractional and Full Reserve Banking
Under a full reserve banking system, banks must hold 100% of their customer deposits as reserves. This eliminates the ability of banks to lend funds on top of the reserve funds that they have, as those funds are already being used as liquidity for customer withdrawals.
However, the main difference between a full reserve and fractional reserve banking system is that under a fractional reserve system, banks are not required to keep 100% of their customer deposits on reserve. As a result, banks are able to lend out some of the funds that customers have deposited with them.
The Money Multiplier Effect
An important concept to understand within a fractional reserve system is the money multiplier effect. This effect states that when banks make new loans, that money is then deposited into another bank, inducing them to also make new loans and create new deposits. This is known as the “money multiplier”.
For example, if ABC bank has a reserve ratio of 10%, then when ABC bank lends out $1000 to a customer, then $1000 is deposited into another bank. This new bank then has $1000 of additional reserves and is able to lend out $900. This $900 is then deposited into another bank, and so forth, producing an exponential increase in the amount of money available in the banking system.
Advantages of Fractional Reserve Banking
Fractional reserve banking offers numerous advantages to economies. First, fractional reserve banking enables banks to expand the money supply and therefore increase access to credit. By allowing banks to create money out of nothing, fractional reserve banking effectively allows for the financing of investment and fuel economic development.
Second, the law of reserve ratios ensures stability and safeguards against bank runs. By maintaining a reserve ratio of a certain percentage, banks are able to respond to unexpected withdrawals that customers may wish to make.
Finally, fractional reserve banking allows for easier monetary and fiscal policy implementation. By allowing for more money to be lent out and invested into the economy, this ensures that governments can utilize a variety of strategies to stimulate economic activity.
Disadvantages of Fractional Reserve Banking
Although there are advantages to fractional reserve banking, it is important to note that there are also many potential drawbacks. Firstly, fractional reserve banking leads to an increase in debt. When banks create money to lend out and invest in various ventures, it leads to an increase in public and private debt which can burden future generations.
In addition, fractional reserve banking can have serious implications in times of crisis. As the banks are unable to anticipate economic shocks and subsequent withdrawals, it can lead to extreme instability in the banking system leading to a financial crisis.
Fractional reserve banking is a system that creates money out of nothing and incentivizes the creation of debt. There are advantages to fractional reserve banking, including the ability to finance investments and use monetary and fiscal policy to stimulate economic activity. However, fractional reserve banking can lead to excess debt and instability in the event of an economic shock. It is important for governments to effectively manage reserve ratios in order to ensure banks are able to respond to unforeseen withdrawal requests and maintain economic stability.
