What is Fractional Reserve Banking?
Fractional reserve banking is a banking system in which banks are required to hold only a fraction of their depositors’ funds in reserve, and are allowed to lend out the rest. The reserve requirement is set by the central bank of a country and is typically a percentage of the total deposits held by the bank.
Here’s how fractional reserve banking works in practice:
- Deposits: When customers deposit money into a bank, the bank keeps a portion of the funds in reserve, as required by the central bank. This reserve requirement is typically a percentage of the total deposits held by the bank.
- Lending: The bank is then allowed to lend out the remaining funds to other customers, typically in the form of loans. These loans generate interest income for the bank, which helps to cover its operating costs and generate profits.
- Interest Payments: When borrowers repay their loans with interest, the bank receives the principal amount of the loan plus the interest payments. The bank then has the option to keep the interest income as profits or to pay it out to depositors in the form of interest payments.
- Reserve Maintenance: Banks must maintain their required reserve ratios at all times. If a bank falls below its required reserve level, it can borrow from other banks or from the central bank to meet its obligations.
Fractional reserve banking allows banks to create money through the lending process. When a bank lends out money, it effectively creates new money, since the borrower now has access to additional funds that did not exist before. This can lead to an increase in the money supply in the economy, which can have both positive and negative effects.
Overall, fractional reserve banking is a widely used banking system that allows banks to lend out a portion of their depositors’ funds while maintaining a reserve to ensure that they can meet their obligations.
Assuming that the reserve requirement is 10% and a bank has $100 in deposits, the table below shows how the bank could lend out the remaining funds after keeping the required reserves in reserve:
| Transaction | Assets | Liabilities |
|---|---|---|
| Initial Deposit | $100 | $100 |
| Reserve Requirement (10%) | $10 | $90 |
| Loan Made to Borrower | $90 | $180 |
| Repayment of Loan | $90 | $90 |
In this example, the bank has $100 in deposits from customers. The reserve requirement is 10%, so the bank must keep $10 in reserve and can lend out the remaining $90. The bank then lends $90 to a borrower, which increases the bank’s assets to $180 (the loan plus the initial deposit), while also increasing its liabilities to $180 (the deposit plus the amount of the loan). When the borrower repays the loan with interest, the bank’s assets decrease to $90 (the initial deposit plus the interest earned), while its liabilities also decrease to $90 (the deposit plus the amount of the interest paid).
This table demonstrates how fractional reserve banking allows banks to lend out a portion of their depositors’ funds while maintaining a reserve to ensure that they can meet their obligations.
Bank run
A bank run is a situation where a large number of depositors simultaneously withdraw their money from a bank because of concerns about the bank’s solvency. Bank runs can be triggered by a variety of factors, such as rumors of financial instability, fears of economic downturns, or lack of confidence in the bank’s management.
Bank runs are closely related to fractional reserve banking because banks that engage in fractional reserve banking are inherently vulnerable to bank runs. This is because banks lend out a portion of their depositors’ funds and hold only a fraction of those funds in reserve. If a large number of depositors were to withdraw their funds simultaneously, the bank may not have enough reserves to meet all of the withdrawal requests.
In a bank run scenario, a bank may try to sell its assets to meet the demand for withdrawals, but this can be difficult in a distressed market where the value of the assets may have decreased. In extreme cases, a bank may become insolvent and unable to repay its depositors.
To prevent bank runs, central banks and governments often provide deposit insurance to protect depositors in the event of a bank failure. They may also provide emergency liquidity to banks to help them meet their obligations during periods of financial stress. These measures can help to reduce the risk of bank runs and ensure the stability of the financial system.
In conclusion our current monetary system has proven to be quite problematic over the last 25-30 years. Is there a better way? Have we let the banks go too far? What s the end goal for an economy built on fractional reserve banking? Ive seen a “once in a lifetime crash” I think 4-5 times in my 29 years of consciousness. It may be time to start looking at our finance system at the root.
Millennial Money Takes 