Fractional-reserve banking is the practice whereby a bank takes in deposits. creates credit or makes loans. and holds reserves (to satisfy demands for withdrawals) that are less than the amount of its customers’ deposits. Reserves are held at the bank as currency, or as deposits in the bank’s accounts at the central bank. Because bank deposits are usually considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying reserves of base money originally created by the central bank. [ 1 ] [ 2 ]

To mitigate the risks of bank runs (when a large proportion of depositors seek withdrawal of their deposits at the same time) or, when problems are extreme and widespread, systemic crises. the governments of most countries regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks. [ 1 ] [ 2 ] In most countries, the central bank (or other monetary authority) regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This can limit the amount of money creation that occurs in the commercial banking system, and helps to ensure that banks are solvent and have enough funds to meet demand for withdrawals. [ 2 ] Rather than directly limiting the money supply, central banks may pursue an interest rate target to control bank issuance of credit. [ 3 ]

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§ History [ edit ]

Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers’ realization that generally not all depositors demand payment at the same time. [ 5 ]

In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths. receiving in exchange a note for their deposit (see Bank of Amsterdam ). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money. [ 6 ] As the notes were used directly in trade. the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion. charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks. [ 6 ]

Starting in the late 1600s nations began to establish central banks which were given the legal power to set the reserve requirement and to specify the form in which such assets (called the monetary base ) are required to be held. [ 7 ] In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks’ storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today. [ 2 ]

During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international balance of payments. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and monetary base. [ 8 ]

§ How it works [ edit ]

In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account ). That deposit account is a liability on the balance sheet of the bank. Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits.

Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis. demands for withdrawal can exceed the bank’s funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g. by borrowing in the interbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.

Many of the practices of contemporary bank regulation and central banking. including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance. are designed to prevent the occurrence of such bank runs.

§ Economic function [ edit ]

Fractional-reserve banking allows banks to create credit in the form of bank deposits, which represent immediate liquidity to depositors. The banks also provide longer-term loans to borrowers, and act as financial intermediaries for those funds. [ 2 ] [ 9 ] Less liquid forms of deposit (such as time deposits ) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor’s wealth for a period of time, making it unavailable for use on demand. This borrowing short, lending long, or maturity transformation function of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system. [ 10 ]

Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by the government to promote macroeconomic stability. [ 11 ]

The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. [ 12 ] [ 13 ]

§ Money creation process [ edit ]

There are two types of money in a fractional-reserve banking system operating with a central bank: [ 14 ] [ 15 ] [ 16 ]

1. Central bank money: money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money
2. Commercial bank money: demand deposits in the commercial banking system; sometimes referred to as chequebook money

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks’ reserves (it is no longer counted as part of M1 money supply ). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank’s reserves, the m1 money supply expands by the size of the loan. [ 2 ] This process is called deposit multiplication.

§ Example of deposit multiplication [ edit ]

The table below displays the relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times (of course, they do not really pay out loans from the money they receive as deposits) [ 17 ] with a fractional-reserve rate of 20% to ultimately create $500 of commercial bank money (it is important to note that the 20% reserve rate used here is for ease of illustration, actual reserve requirements are usually much lower, for example around 3% in the USA and UK). Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.