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Fractional Reserve Banking

Updated on June 5, 2024
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

Fractional Reserve Banking Definition

Fractional reserve banking refers to a system in which banks are obliged to hold a small percentage of the client’s deposit in its reserve. Banks use the amount left after reserve for various investment activities like providing loans.

The method usually is safe because it is unlikely for all account holders to withdraw the deposits simultaneously. However, the method is criticized for being harmful to the economy due to its detrimental effect during a bank run.

Key Takeaways

  • Fractional reserve banking is a regulatory measure that mandates banks to keep a certain percentage of total deposits as reserves and invest the remaining to maintain the banking system’s functioning.
  • The debates about the fractional reserve model are still in the limelight. A section believes investing a significant portion of the deposits stimulates the economy.
  • Opponents argue that it is harmful to the economy since it creates money through lending. As a result, unsustainable economic booms are inevitable.
  • Several banks had to liquidate during the Great Depression because most clients attempted to withdraw their savings.

Explanation

The term fractional reserve banking directly indicates the fraction of the deposit that banks need to maintain at all times. Generally, the nation’s central bank determines how much money commercial banks based in the country need to store. The most common value is 10%. So, for example, a bank with $10 billion could invest $9 billion while keeping the rest to pay the consumers if they wished to withdraw.

The fractional reserve requirement may change from time, place, and as laws get harder or lighter on the financial institutions with the changes in the economy. For example, a few countries, such as the UK and New Zealand, do not impose reserve requirements on banks; instead, they implement effective capital requirement criteria. Also, the U. S. Federal Reserve has decided to drop the reserve requirement to zero in 2020 in response to the pandemic situations.

Fractional Reserve Banking

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Maintaining a portion of the deposit with the bank’s vault or Federal Reserve will help meet the normal flow of withdrawal requests. It ensures liquidity in bank operations. In addition, the remaining amount helps the banks engage in investment or profitable activities rather than storing the total amount as a reserve. Banks offer interest income to customers who deposit their savings and utilize a significant portion of deposits to lend it out at a higher interest rate than the interest rate on deposits.

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History of Fractional Reserve Banking System

The evolution of the fractional reserve banking system started with the practice of goldsmiths providing the safekeeping depository services in the 17th century in Europe. Goldsmiths at that time helped wealthy people in storing precious metals like gold in their vault in return for a storage fee. For acknowledging the deposit, goldsmiths furnished notes or receipts and handover to the depositor.

They noticed that depositors were using these notes essentially as a medium of exchange. Also, from experience, they analyzed that the possibility of redemption of receipts simultaneously by all depositors is minimal. This situation gave goldsmiths the idea of creating receipts without equivalent precious metals in their vault and started lending out, marking the early period of modern banking practices.

Example

Let’s see an example to illustrate how the fractional reserve system works.

  • You go to a bank and make a demand deposit of $2,000.
  • The central bank allows banks to invest up to 90% of the deposit and maintain 10% of the deposit as a reserve. It means the bank could essentially use $1,800 for providing loans.
  • Afterward, the bank gave a loan of $1,800 to another customer utilizing the reserve of your deposit. Banks pay interest on customer deposits and earn interest on the lent-out sum.
  • When you check your account balance, it will show the amount you deposited, $2,000, even if 90% of it is lent out. Curiously, this means that $3,800 could be circulating in the economy simultaneously, despite only $2,000 existing in the first place. Theoretically, that second person would give the money back, though, which would equalize the math.

Is Fractional Reserve Banking System Bad?

The highly criticized notion about the financial institutions following the fractional reserve model is that they create money out of nothing and make the financial system more vulnerable to boom and bust. However, opponents argue that by providing loans, banks are speeding the money circulation. So, when faced with a bank run scenario, they are left with not much choice but to liquidate their illiquid assets or get help from the central bank to avoid situations breaking the contractual obligation to repay. Hence, we can say that there is default risk and chances of insolvency of the institution.

Trust is an established factor strengthening the system following the fractional reserve model. From experience and statistical calculations, banks analyze the reserve requirement to meet the withdrawal requests, maintain the appropriate amount, or contemplate replenishing their reserves. Thus, the well-managed banking system creates trust in the people.  However, any piece of bad information can break the trust quickly and can cause a bank run. At this point, the institutions following the fractional reserve model suffer.

One of the largest bank runs in history happened in the United States during the Great Depression of 1929. During the period of financial uncertainty, several investors opted to withdraw their funds, and banks were unable to keep up. It sparked an even greater panic, causing more individuals to withdraw their deposits and, consequently, causing many bank failures.

If banks are directed to maintain 100% of the deposit in reserves without any assistance from the central bank or the government, it will affect their revenue. It, in turn, increases the chance of charging fees for safely storing the deposits rather than paying interest on the deposit. Furthermore, it reduces the money in circulation and stimulus to the economy.

Frequently Asked Questions (FAQs)

How does fractional reserve banking work?

The fractional reserve model core principle is that the banks should hold a portion of the total deposit specified by the central bank or governing authority rather than storing the total amount in its vault or lending out the total deposits. The deposit in excess of the reserve is converted into investments.

What is wrong with fractional reserve banking?

The fractional reserve model manifests an alarming default risk and inability to meet multiple clients’ unconditional redemption requests. As a result, the institution may not successfully settle all withdrawal requests during a bank run and become insolvent.

What is the fractional reserve banking myth?

Many economists denounce the money creation or multiplier effect associated with the fractional reserve model as a misconception. They elucidate that no new money is created; rather, the model only increases the money in circulation.

This has been a guide to what is Fractional Reserve Banking and its Definition. Here we discuss the history and example of fractional reserve banking with a detailed explanation. You may also have a look at the following articles to learn more –