- Overview of fractional reserve banking
- What Is Fractional Reserve?
- Weaknesses of fractional reserve lending
Overview of fractional reserve banking
Fractional-reserve banking is currently the most common practice by commercial banks If, in response, a bank could not raise enough funds by calling in loans or . There are two types of money created in a fractional-reserve banking system . In practice this means that the bank sets a reserve ratio target and responds.does
Reviewed by Raphael Zeder Updated Jun 13, Fractional reserve banking is a banking system in which banks only hold a fraction of the money their customers deposit as reserves. This allows them to use the rest of it to make loans and thereby essentially create new money. This gives commercial banks the power to directly affect money supply. In fact, even though central banks are in charge of controlling money supply , most of the money in modern economies is created by commercial banks through fractional reserve banking. To understand how exactly this works, we will look at the process in more detail below. To explain the idea behind fractional reserve banking, we first have to consider its opposite: percent reserve banking. In this system, banks are required to hold all deposits as reserves.
Fractional-reserve banking is currently the most common practice by commercial banks worldwide. Fractional-reserve banking allows banks to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors providing the function of maturity transformation. However, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves that are held by the bank. To mitigate the risks of bank runs and systemic crises when problems are extreme and widespread , governments of most countries regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks. Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. This helps ensure that banks are solvent and have enough funds to meet demand for withdrawals, and can limit the process of money creation that occurs in the commercial banking system.
What Is Fractional Reserve?
Weaknesses of fractional reserve lending
Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending. Banks are required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. This requirement is set by the Federal Reserve and is one of the Fed's tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy, while decreasing the reserve requirement puts money into the economy.