A fractional reserve banking system is one in which only a portion of bank deposits must be available for withdrawal. Banks only need a certain amount of cash on hand and can make loans using the money you deposit. By releasing cash for lending, fractional reserves help to boost the economy. Today, the majority of economies’ financial systems employ fractional reserve banking.
Overview of Fractional Reserve Banking
When you open an account with a bank, you agree in the contract to enable the bank to lend a percentage of your deposits to other bank customers. This doesn’t mean you can’t withdraw the money you deposited; it just means that if you want to withdraw more than the proportion a bank has on hand, such as the full balance, the bank will need to access funds from somewhere else to give you your balance.
When you deposit funds in your savings account, your bank may take a portion of the funds as capital to support loans and compensate you for utilizing your funds. Assume you deposited $2,000 in a savings account. Savings accounts pay interest—usually between 0.5% and 2%—so you get interest on your money, and the bank can use some of it to make a loan. As a result, the bank may wish to access 80% of your funds to make loans to other clients.
You get interest as a reward for holding money in an account that the bank can use to make loans.
The Federal Reserve sets interest rates. They are determined by economic circumstances and how the government determines how best to accomplish its twin goals of maximum employment and price stability. If a bank needs cash to support loans, withdrawals, debt payments, or other commitments, it can borrow and pay interest to other banks. As a last option, the Federal Reserve operates the discount window, where it lends money to banks at a greater interest rate than they charge each other. This encourages banks to seek funds from one another instead of the Fed.
Process of Fractional Reserve Banking
The process of fractional reserve banking generates money, which is then injected into the economy. When you deposit $2,000, your bank may lend 90% of it to other customers, along with 90% from the accounts of five other clients. This generates sufficient capital to fund $9,000 in loans.
Your balance is still $2,000, and the balances of the consumers from whom the bank borrowed are also unaltered. If all five customers have $2,000 account balances, it will appear like this:
- You and four other customers each have $2,000 in savings accounts that pay 1% per year.
- If the bank can lend out 90% of its deposits, its available capital is $9,000 (90% of $10,000).
- A sixth customer requests a $1,000 loan.
- The bank borrows 10% of the total amount of $1,000 from each of the five accounts.
- Each account still has a $2,000 balance ($10,000 total among the five accounts).
- The bank simply generated $1,000 and gave it to the customer at a 5% annual interest rate.
- You receive 1% annual interest payments on your $2,000, and the bank keeps the difference of 4% as profit.
History of the Fractional Reserve Banking System
The emergence of the fractional reserve banking system began in Europe in the 17th century with the practice of goldsmiths providing safekeeping depository services. In exchange for a storage fee, goldsmiths of the time assisted wealthy people in storing precious metals such as gold in their vaults. Goldsmiths sent notes or receipts to the depositor to acknowledge the deposit.
They realized that depositors were essentially using these notes as a means of exchange. Furthermore, based on previous experience, they determined that the prospect of simultaneous redemption of receipts by all depositors is small. This predicament inspired goldsmiths to create receipts without comparable precious metals in their vaults and begin lending out, heralding the beginning of contemporary banking procedures.
Example
Let us look at an example to see how the fractional reserve system works.
You go to a bank and make a $2000 demand deposit.
The central bank enables banks to invest up to 90% of their deposits while keeping 10% as a reserve. This indicates that the bank may effectively utilize $1,800 to make loans.
The bank then loaned $1,800 to another customer using the reserve from your deposit. Banks pay interest on deposits from customers and earn interest on loans.
When you check your account balance, you’ll see the amount you deposited—$2,000—even if 90% of it has been lent out. Surprisingly, this means that $3,800 might be circulating in the economy at the same time, despite the fact that only $2,000 exists in the first place. However, in theory, that second person would return the money, bringing the numbers back into balance.
Fractional Reserve vs. Other Types of Banking
Because 100% reserve banking is impractical in most nations today, fractional reserve banking is used. Furthermore, a system that compels banks to keep 100% of deposits cannot produce additional money without depreciating the currency. As a result, banks would need to keep a considerable amount of capital in order to provide loans.
This would have a significant impact on growth in both developing and established economies since banks would be unable to issue debt to businesses and people who rely on it for substantial purchases and investments.
