Fractional Reserve Banking

Fractional reserve banking is a regulation in the banking industry whereby banks (and other similar institutions) keep reserves that are less than their total deposits.
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Fractional Reserve Banking

Definition

Fractional reserve banking is a banking system in which banks are required to keep only a fraction of their depositors’ balances in reserve as cash or other highly liquid assets. This allows banks to use the remaining deposits to make loans and create credit. Central banks set the reserve requirements which dictate the minimum percentage of deposits that must be held in reserve.

Examples

  1. Example 1: Reserve Requirement of 10%

    • A bank receives $1,000 in deposits and is required to keep 10% in reserve.
    • The bank keeps $100 in reserve and lends out the remaining $900.
    • This lending process generates new money and increases the money supply in the economy.

  2. Example 2: Reserve Requirement of 20%

    • A bank receives $5,000 in deposits with a 20% reserve requirement.
    • The bank holds $1,000 in reserve and is able to lend out $4,000.
    • The loaned amount is then deposited and re-loaned, amplifying the effect of the initial deposit.

Frequently Asked Questions (FAQ)

Q1: What is the primary benefit of fractional reserve banking?

  • A1: The primary benefit is its ability to expand the money supply through the lending process, which can stimulate economic growth.

Q2: Why do central banks impose reserve requirements?

  • A2: Reserve requirements are imposed to ensure stability in the banking system and to control the money supply.

Q3: Can a bank run out of cash in a fractional reserve system?

  • A3: Yes, if many depositors demand their money back simultaneously, a bank may face liquidity issues. This is why central banks act as lenders of last resort.

Q4: How does fractional reserve banking affect interest rates?

  • A4: By influencing the supply of money available for loans, fractional reserve banking can impact interest rates. More lending capacity typically leads to lower interest rates.

Q5: What is the reserve ratio?

  • A5: The reserve ratio is the fraction of deposits that a bank is required to hold in reserve and not lend out.
  • Reserve Requirement: The minimum amount of reserves a bank must hold against deposits.
  • Money Multiplier: The ratio of the increase in money supply to the initial deposit. It shows how money supply is magnified.
  • Central Bank: The institution responsible for managing the nation’s money supply and monetary policy.
  • Liquidity: The availability of liquid assets to a bank or company.
  • Bank Run: When a large number of bank’s customers withdraw their deposits simultaneously due to concerns about the bank’s solvency.

Online References

Suggested Books for Further Studies

  1. “Money, Bank Credit, and Economic Cycles” by Jesús Huerta de Soto
  2. “Man, Economy, and State with Power and Market” by Murray Rothbard
  3. “The Mystery of Banking” by Murray Rothbard
  4. “Principles of Economics” by N. Gregory Mankiw
  5. “Monetary Theory and Policy” by Carl E. Walsh

Fundamentals of Fractional Reserve Banking: Finance Basics Quiz

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