An introduction to fractional reserve banking

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Fractional reserve banking (FRB) is a regulatory system in which banks hold at least a specific fraction of their customers’ deposits in reserve and lend out the rest. When a bank accepts customer deposits, it must keep a certain percentage of those deposits in reserve, typically held at that country’s central bank. After that, the bank can use the rest of the deposits to make loans or investments.

This system allows banks to create money by effectively “printing” new money through the issuance of loans. For example, if a bank has collected $100 in deposits and is required to keep 10% in reserve, it can lend out $90 to borrowers. When the borrowers use the funds to make purchases or investments, a good part of this money gets deposited in other banks — the process repeats, effectively creating new money in the economy.

The fractional reserve system is used in most countries worldwide and is a key component of the modern banking system. However, it can also create risks for the economy, such as the possibility of bank runs or financial crises, which is why central banks regulate the reserve requirements and other aspects of banking activities.

History of fractional reserve banking

The origins of fractional reserve banking can be traced back to ancient times when goldsmiths would store people’s gold and issue receipts as proof of ownership. The goldsmiths realised that only a fraction of the gold would be withdrawn at any one time, so they began issuing more receipts than the corresponding gold they held, effectively creating new money.

In the 17th and 18th centuries, fractional reserve banking became more common in Europe and the U.S. In addition to holding deposits, banks began issuing their own banknotes, which could be used as a form of currency. These banknotes were backed by a fraction of the bank’s deposits, with the rest used to make loans.

The U.S. established a national banking system in the mid-19th century, requiring banks to hold a specific percentage of their deposits in reserve at the central bank, the Federal Reserve. The reserve requirements have changed over time, with the current reserve requirement for banks in the U.S. set at 10% of their deposits.

Fractional reserve banking played a significant role in the development of the modern financial system. But it has also been associated with financial crises and instability, such as the Great Depression in the 1930s and the Global Financial Crisis of 2008. As a result, there has been an ongoing debate about the merits and risks of fractional reserve banking, and regulatory authorities continue to monitor and adjust the rules and regulations governing banking activities.

Full-reserve banking as an alternative to fractional reserve banking

The alternative to fractional reserve banking is a system of full-reserve banking, also known as 100% reserve banking. In a full-reserve banking system, banks would be required to hold 100% of their deposits in reserve, meaning they would not be able to lend out any of their customers’ deposits. Instead, banks would only be able to lend out money that they had obtained through borrowing or other means.

Advocates of full-reserve banking argue that it would eliminate the risk of bank runs and financial crises caused by the fractional reserve system. They also say that it would prevent banks from creating money by issuing loans, which they believe contributes to inflation and economic instability.

However, opponents of full-reserve banking argue that it would severely limit the ability of banks to make loans, which would stifle economic growth and innovation. They also say that the ability of banks to create money through the fractional reserve system is an important tool for monetary policy, allowing central banks to influence the supply of money and credit in the economy.

Overall, both fractional reserve banking and full-reserve banking have their advantages and disadvantages, and there is an ongoing debate about the best approach to regulating the banking system to balance economic growth and stability.

Full-reserve banking in practice

Full-reserve banking is not commonly used in modern banking systems, and no major banks currently follow a full-reserve banking model. The reason is that full-reserve banking would severely limit the ability of banks to make loans and earn interest, which is a primary source of revenue for banks.

Some small banks and credit unions have experimented with full-reserve banking, but they are generally unable to compete with larger banks and do not offer the same range of services. In addition, the regulatory environment for full-reserve banking is not well-developed, and there are few guidelines for how such a system would be implemented and regulated.

Overall, while full-reserve banking is an interesting theoretical concept, it is not a practical solution for modern banking systems, which rely on fractional reserve banking to provide loans and credit to individuals and businesses.

Advantages and disadvantages of fractional reserve banking

Advantages of fractional reserve banking include:

Provides liquidity: Fractional reserve banking allows banks to lend out a significant portion of their deposits, providing borrowers with access to credit and increasing liquidity in the economy.
Increases economic growth: Credit availability can promote economic growth by allowing individuals and businesses to invest in new projects and expand their operations.
Provides a stable source of funding: The deposits held by banks offer a stable source of funding that can be used to make loans or investments, which can be important for businesses that need long-term funding.
Enables monetary policy: Fractional reserve banking provides central banks with a tool to control the money supply and interest rates, which can be used to stabilise the economy and prevent inflation.

Disadvantages of fractional reserve banking include:

Risk of bank runs: Fractional reserve banking exposes banks to the risk of bank runs, where depositors try to withdraw their money all at once, potentially leading to a bank’s failure and instability in the financial system.
Risk of financial crises: The creation of new money through fractional reserve banking can lead to financial bubbles and crises, such as the Global Financial Crisis of 2008, partly caused by the excessive lending and borrowing facilitated by the fractional reserve system.
May contribute to inflation: The creation of new money through lending can increase the money supply and contribute to inflation, which can harm consumers and investors.
May lead to moral hazard: The possibility of government bailouts or other forms of support for banks that engage in risky lending practices can create a moral hazard, where banks take on excessive risk knowing they will not bear the full cost of any failures.

Overall, fractional reserve banking is a complex system with both advantages and disadvantages. So the regulators must carefully balance the benefits of credit creation and economic growth against the risks of financial instability and inflation.

Measures you can take to mitigate the risks of fractional reserve banking

As a commoner, there are several measures you can take to mitigate the risks of fractional reserve banking:

Diversify your cash: Don’t keep all your cash in one bank. Diversify your cash across different banks to minimise the risk of losing your savings in the event of a bank failure.
Stay informed: Keep up to date with news and events in the banking and financial sector. This knowledge-gathering will help you identify potential risks and take appropriate action to protect your savings and investments. We agree that some of the developments in the global financial sector can be difficult to comprehend for a significant portion of people. Hence, consider seeking professional financial advice.
Understand deposit insurance: Many countries have deposit insurance schemes that protect depositors in the event of a bank failure. Ensure you understand the limits and terms of deposit insurance in your country.
Diversify your investments: If you are a do-it-yourself investor, you better be highly skilled at setting up a diversified investment portfolio. If you are a delegator, consider opting for a discretionary investment management service.
Maintain a rainy-day fund: A rainy-day fund can provide a buffer in case of unexpected loss of income or an unexpected uptick in expenses.
Seek professional advice: Consult with a financial adviser to help you make informed decisions about your investments and financial planning.
Use credit responsibly: Borrowing money from banks at a reasonable interest rate can be a useful tool, but it’s essential to use credit responsibly and avoid taking on too much debt. So consider borrowing money from the bank only if you can effectively use that loan, that is, it makes financial sense for you to keep paying the interest rates. It would be best to consider this option only after taking professional financial advice.

These measures can help you mitigate the risks of fractional reserve banking and protect your savings and investments.

Related information

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