Did you know that if you were to deposit $10,000 at your local bank, the bank is allowed to keep $1,000 and use the remaining to make loans? That's because banks operate under a fractional reserve system. That means that banks must keep only a portion of deposits in their reserve while lending out the remaining.
But does this mean that your funds are safe when you deposit them at the bank? What happens if someone who borrowed from the bank can't repay the loan? Does it mean that you will get your money back?
Why don't you read on and find out how the fractional reserve system works and how it is regulated so that the bank doesn't lose your money?
Fractional Reserve System Definition Economics
Fractional reserve system definition in economics refers to a banking system in which banks are required to keep a portion of their checkable deposits in their reserves.
A fractional reserve banking system is a banking system in which banks keep a part of client deposits as reserves while using the remainder to make loans to other customers.
Consumers can continue borrowing and spending, which contributes to the economy's expansion and makes use of money that would otherwise be sitting in bank accounts.
Consider the following scenario: you have $40,000 in your savings account. Another consumer has approached the bank in hopes of borrowing $36,000. The bank can use the money you have in your savings account to make the $36,000 loan that the other consumer demands.
The bank pays interest in your savings account and charges a higher interest rate on the loan it makes to the other client. The difference between these two interest rates is the bank's profit.
This system not only increases the money supply but also promotes economic development. However, for it to be successful during times of financial turmoil, it also needs to be regulated.
This method is monitored in the United States by the Federal Reserve System, which also serves as a lender of last resort in the case that a bank can't meet the withdrawal demands from clients.
The Federal Reserve ensures that all the banks keep a set percentage of their total deposits in their reserve. This is known as the reserve requirement ratio.
The reserve requirement ratio is the portion of client deposits banks must keep in their reserves.
The Fed uses the reserve requirement ratio to increase or decrease the money supply in the economy.
- When the Fed lowers the reserve requirement ratio, banks are obliged to keep fewer funds in their reserves. This enables them to generate more loans, and the supply of funds available for lending purposes increases. More lending means lower interest rates and more money injected into the economy.
- On the other hand, when the money supply in the economy is high, the Fed increases the reserve requirement ratio. This causes banks to keep more funds in their reserves, which lowers the number of loans they can make.
Functions of the Federal Reserve System
Functions of the Federal Reserve System are important in enabling banks to operate effectively under a fractional reserve system. The three primary functions of the federal reserve system included in Figure 1 are monetary policy, supervision and regulation, and services to depository institutions.
Monetary Policy
The function of the Federal Reserve's monetary policy is to foster economic development, lower the unemployment rate, and encourage appropriate balance in the nation's trade with other countries.
In addition to advancing these goals, the Federal Reserve impacts the cost of money and credit and the amount available. Monetary policy directly impacts the interest rate in the economy, which affects the amount and cost of funds that are available for borrowing. As such, this function of the Federal Reserve becomes significantly important under a fractional reserve system.
The Fed is responsible for designing a monetary policy that keeps the interest rate according to the economic environment.
Supervision and Regulation
Commercial banks are subject to a wide range of laws, which aim to guarantee that these institutions provide satisfactory service to their depositors and communities and adhere to ethical banking practices.
Both the formulation of these laws and the conducting of compliance checks on banks are the shared responsibilities of the Federal Reserve and the other regulatory organizations that oversee the banking industry.
The Federal Reserve Board of Governors is responsible for carrying out the regulatory tasks of the Federal Reserve by creating regulations that either limit or allow the activity of banks. The Board often adopts these rules as a reaction to legislation passed at the federal level.
Services to depository institutions
The services provided by Federal Reserve Banks to depository institutions are, in some respects, comparable to those provided by depository institutions to their clients. These services include moving money, giving cash, taking deposits, and protecting deposits.
Fractional Reserve Banking System Characteristics
Two crucial fractional reserve banking system characteristics include creating money through lending and banks' vulnerability to panic.
The fractional reserve banking system allows banks to create money through lending.
