Fractional reserve banking

Definition

Fractional reserve banking is a banking system in which banks hold only a fraction of the total deposits as reserves, while using the majority of the funds for lending and investment purposes. This practice allows banks to create money through the lending process, effectively increasing the money supply in the economy. By holding reserves that are only a small percentage of their deposits, banks can facilitate economic growth while also managing liquidity.

5 Must Know Facts For Your Next Test

1. In fractional reserve banking, banks typically hold around 10% of deposits as reserves, but this can vary based on regulatory requirements and bank policy.
2. This system enables banks to lend out a significant portion of their deposits, which helps stimulate economic activity by making more funds available for borrowing.
3. If many depositors withdraw their funds simultaneously, it can lead to a bank run because banks may not have enough liquid assets to cover all withdrawals.
4. Central banks monitor and regulate fractional reserve banking to maintain financial stability and prevent excessive risk-taking by commercial banks.
5. The money created through loans in a fractional reserve banking system is part of what is known as 'bank money,' which includes deposits held in checking accounts.

Review Questions

• How does fractional reserve banking affect the overall money supply in an economy?
  • Fractional reserve banking affects the overall money supply by allowing banks to lend out most of the deposits they receive while keeping only a fraction as reserves. This lending process effectively multiplies the amount of money circulating in the economy, as new loans create additional deposits. Consequently, this mechanism contributes to economic growth by providing businesses and consumers with access to funds for investments and spending.
• Evaluate the risks associated with fractional reserve banking for both banks and depositors.
  • The risks associated with fractional reserve banking include potential liquidity issues for banks if many customers decide to withdraw their deposits at once, leading to bank runs. Additionally, if banks engage in excessive lending without adequate risk assessment, they could face insolvency. For depositors, this means that while their funds are theoretically safe, there is a possibility of losing access to their savings if the bank encounters financial difficulties.
• Discuss the implications of fractional reserve banking on monetary policy and its effectiveness in managing economic stability.
  • Fractional reserve banking has significant implications for monetary policy because it influences how central banks manage the money supply and interest rates. Through tools like adjusting reserve requirements or open market operations, central banks can control the amount of money created by banks, thereby impacting inflation and economic growth. However, reliance on this system also introduces challenges, such as potential over-leverage by banks and the risk of financial instability during economic downturns. As a result, understanding fractional reserve banking is crucial for policymakers aiming to maintain a balanced and stable economy.

Related terms

Reserve Requirement: The minimum amount of reserves that a bank must hold against its deposits, set by central banks to ensure stability in the banking system.

Money Multiplier: The ratio that indicates how much money can be created in the economy from each dollar of reserves, demonstrating the impact of fractional reserve banking.

Liquidity: The ease with which assets can be converted into cash without affecting their market price, essential for banks to meet withdrawal demands from depositors.