Fractional reserve banking is a banking system where banks are required to hold only a fraction of their customers’ deposits as reserves. This allows banks to lend out the remaining deposits to borrowers, creating new money in the economy.
Key Facts
- Definition: Fractional reserve banking is a system in which banks are only required to keep a fraction of their customers’ deposits as reserves, while the rest can be lent out to borrowers.
- Reserve Requirements: Most countries have reserve requirements that dictate the minimum amount of reserves banks must hold. These reserves can be in the form of cash or balances in the bank’s account at the central bank.
- Creation of Money: When a customer deposits money into a bank, the bank can lend out a portion of that deposit to other customers. This process creates new money in the economy, as the original depositor still has access to their funds while the borrower also has access to the newly created loan.
- Capital and Loans: Banks use the deposits they receive to fund loans to individuals and businesses. This stimulates economic growth by providing capital for investments and purchases.
- Bank Runs: Banks with low reserve ratios are vulnerable to bank runs, where depositors rush to withdraw their funds. If withdrawals exceed the available reserves, the bank may face liquidity problems.
Reserve Requirements
Most countries impose reserve requirements on banks, specifying the minimum amount of reserves banks must maintain. These reserves can be held as cash or as balances in the bank’s account at the central bank. Reserve requirements are intended to ensure that banks have sufficient funds to meet depositor withdrawals and maintain financial stability.
Creation of Money
When a customer deposits money into a bank, the bank can lend out a portion of that deposit to other customers. This process creates new money in the economy, as the original depositor still has access to their funds while the borrower also has access to the newly created loan. The amount of money created depends on the bank’s reserve requirement ratio.
Capital and Loans
Banks use the deposits they receive to fund loans to individuals and businesses. These loans provide capital for investments and purchases, stimulating economic growth. The amount of lending a bank can engage in is limited by its capital adequacy ratio, which ensures that banks have sufficient capital to absorb potential losses.
Bank Runs
Banks with low reserve ratios are vulnerable to bank runs, where depositors rush to withdraw their funds. If withdrawals exceed the available reserves, the bank may face liquidity problems and potentially fail. To prevent bank runs, central banks often act as lenders of last resort, providing liquidity to banks in need.
Conclusion
Fractional reserve banking is a complex system that plays a crucial role in the modern economy. It allows banks to create new money, stimulate economic growth through lending, and provide financial stability by holding reserves. However, it also introduces risks, such as bank runs and systemic financial crises, which require careful management by central banks and regulatory authorities.
Sources
- Investopedia: Fractional Reserve Banking
- Wikipedia: Fractional-Reserve Banking
- NerdWallet: Fractional Reserve Banking
FAQs
What is fractional reserve banking?
Fractional reserve banking is a system where banks are required to hold only a fraction of their customers’ deposits as reserves, allowing them to lend out the remaining deposits to borrowers.
What are reserve requirements?
Reserve requirements are the minimum amount of reserves that banks are required to hold, typically as a percentage of their deposits.
How does fractional reserve banking create new money?
When a customer deposits money into a bank, the bank can lend out a portion of that deposit to other customers. This process creates new money in the economy, as the original depositor still has access to their funds while the borrower also has access to the newly created loan.
What is the role of capital in fractional reserve banking?
Banks use their capital to absorb potential losses and ensure their financial stability. The amount of lending a bank can engage in is limited by its capital adequacy ratio.
What are bank runs?
Bank runs occur when depositors rush to withdraw their funds from a bank, typically due to concerns about the bank’s financial stability. If withdrawals exceed the available reserves, the bank may face liquidity problems and potentially fail.
How do central banks prevent bank runs?
Central banks often act as lenders of last resort, providing liquidity to banks in need to prevent bank runs and maintain financial stability.
What are the risks of fractional reserve banking?
Fractional reserve banking can introduce risks, such as bank runs and systemic financial crises, if not carefully managed by central banks and regulatory authorities.
What are the benefits of fractional reserve banking?
Fractional reserve banking allows banks to create new money, stimulate economic growth through lending, and provide financial stability by holding reserves.