Do you know what is fractional reserve banking? It’s basically putting your money on the bank not just for safekeeping, but also allowing the bank to hold a portion of your funds as reserves.
Sounds complicated? Well, that is precisely why we are here!
We are going to discuss what fractional reserve banking is all about for you to be able to understand, at the same time, appreciate the whole concept.
As a saver or a bank customer, it is a plus to learn about this process. This way you get to know how you can potentially earn more from your money.
While the term sounds complicated, it’s actually simple and easy to understand. We thought once you have read through everything, you’d have a better appreciation of what fractional reserve banking is all about.
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Here’s the thing, when a saver deposits his or her money in the bank, that money is usually available for withdrawal anytime he or she needs it, right? However, what savers do not know is that the bank does not keep all their cash on hand for safekeeping purposes. Instead, a fractional reserve banking system is practiced. This system basically allows the bank to invest the savers’ money, but, still showing the funds sitting in their accounts (otherwise, savers will surely freak out).
It’s like, making use of your money while you do not need it yet — but, in a legal way.
Yes, fractional reserve banking is legal. In fact, according to Encyclopedia.com, all banks in the United States operate under the said system, which means, “the law requires banks to keep a percentage of their deposits as reserves in the form of vault cash or as deposits with the nearest Federal Reserve Bank.”
But for you to fully understand the whole concept of fractional reserve banking, we are going to walk you through some of the most important information regarding this system. As a bank saver, it is your every right to know more about this so you get an idea about what exactly is happening with your money while in the bank.
To be specific, we are going to talk about the following:
- What is fractional reserve banking?
- How does fractional reserve banking work?
- What does expanding money supply means?
- What do bank runs mean?
- What are the requirements for fractional reserve banking?
- How do banks create money?
- What does fractional reserve multiplier effect mean?
- What is the importance of fractional reserve banking?
- What are the disadvantages of fractional reserve banking?
WHAT IS FRACTIONAL RESERVE BANKING?
For us to fully understand what fractional reserve banking is all about, we need to first, define what is fractional reserve banking, and second, know its history.
As mentioned earlier, fractional reserve banking refers to a system wherein a fraction of your bank deposits is held in bank reserves. Banks are required to hold just a portion of the funds deposited with them as reserves.
Generally, banks use customer deposits in making new loans, as well as in awarding interest in the deposits made by their clients.
Meanwhile, reserves are held as balances in the bank’s account either at a central bank or as currency in the bank.
In the United States, the Federal Reserve has set a reserve requirement wherein banks are tasked to set aside a minimum portion of funds. For these funds, banks are expected to hold it as cash in vaults or as deposits with Federal Reserve Banks.
Just to give you an idea, for a financial institution that has over $124.2 million in liabilities, the reserve requirement at the moment is 10 percent. This basically means that banks can lend out $90 of every $100 their clients deposit.
As mentioned, apart from understanding and knowing the definition of what fractional reserve banking is, knowing the history is also important — equally important, if we may say.
So, the concept of fractional reserve baking happened during the gold trading era. The idea came to life after it was realized that not all people need their deposits all at the same time.
Back then, when people deposit their gold and silver coins at a goldsmith, they were, in return, handed a promissory note, which was later accepted as a means of exchange. The holders used them in commercial transactions.
The notes were used straight in trade, which eventually made goldsmiths realize that apparently, not all savers withdraw their money at the same time.
With that realization, they began using the deposits to issue loans as well as bills at high interest. That is in addition to the storage fee that is charged to the deposits.
With that, the goldsmiths transitioned from being safe keepers of valuables to interest-paying, as well as interest-earning banks.
Since then, this system, now called fractional reserve banking, was carried over up until this day, and as mentioned, it is in fact a requirement to every bank out there.
If you want to know more about what is fractional reserve banking, here’s a very informative video by Khan Academy. Watch it by clicking the play button below:
HOW DOES FRACTIONAL RESERVE BANKING WORK?
Apart from understanding what a fractional reserve banking is, it is also key to understand how the system actually works.
Now, when putting your money in a bank, the bank is required to keep a fraction of it or a certain percentage of the total deposits on reserve at the bank.
