What is Fractional Reserve Banking?

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What is Fractional Reserve Banking?


Fractional reserve banking allows banks to only keep a portion (fraction) of their customers’ deposit money and lend the rest to other clients as loans. In this way, banks will be able to stimulate the economy by providing funds for spending.

Fractional reserve banking has its own pros and cons. It allows banks to assist with the economy’s growth with money that would otherwise be left untouched. They can also be detrimental and cause an economic crisis if the bank doesn’t manage its reserves properly.

In this article, you will learn about the basics of fractional reserve banking and how it can help or hurt the economy.

How does fractional reserve banking work?

Fractional reserve banking allows banks to provide capital by using their clients’ deposit money. Based on fractional reserve banking, banks are allowed to keep only a fraction of the deposits and lend the rest to other clients seeking financial aid.

Banks can also use this capital to fund other commercial banks that need help financing customer loans or withdrawals.

As a bank client, you still will have access to your money at the bank and will be able to withdraw your funds whenever you wish to. Banks are required to keep a minimum amount in their reserve to be able to answer their customers’ demands. This minimum amount is known as Reserve Requirement and is set by the central bank of a country.

Fractional reserve banking works with credit creation. Let’s discuss this with an example:

Customer A and Customer B have accounts at a fictional bank called Credit Bank. Customer A has deposited $5000 while Customer B is looking for a $2000 loan. The bank needs funds to be able to fund Customer B’s loan. Based on fractional reserve banking, Credit Bank can take a portion of the deposit of Customer A and lend it to Customer B.

Now, let’s say the interest rate on the loan is 4%. Customer A has a saving account with Credit Bank that comes with a 2% interest rate. Credit Bank will receive the principal money with its interest rate from Customer B, keep 2% of it for itself, and give the other 2% to Customer A.

During this process, Customer A still had a balance of $5000 even though $2000 of it was handed over to Customer B. This is what we call credit creation as Credit Bank created $2000 credit out of nothing.

Advantages of fractional reserve banking

Fractional reserve banking allows banks to use vast amounts of capital to stimulate the economy and help with its growth, a capital that would have stayed dormant otherwise.

It also allows central banks to be able to control the economy by increasing or decreasing the reserve requirements.

If the reserve requirement is increased, it means that banks need to keep more capital in their vaults and decrease the amount of available loans. This can reduce the level of spending and cool off the economy, a method that is used to fight inflation and rising prices. In this situation, central banks usually increase the interest rates as well to also make borrowing expensive and encourage people to save.

On the other hand, central banks can decrease the reserve requirement alongside the interest rates to allow banks to give out more loans while making borrowing less expensive for people. In this way, central banks can boost spending by allowing more capital to enter the economy and stimulate the economy to fight recessions.

Fractional reserve banking and bank runs

A bank run is probably the most tangible disadvantage of fractional reserve banking. As mentioned earlier, banks are just required to keep a minimum amount of funds in their reserves to assist clients with their withdrawals.

Now, let’s say the economic outlook looks gloomy and negative news is spreading throughout the markets. Clients prefer to withdraw their funds from banks and invest in other safe-haven assets like gold.

As this withdrawal continues, banks start to feel the pressure of liquidity and not all of them may have enough liquid funds in their reserves. Let’s go back to Credit Bank from our earlier example.

Credit Bank is one of the banks that is facing liquidity issues as it went too far with its lending and has little capital left in its reserve. As customers start to face problems and delays for withdrawals, fear and negative words spread, causing more clients to move forward with withdrawing their funds from Credit Bank.

This eventually leads the bank to stop withdrawals as it has no capital left in its reserves. Credit Bank may get closed by the central bank or the financial authority of the country and the government would compensate all or some of the clients who have lost their money.

Credit Bank can also be auctioned to be bought by another financial institution which will then take care of its obligations.