- When the fractional banking system started, banks were able to manufacture money when they made loans to customers by providing them with paper money that was only partially backed by gold reserves. The number of loans they could make was proportional to the gold funds they held in reserve.
In today's fractional reserve banking system, banks keep a portion of their client's checkable deposits and use the other part to create loans. The amount of money creation that banks can advance is limited by the reserve requirement.
The second characteristic of the fractional reserve banking system is that banks that function based on fractional reserves are more susceptible to economic crises than other types of financial institutions. That's because banks create loans even if they don't have the necessary funds to cover these loans if the borrower defaults on their loan. During times of economic crises, banks are more likely to file for bankruptcy than other financial institutions.
During the 2008 financial crisis, many banks could not meet their withdrawal demands as they did not have enough in their reserves to cover them.
Imagine a bank receives a deposit of $10,000, and it keeps only $1,000 in its reserves while using the $9,000 to create loans. However, the borrower is incapable of paying back the loan to the Bank for various reasons. The Bank might use some of its other reserves to pay back the $10,000 to the first client, but what would happen if there was a turmoil in the market and everyone would default on their loans? In such a case, the Bank would fail.
We've covered Bank Runs in detail in another article. Feel free to check it out.
Money Creation in a Fractional Reserve Banking System
Money creation in a fractional reserve banking system is due to the ability of banks to keep a portion of deposits in reserves and use the rest to create loans.
In a fractional reserve banking system in which banks are required to keep only a relatively small portion in their reserves, an initial deposit creates more money than was initially deposited.
Although money creation is possible in a fractional reserve banking system, it is limited to three main factors:
- The amount of cash in deposits. When individuals deposit more money into the banks, banks can generate more loans, creating more money in the economy. However, the bank would generate less money if there weren't too many cash deposits.
- Reserve ratio. The reserve ratio, also known as the cash ratio, dictates how much money they have to keep in their reserves. A high reserve ratio would prevent banks from creating money as they need more funds in their reserves and thus they would generate fewer loans.
- Default risk. Default risk limits the money creation in an economy because banks are required to select to which borrowers they can lend based on their ability to pay back the loan. Banks are able to create less money in the economy when borrowers have high default risk.
Money Creation is covered in great detail in our explanation. Check it out!
Fractional Reserve Banking Example
Below is an example that illustrates how money is created under a fractional reserve banking system.
As a fractional reserve banking example, let's consider Anna. Anna deposits $10,000 into a bank account. The bank now has $10,000. In a fractional reserve banking system, the bank must keep a certain percentage of its deposits in reserve (assume 10%). The bank holds Anna's $1,000 in reserves and uses the rest - $9,000 to lend to other customers.
The bank now has Anna's $10,000 and $9,000, which it lends to another client named John. Thus the bank, in total, has created $19,000. John uses the $9,000 borrowed from the bank to purchase a car from Jim. Jim deposits all of the money in the bank. The bank now has to keep 10% of Jim's deposit in their reserves and use $8,100 to make another loan to Bob. Bob uses the $8,100 to buy house furniture from Billy, who deposits the money into the bank.
The bank has therefore created the following total amount of deposits from Anna's deposit, Jim's deposit, and Billy's deposit:
\( \$27,100 = \$10,000 + \$9,000 + \$ 8,100 \)
So the bank has in total $27,100.
The bank created $27,100 from Anna's $10,000 due to the fractional reserve system. The story doesn't end here; the cycle continues, and the total money created from an initial deposit increases.
Money Multiplier plays an important role in helping banks create money.
Check it out; we've covered it in great detail in our article!
Fractional Reserve System - Key takeaways
- A fractional reserve banking system is a banking system in which banks keep a part of client deposits as reserves while using the remainder to make loans to other customers.
- The reserve requirement ratio is the portion of client deposits banks must keep in their reserves.
- Two crucial fractional reserve banking system characteristics include creating money through lending and banks' vulnerability to panic.
- Although money creation is possible in a fractional reserve banking system, it is limited to three main factors: the amount of cash in deposits, reserve ratio, and default risk.
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