A banking system in which banks hold only a fraction of deposits as reserves

Fractional reserve banking refers to a system in which banks are obliged to hold a small percentage of the client’s deposit in its reserve. Banks use the amount left after reserve for various investment activities like providing loans.

The method usually is safe because it is unlikely for all account holders to withdraw the deposits simultaneously. However, the method is criticized for being harmful to the economy due to its detrimental effect during a bank run.

Table of contents

Key Takeaways

• Fractional reserve banking is a regulatory measure that mandates banks to keep a certain percentage of total deposits as reserves and invest the remaining to maintain the banking system’s functioning.
• The debates about the fractional reserve model are still in the limelight. A section believes investing a significant portion of the deposits stimulates the economy.
• Opponents argue that it is harmful to the economy since it creates money through lending. As a result, unsustainable economic booms are inevitable.
• Several banks had to liquidate during the Great Depression because most clients attempted to withdraw their savings.

Explanation

The term fractional reserve banking directly indicates the fraction of the deposit that banks need to maintain at all times. Generally, the nation’s central bank determines how much money commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more based in the country need to store. The most common value is 10%. So, for example, a bank with $10 billion could invest $9 billion while keeping the rest to pay the consumers if they wished to withdraw.

The fractional reserve requirement may change from time, place, and as laws get harder or lighter on the financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more with the changes in the economy. For example, a few countries, such as the UK and New Zealand, do not impose reserve requirements on banks; instead, they implement effective capital requirement criteria. Also, the U. S. Federal Reserve has decided to drop the reserve requirement to zero in 2020 in response to the pandemic situations.

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Maintaining a portion of the deposit with the bank’s vault or Federal Reserve will help meet the normal flow of withdrawal requests. It ensures liquidity in bank operations. In addition, the remaining amount helps the banks engage in investment or profitable activities rather than storing the total amount as a reserve. Banks offer interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more to customers who deposit their savings and utilize a significant portion of deposits to lend it out at a higher interest rate than the interest rate on deposits.

History of Fractional Reserve Banking System

The evolution of the fractional reserve banking system started with the practice of goldsmiths providing the safekeeping depository services in the 17th century in Europe. Goldsmiths at that time helped wealthy people in storing precious metals like gold in their vault in return for a storage fee. For acknowledging the deposit, goldsmiths furnished notes or receipts and handover to the depositor.

They noticed that depositors were using these notes essentially as a medium of exchange. Also, from experience, they analyzed that the possibility of redemption of receipts simultaneously by all depositors is minimal. This situation gave goldsmiths the idea of creating receipts without equivalent precious metals in their vault and started lending out, marking the early period of modern banking practices.

Example

Let’s see an example to illustrate how the fractional reserve system works.

• You go to a bank and make a demand depositDemand DepositMoney deposited with a bank or financial institution that can be withdrawn without notice is known as a demand deposit. Due to the shorter lock-in time, it does not pay any interest or a nominal amount of interest.read more of $2,000.
• The central bank allows banks to invest up to 90% of the deposit and maintain 10% of the deposit as a reserve. It means the bank could essentially use $1,800 for providing loans.
• Afterward, the bank gave a loan of $1,800 to another customer utilizing the reserve of your deposit. Banks pay interest on customer deposits and earn interest on the lent-out sum.
• When you check your account balanceAccount BalanceAccount Balance is the amount of money in a person's financial account, such as a savings or checking account, at any given time. Furthermore, it can refer to the total amount of money owed to a third party, such as a utility company, credit card company, mortgage banker, or other similar lender or creditor.read more, it will show the amount you deposited, $2,000, even if 90% of it is lent out. Curiously, this means that $3,800 could be circulating in the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more simultaneously, despite only $2,000 existing in the first place. Theoretically, that second person would give the money back, though, which would equalize the math.

Is Fractional Reserve Banking System Bad?

The highly criticized notion about the financial institutions following the fractional reserve model is that they create money out of nothing and make the financial system more vulnerable to boom and bust. However, opponents argue that by providing loans, banks are speeding the money circulation. So, when faced with a bank run scenario, they are left with not much choice but to liquidate their illiquid assetsIlliquid AssetsIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment.read more or get help from the central bank to avoid situations breaking the contractual obligation to repay. Hence, we can say that there is default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more and chances of insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more of the institution.

Trust is an established factor strengthening the system following the fractional reserve model. From experience and statistical calculations, banks analyze the reserve requirementReserve RequirementReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more to meet the withdrawal requests, maintain the appropriate amount, or contemplate replenishing their reserves. Thus, the well-managed banking system creates trust in the people.  However, any piece of bad information can break the trust quickly and can cause a bank run. At this point, the institutions following the fractional reserve model suffer.

One of the largest bank runs in history happened in the United States during the Great Depression of 1929Great Depression Of 1929The Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more. During the period of financial uncertainty, several investors opted to withdraw their funds, and banks were unable to keep up. It sparked an even greater panic, causing more individuals to withdraw their deposits and, consequently, causing many bank failures.

If banks are directed to maintain 100% of the deposit in reserves without any assistance from the central bank or the government, it will affect their revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. It, in turn, increases the chance of charging fees for safely storing the deposits rather than paying interest on the deposit. Furthermore, it reduces the money in circulation and stimulus to the economy.

Frequently Asked Questions (FAQs)

How does fractional reserve banking work?

The fractional reserve model core principle is that the banks should hold a portion of the total deposit specified by the central bank or governing authority rather than storing the total amount in its vault or lending out the total deposits. The deposit in excess of the reserve is converted into investments.

What is wrong with fractional reserve banking?

The fractional reserve model manifests an alarming default risk and inability to meet multiple clients’ unconditional redemption requests. As a result, the institution may not successfully settle all withdrawal requests during a bank run and become insolvent.

What is the fractional reserve banking myth?

Many economists denounce the money creation or multiplier effect associated with the fractional reserve model as a misconception. They elucidate that no new money is created; rather, the model only increases the money in circulation.

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