For example, you deposited $100,000 at the bank, and based on the bank’s assets, it has a reserve requirement of 10 percent. Having said that, the bank has to keep $10,000 of your total money on reserve, while the remaining $90,000 can be lent out.
Essentially, the bank has taken $100,000 and turned your money into $190,000 by providing you a $100,000 credit on your deposits, and then lending the additional $90,000 to other customers.
Using the above example, the initial deposited amount, which is $100,000 can eventually grow into $1,000,000 with a 10 percent reserve requirement.
Now, if you are interested in finding out how much money the fractional reserve banking system can theoretically create with your initial deposited amount, you may use below money multiplier equation (which we are going to discuss further later on):
Total Money Created = Initial Deposit x (1 / Reserve Requirement)
WHAT DOES EXPANDING MONEY SUPPLY MEANS?
If you have been using banks to save your money or to save funds, perhaps in one way or another (especially if you are not that familiar with how banking works), you wondered how does the bank earn from keeping other people’s funds, right?
Basically, the supply of money in a bank grows when it shows money as deposits, at the same time, lending the funds out as loans to other people or clients.
When a saver like you (and me) deposits your money into your bank account, when you do a balance check, the bank will show 100 percent of your account balance.
But in reality, the bank is allowed to lend 90 percent of your deposited funds to other customers or clients, which in return help double (almost) the amount of money in the economy.
If we may just add, by following this kind of system, banks earn, and you as a saver earns as well. How? Well, it’s through interest. The bank won’t be able to grow your money and give you an annual interest if it’s just sitting there and they do nothing about it.
So, the more clients, borrowers they have, it’s actually better. It also helps strengthen the financial stability of a bank.
WHAT DO BANK RUNS MEAN?
If you come to think about it, and also basing on the history of fractional reserve banking, you will get to realize that this kind of system works because true enough, people do not need to access all their money all at the same time. It’s unlikely for someone, or for an account holder to withdraw all the money in his or her account at the same time. Now if you do, for instance, the reserve form other customer accounts should be enough to cover what you need.
But what if everyone in the system actually withdraws their money all at the same time? What happens, then?
Well, this circumstance is actually referred to as a “bank run.”
A bank run usually happens when customers feel or fear that the financial institution is in trouble. When customers lose faith and trust with the bank, withdrawal demands transpire.
In this kind of situation, there is a great chance that money will not be enough to satisfy all customer requests. When that happens, the bank becomes insolvent.
While in some cases bank runs are justified, at other times, it happens as a result of panic, which unfortunately causes a bank to fail.
Bank failures are catastrophic. Thus, the Banking Act of 1933 established the Federal Deposit Insurance Corp. Its primary job is to protect deposits in participating banks up to specified limits.
FDIC is like a security blanket. It provides a government guarantee that bank customers will get their money should something unlikely happens to their bank of choice. The same goes for credit unions. However, it’s the National Credit Union Share Insurance Fund that takes care of it.
WHAT ARE THE REQUIREMENTS FOR FRACTIONAL RESERVE BANKING?
Reserve requirements refer to central bank regulations regarding the minimum amount of reserves that a bank should hold.
Banking institutions are required to report their transaction accounts, as well as time and savings deposits, vault cash, and other obligations that need a reserve to the Fed on a weekly or quarterly basis.
While there are some banks that are exempted from holding reserves, all banks are paid a rate of interest on reserves, which is called the “interest rate on reserves” (IOR) or the “interest rate on excess reserves” (IOER). This rate serves as an incentive for banks for keeping excess reserves. Excess reserves refer to reserves that are over the level of reserve needed or required.
As mentioned earlier, banks with assets amounting to less than $124.2 million but more than $16.3 million have a 3% reserve requirement. Meanwhile, those with more than $124.2 million in assets have a 10% reserve requirement. As with banks with less than $16.3 million in assets, they are not required to hold reserves.
Please note though that the amount required may change from time to time. Thus, banks need to always stay up-to-date with regards to their assets, and the requirements of the Fed.
HOW DO BANKS CREATE MONEY?