This difficulty is also present in a system backed by precious metals, like gold. If a given quantity of a country’s currency must be represented by a specific amount of gold, the country limits its growth potential because gold is limited. To fulfill the rising demand for capital, the currency’s value would be steadily lowered. To address the demand for growth, a country can use fractional reserve banking to increase its money supply.
The Benefits and Drawbacks of Fractional Reserve Banking
Benefits
- Banks do not require large sums of capital: Because banks employ deposits left in clients’ accounts, fractional reserve banking frees up money for the economy. This promotes economic progress by keeping funds flowing.
- Banks boost the economy through lending: Capital is required for the economy to grow. Banks supply this need by lending to businesses and individuals using money held in reserve. Mortgages, vehicle loans, and other loans, for example, are all made possible by fractional reserve banking. Without it, most consumers would be unable to buy housing and other contemporary essentials.
- Regulation is possible: Reserve ratios can be used by central banks to regulate the economy as a macroeconomic instrument. Increasing reserve requirements limits lending, causing the economy to cool. Reduced reserve requirements boost lending, which expands the economy. The Federal Reserve rarely uses this instrument, but other central banks, most notably the People’s Bank of China, do.
Drawbacks
- Consumer panic can result in mass withdrawals and a lack of capital: When consumers, investors, and businesses are concerned about the economy, they tend to rush to their banks to withdraw whatever they can to avoid additional losses. This is known as a bank run, and a fractional reserve system prevents banks from withdrawing capital because they do not physically have it.
- Excessive lending can lead to economic overheating: When the economy expands, it expands. During moments of expansion, consumers tend to spend more and banks lend more. When more money is created through loans, demand rises, causing prices to rise. Producers increase output to fulfill demand. This can lead to the economy overheating and growing too quickly.
Arguments Against Fractional Reserve Banking
The biggest argument leveled against fractional reserve banking is that there isn’t enough money for everyone to withdraw all at once. However, this is often not an issue because most people will not need to withdraw all of their capital.
Prior to the establishment of the Fed in the early twentieth century, the National Bank Act of 1863 imposed 25% reserve requirements on U.S. banks under its supervision.
This can be seen by looking at the Greek financial crisis, which began in 2009. In the midst of a worldwide financial crisis, Greece defaulted on its payments to the International Monetary Fund in 2015. As a result, citizens went to banks to withdraw their savings, forcing banks to seal their doors in order to prevent a total outflow of capital from a faltering system.
Earlier, at the outset of the Great Depression in the United States, people raced to banks to withdraw all of their funds, resulting in the failure of New York’s Bank of the United States.
What Is the Difference Between Fractional Reserve and 100% Reserve Banking?
Banks can utilize cash (i.e., the majority of deposits) that would otherwise be unused and idle to create returns in the form of interest rates on new loans—and therefore make more money available to build the economy. As a result, capital can be better allocated to where it is most needed. 100% reserves necessitate banks holding all deposited funds.
Is Fractional Reserve Banking Legal?
Yes. The majority of countries adopt fractional reserve banking because it is the only financial system model that permits banks to earn a consistent profit. Banks would have to fund their operations by collecting exorbitant deposit fees if they couldn’t earn money on their assets.
Where Did Fractional Reserve Banking Originate?
Nobody knows when fractional reserve banking began, although it is not a recent development. Goldsmiths in the Middle Ages created demand receipts for gold on hand that exceeded the amount of physical gold under custody, knowing that only a minuscule portion of that gold would be needed on any given day.
Is UK Fractional Reserve Banking?
In the United Kingdom, there is no longer a fractional reserve system. This means that there is no limit to the amount of money that banks can lend – it has no bearing on the amount of money they have in reserve.
How much do banks have to keep in reserves UK?
For starters, the required reserve ratio in the UK is zero, not 10%. But, more essentially, the reserve ratio would only limit the quantity of money that banks may generate if the’reserve’ money was removed from circulation and placed in a safe deposit box or an electronic equivalent.
What are the Fractional Reserve Requirements in UK?
All UK banks have agreed to maintain minimum reserve ratios of 12% and finance houses at least 10%.
In Conclusion
Today, the banking system employed around the world is fractional reserve banking. Banks make loans to businesses and consumers using fractional reserves. Without this capability, an economy’s growth is stifled, causing it to struggle while those in need of funds for significant purchases and investments rely on a bank’s substantial assets.
Because the alternatives limit the amount of money that may be created or controlled in an economy to support or discourage growth, fractional reserve banking is vital for modern economies.
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