Fractional Reserve Banking: Definition, Benefits and Drawbacks
Written by MasterClass
Last updated: Jul 28, 2022 • 5 min read
The fractional reserve banking system is common throughout the entire world. In this approach, banks only keep a small required reserve ratio of cash on hand and lend out the rest in the interest of expanding the money supply. Proponents believe this system has led to previously unthinkable levels of economic growth, while critics insist it’s too innately precarious to function in perpetuity.
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What Is Fractional Reserve Banking?
In a fractional reserve banking system, banks keep a certain amount of money on hand for safekeeping and then lend the remainder of their deposits out to other people and entities. This system expands the money supply and encourages economic growth, but it also requires firm regulations and safety nets to remain effective through financial crises. In the United States, the Federal Reserve System oversees this approach to ensure banks maintain a three to ten percent reserve at a minimum and acts as a lender of last resort in the event of a bank run.
Fractional banking is possible with any medium of exchange. While it’s easier to accomplish with fiat currency (any currency a government issues that is not commodity-backed), banks throughout history have utilized a fractional banking approach whenever they relied more heavily on precious metals, like gold and silver, for money.
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Steps of Fractional Reserve Banking
Fractional reserve banking is complex in practice but easy to understand in theory. By following these three steps, banks can keep enough cash on hand to cover day-to-day transactions while also helping to expand the total circulation of money in the financial system:
- Average people deposit funds. Commercial banks serve as depository institutions for the average person looking to store their money somewhere. Banks often entice depositors by ensuring them they’ll accrue positive interest on the money they store in their bank accounts. Rather than letting these bank deposits just sit there as vault cash, bankers keep a minimum amount on hand and turn the rest of the money into new loans.
- Banks loan out the money. Borrowers come to banks with the hope they’ll have enough money on hand to fund their endeavors. Banks utilize customer deposits to create new money for such requests. These loans serve as assets to the bank so long as they receive prompt payments from those to whom they lend. If enough people were to stop paying back these loans, the loans would then become massive liabilities.
- Cash reserves accrue over time. So long as the economy remains largely stable, the fractional reserve system helps both depositors and banks prosper. Depositors earn interest on the amount of money they keep in the bank at the same time bankers have a greater amount of liquidity. As more and more people deposit their money, the bank also has more reserve cash to cover any losses while still lending out more money to other people or companies.
3 Positives of Fractional Reserve Banking
Fractional reserve banking has many upsides. Here are three of the most essential to consider:
- 1. An expanded money supply: Perhaps the greatest benefit of the fractional reserve banking system is its ability to act as a money multiplier. By turning deposits into loans and keeping only a small amount of reserve cash on hand, banks can continuously lend out funds to help further grow the economy. In turn, this allows a greater number of people to then deposit more money in banks, shoring up the system further.
- 2. Backing by central banks: Fractional reserve banking is generally part of a wider monetary policy set by central banks. For instance, in the United States, the Federal Reserve Bank (colloquially known as the Fed) sets interest rates and reserve requirements and ensures banks it will act as a lender of last resort to keep this system running. This sort of guidance and reassurance from the entity issuing all banknotes in the first place helps keep the fractional approach on track even through difficult economic times.
- 3. Interest gains for consumers: Bank money accrues interest, whereas simply storing your funds at home can leave you at the mercy of inevitably increasing inflation. As a result, savers can often get a better return on their own personal savings accounts by allowing banks to utilize their money for fractional reserve lending. This comes, however, with the potential risk the bank might not have excess reserves to cover its losses in the event of a financial crisis.
3 Downsides of Fractional Reserve Banking
While many economists extol the successes of fractional reserve banking, others advise caution when it comes to implementing this system. Here are three key downsides to this approach:
- 1. A heavy reliance on normality: The financial system goes through many ups and downs, but fractional banking works best in times of relative normalcy. During a financial crisis, a bank’s balance sheet can end up totally disrupted in a way that would have been unpredictable at an earlier time.
- 2. A higher risk of bank runs: If everyone demands their deposit money back at the same time, the bank will swiftly run out of excess reserves. It’s easier to avoid such an outcome if banks keep all the money someone deposits safely in a vault rather than lending most of it out. The FDIC (Federal Deposit Insurance Corporation) allows for the best of both worlds: The US government guarantees to cover substantial losses while still allowing for the benefits of fractional banking.
- 3. A record of historical failures: The Great Depression, in particular, stands as a cautionary tale about the perils of unregulated fractional reserve banking. After the stock exchange crash of 1929, floods of people tried to withdraw all their money from banks at once. This rendered multiple depository institutions completely insolvent, as they only had a small amount of reserve money on hand. Since then, the Federal Reserve and US government have both placed further guardrails on the system to prevent such a catastrophe from happening again.
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