Now, it’s time to know how exactly banks create money. As a customer or a bank client, while it is not a prerequisite to understanding how a bank earns, we thought, it’s good information to know. This will also give you an idea if the bank is generous enough with their customers, or if their rates are reasonable or not.
Moving on, all commercial banks are required to hold only a certain percentage of customer deposits as reserves, while the rest has to be used for awarding loans to borrowers (which, by the way, is one way that banks earn money).
If you have loaned money from banks before, most likely you already have an idea that when a bank gives a loan, it accepts promissory notes in lieu of the credit that is deposited in the borrower’s account in the bank.
It is through depositing to the borrower’s account instead of giving loans in the form of currency is part of the process that banks use in creating money.
Remember we earlier said that the more loans a bank give or approves, the better? Well, that is because it is by giving out loans that the bank creates money. Every issued loan is equivalent to new money, which in return adds up to the increasing money supply.
WHAT DOES FRACTIONAL RESERVE MULTIPLIER EFFECT MEANS?
By now you already know what is fractional reserve banking is all about, right?
But just to reiterate, the fractional reserve is defined as the fraction of deposits that are held in reserves. For instance, if a bank has $400 million in assets, it is required to put $40 million (which is 10 percent of the total asset) on hold in reserve.
When estimating the impact of the reserve requirement on the economy as a whole, analysts refer to an equation called the multiplier equation. The multiplier equation basically provides an estimate for the amount of money created with the fractional reserve system. It is calculated by multiplying the initial deposit by one divided by the reserve requirement. So, for the above example, the calculation is $400 million multiplied by one divided by 10%, or $4 billion.
Again, here’s the multiplier equation for your reference:
- Total Money Created = Initial Deposit x (1 / Reserve Requirement)
This equation is just a way to look into the possible impact of the fractional reserve system on the money supply of a bank. However, while the equation seems useful for economics professors, generally speaking, it is regarded as an oversimplification by legislators.
WHAT IS THE IMPORTANCE OF FRACTIONAL RESERVE BANKING?
We believe fractional reserve banking exists for a purpose. With all the information we shared, it truly is beneficial. Do you agree?
However, we thought one of the essential benefits of fractional reserve banking is the fact that it pools together smaller savings, which eventually are lent out to a variety of markets — to individuals, households, small enterprise, and even big businesses!
Furthermore, through fractional reserve banking, banks are able to earn. Without earnings, a bank cannot sustain itself. If the bank will not loan money to people, there is no chance they’ll earn money. More so, it would be impossible for them to offer interest rates.
WHAT ARE THE DISADVANTAGES OF FRACTIONAL RESERVE BANKING?
Critics will always be there. And yes, even fractional reserve banking has its own critics. They believe that the system is a Ponzi scheme. The process of fractional reserve banking is like robbing the depositor to pay the borrower, which critics find as something that is not sustainable in the long run.
Whether you agree to this perspective or not, the thing is, fractional reserve banking has glaring downsides that are difficult to refute.
One downside is that the money multiplier effect of fractional-reserve banking may result in a growing supply of money. As it is, as the money supply increases, the value of dollar decreases or also known as inflation. Over time, the rapid growth of the money supply may result in a massive decrease in the U.S. dollar’s purchasing power.
Another downside is bank runs, which we have already explained earlier. Bank runs can cause panic among depositors, and essentially, may result in a Depression, or put the bank in big financial trouble.
You see, nothing is really perfect. While fractional reserve banking has its highs, it definitely has its share of lows as well.
FINAL THOUGHTS ON WHAT IS FRACTIONAL RESERVE BANKING
Typically, bank depositors see banks as safe-keepers of their money. They go there, open an account, and save. That’s it.
But what most bank customers do not know is that fractional reserve banking does exist. What we do not know is that this system allows banks to hold a fraction of our money and use the remaining to lend to other people.
If the idea of fractional reserve banking is new to you, you may find it quite surprising. But essentially, understanding the whole concept of the system will make you realize that it’s part of the risks of putting your money in the bank, and you got to just really trust that the bank knows how to keep the wheel turning.
So, what are your thoughts on fractional reserve banking?