Fractional Reserve Banking

What is Fractional Reserve Banking?

Fractional-reserve banking is a system in which only a fraction of the Bank deposits are backed by real cash and available for withdrawal. This is done to theoretically expand the economy by freeing up capital for lending. Today, most financial systems in economies use fractional-reserve banking.

Key points to remember

  • Fractional reserve banking describes a system by which banks can lend out a certain amount of deposits they have on their balance sheets.
  • Banks are required to keep on hand a certain amount of money that depositors give them, but banks are not required to keep the entire amount on hand.
  • Often, banks are required to keep a portion of deposits on hand, known as bank reserves.
  • Some banks are exempt from holding reserves, but all banks charge an interest rate on reserves.

Fractional Reserve Bank

Understanding Fractional Reserve Banking

Banks are required to keep on hand and available for withdrawal a certain amount of money given to them by depositors. If someone deposits $100, the bank cannot lend the full amount.

Banks are also not required to keep the entire amount on hand. Many central banks have historically required banks under their jurisdiction to retain 10% of the deposit, called reservations. This requirement is established in the United States by the Federal Reserve and is one of the central bank’s tools for implementing monetary policy. Increasing reserve requirements takes money out of the economy while decreasing reserve requirements injects money into the economy.

Historically, the requirement Reserve ratio on non-transaction accounts (such as CDs) is zero, while the requirement on transaction deposits (eg checking accounts) is 10%. However, following recent efforts to stimulate economic growth, the Fed has also reduced reserve requirements for trading accounts to zero.

Fractional reserve requirements

Depository institutions must report their transaction accounts, time and savings deposits, safe deposit cash, and other reservable obligations to the Fed on a weekly or quarterly basis. Some banks are exempt from holding reserves, but all banks charge an interest rate on reserves called the “interest rate on reserves” (IOR) or “interest rate on reserves”. Excess reserves(IOER). This rate acts as an incentive for banks to hold excess reserves.

mandatory reserves for banks under the Federal Reserve Act were set at 13%, 10%, and 7% (depending on the type of bank) in 1917. In the 1950s and 1960s, the Fed had set the reserve rate at 17, 5% for some banks, and it remained between 8% and 10% for most of the 1970s until the 2010s. During this period, banks with less than $16.3 million in assets were not required to hold reserves. Banks with assets less than $124.2 million but greater than $16.3 million were required to have 3% reserves, and banks with more than $124.2 million in assets had a reserve requirement by 10%.

Effective March 26, 2020, the reserve requirement ratios of 10% and 3% to net transaction deposits were reduced to 0% for all banks, essentially eliminating reserve requirements.

Prior to the introduction of the Fed in the early 20th century, the National Bank Act of 1863 imposed 25% reserve requirements on US banks under its responsibility.

Fractional reserve multiplier effect

“Fractional reserve” refers to the fraction of deposits held in reserve. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve.

Analysts refer to an equation called the multiplier equation when estimating the impact of reserve requirements on the economy as a whole. The equation provides an estimate of the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $500 million multiplied by one divided by 10%, or $5 billion.

This is not how money is actually created, only a way to represent the possible impact of the fractional reserve system on the money supply. As such, while useful for economics professors, it is generally considered an oversimplification by policy makers.

What are the benefits of fractional reserve banking?

Fractional reserve banking allows banks to use funds (i.e. the bulk of deposits) that would otherwise be idle and idle to generate returns in the form of interest rates on new loans – and to make more money available to grow the economy. It is thus able to better allocate capital where it is most needed.

What are the disadvantages of fractional reserve banking?

Fractional Reserve Banking Could Catch a Cash-Strapped Bank in the Self-Perpetuating Panic of a bank rush. This happens when too many depositors request their money at once, but the bank only has, say, 10% of the cash deposits available. Many US banks were forced to close during the Great Depression because too many clients attempted to withdraw assets at the same time. Nevertheless, fractional reserve banking is an accepted business practice that is used in banks around the world.

Where does fractional reserve banking come from?

No one knows for sure when fractional reserve banking originated, but it’s certainly not a modern innovation. Medieval goldsmiths were thought to issue demand receipts for gold on hand that exceeded the amount of physical gold they had in custody, knowing that on any given day only a small fraction of that gold would be demanded. .

In 1668, the Riksbank of Sweden introduced the first instance of modern fractional reserve banking.