What Is Fractional Reserve Banking System?
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What Is Fractional Reserve Banking System?

6 Min.

Basics

The banking system known as fractional reserve allows commercial banks to lend a portion of their customers’ deposits while keeping only a small fraction of the deposits in actual cash available for withdrawal. This creates money from a percentage of the customers' bank deposits. 

The banks must maintain a minimum percentage, or fraction, of deposited funds as reserves, meaning they can lend out the rest of the money. This creates an economic doubling effect, as both the bank and the borrower count the loaned funds as assets. The currency is then re-used, re-invested, and re-loaned multiple times, resulting in the multiplier effect, which “creates new money”.

Central banks often play a key role in the fractional reserve banking system, both as regulatory agencies and as providers of new currency. They may also establish minimum reserve requirements. The lending and debt that are integral to this system require central banks to ensure that commercial banks have the sufficient currency on hand to meet withdrawal requests.

Overall, fractional reserve banking is a widely used system in many free-trade countries, and its usage allows financial institutions to profit by lending out a portion of deposited funds.

The History of Fractional Reserve Banking Systems 

The concept of fractional reserve banking systems dates back to around 1668 when the Swedish Riksbank was established as the world's first central bank. Although primitive forms of fractional reserve banking had existed before this time, the establishment of a central bank provided an official framework for the practice.

The idea of using money deposits to stimulate the economy through loans quickly gained popularity. It was deemed more practical to invest resources in encouraging spending rather than hoarding them in a vault. After Sweden adopted this practice, the fractional reserve structure spread rapidly.

In the United States, two central banks were established in 1791 and 1816, but they were short-lived. In 1913, the Federal Reserve Act established the U.S. Federal Reserve Bank, which is now the country's central bank. The institution is responsible for stabilizing and overseeing the economy concerning employment, pricing, and interest rates. These are the named objectives of the Federal Reserve Bank.

How Does Fractional Reserve Banking Work?

This system works by allowing banks to use a portion of deposited money to issue loans while holding a fractional reserve. When a customer deposits money in their account, the bank owns it, and the customer receives a deposit account they can access. However, only a small percentage of the deposit is reserved, typically between 3% and 10%, with the rest used to make loans to other customers. These loans, in turn, create new money via the multiplier effect.

For instance, when Customer A deposits $50,000 in Bank 1, the bank loans Customer B $45,000, who then deposits $45,000 in Bank 2. Bank 2 loans Customer C $40,500, and the cycle continues. With a fractional reserve requirement of 10%, the original $50,000 deposit grows to $234,280 in the total currency available, including all customers' deposits and the last loan issued. Although this is a simplified example, it illustrates the concept of how fractional reserve banking generates money.

The way fractional reserve banking works is based on the principle of debt. Banks owe their customers money in the form of deposit accounts, which is considered their liability. The most profitable asset for banks is interest-earning loans, which are considered their asset. In short, banks make money by creating more loan account assets than deposit account liabilities.

How Do Bank Runs Happen?

Bank runs occur when all depositors of a bank try to withdraw all their money at the same time, which could cause a bank to fail because it only holds a fraction of its customers' deposits. This can pose a risk to the fractional reserve banking system as it relies on depositors not all attempting to withdraw their funds at once. However, this is not a typical behavior for customers, they only attempt to withdraw all their money if they think the bank is experiencing financial difficulties. 

The Great Depression is an example of a massive withdrawal causing devastation in the U.S. financial system. Today, to reduce the likelihood of bank runs, financial institutions hold more than the mandated minimum reserves and try to meet their customers' demands for access to their deposit account funds.

Advantages and Disadvantages of Fractional Reserve Banking

Fractional reserve banking provides several benefits to banks, which in turn benefit their customers through earned interest on deposit accounts. Additionally, the government supports this system, stating that it promotes spending, economic stability, and growth.

Despite these advantages, some economists argue that fractional reserve banking is unsustainable and risky. This is especially concerning given that the current monetary system of most countries is based on credit and debt, rather than actual money. This system relies on public trust in banks and fiat currency, which governments have established as legal tender.

Fractional Reserve Banking and Crypto

The context of cryptocurrency is entirely different from traditional banking, so there is no such concept as a fractional reserve in the world of cryptocurrencies. Bitcoin and other cryptocurrencies rely on a decentralized network of nodes to maintain their ledger, with all data secured by cryptographic proofs and recorded on a public blockchain. Unlike traditional fiat currencies, there is no need for a central bank, as there is no authority in charge of regulating the system.

Furthermore, the total supply of Bitcoin is finite, with a maximum limit of 21 million units, meaning that no additional coins will be generated. Hence, unlike the traditional system, the world of Bitcoin and cryptocurrencies operates in a completely distinct context where fractional reserve banking is non-existent.

Conclusion

Fractional reserve banking has been a widely used system in many countries for centuries, allowing financial institutions to profit by lending out a portion of deposited funds. While the system has its advantages, it also has potential risks and sustainability concerns. For instance, it makes bank runs possible. It happens when all depositors of a bank attempt to withdraw their funds at once, posing a risk to the system. In the context of cryptocurrencies, however, fractional reserve banking doesn’t exist, as the decentralized nature of the network and the finite supply of coins render the concept irrelevant. Overall, understanding fractional reserve banking is essential for comprehending the workings of the global financial system.

 

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