Fractional Reserve Banking

People have been educating themselves a lot lately on how the banking system actually works. Once you understand, it’s hard to view the system in the same light, and trust it. This will explain in simple terms, generally what fractional reserve banking is, and how banks do it.  

Fractional reserve banking is a system in which banks are required to hold only a fraction of the total deposits made by their customers. The remaining funds can be lent out to other borrowers in the form of loans, thereby creating new money in the economy. This system has been in place for centuries and has played a crucial role in the growth and development of modern economies.

What is Fractional Reserve Banking?

Fractional reserve banking refers to the practice of banks holding only a fraction of the deposits they receive from their customers in reserve. This means that a bank can lend out the remaining funds to borrowers, thereby creating new money in the economy. The reserve fraction is typically set by the central bank or government, and it varies depending on the country and the specific regulations in place.

For example, if a bank has a reserve requirement of 10%, and a customer deposits $1000 into their account, the bank is required to hold $100 in reserve and can lend out the remaining $900 to other borrowers. The borrower who receives the loan can then deposit the funds into their own bank account, which allows the process to repeat itself.

How Does Fractional Reserve Banking Work?

Fractional reserve banking works by relying on the assumption that not all customers will withdraw their funds at the same time. Banks use the funds they have on reserve to meet the demands of customers who wish to withdraw their money, while using the remaining funds to generate income by lending them out to other borrowers.

This process creates new money in the economy, as the funds that are lent out become deposits for the borrowers' banks. This new money can then be lent out again, creating a multiplier effect on the original deposit.

For example, if a bank receives a deposit of $1000 and has a reserve requirement of 10%, it can lend out $900 to another borrower. That borrower deposits the $900 into their own account, which the bank can then use to lend out again, creating new deposits and new loans. This process can continue until the original $1000 deposit has been multiplied several times over.

History of Fractional Reserve Banking

The origins of fractional reserve banking can be traced back to the goldsmiths of medieval Europe. Goldsmiths would hold the gold and silver of their clients in secure vaults, and issue receipts that could be used to redeem the precious metals at a later date. These receipts were essentially the first banknotes, and they were widely used as a form of payment.

Over time, goldsmiths began to realize that not all clients would withdraw their gold at the same time, and they started to lend out some of the gold that they held in reserve. This practice eventually evolved into fractional reserve banking, which became a widespread practice in the modern era.

 

Today, fractional reserve banking is the dominant form of banking in most countries, and it plays a crucial role in the functioning of modern economies. While there are criticisms of the system, such as the potential for bank runs and the creation of debt-based money, fractional reserve banking has proven to be an effective way to stimulate economic growth and provide financial services to individuals and businesses around the world- Is this model sustainable? What if everyone tried to withdraw all their funds at about the same time? The next article will go into that, and explain the "bank run."