Fractional Reserve Banking
What is Fractional Reserve Banking?
Fractional reserve banking is a system in which banks hold only a fraction of deposits as reserves and lend out the rest.
By lending excess reserves, banks create new money, expanding the money supply through the money multiplier. The fraction held is set by the required reserve ratio. The system assumes that not all depositors withdraw at the same time.
Fractional Reserve Banking: a worked example
A customer deposits $5,000 in cash at Bank A and the required reserve ratio is 20%. Bank A keeps 0.20 x $5,000 = $1,000 as required reserves and lends the $4,000 of excess reserves. The borrower spends that $4,000, the seller deposits it at Bank B, which keeps $800 and lends $3,200. Carried through the whole chain, deposits reach $5,000 x (1 / 0.20) = $25,000. The original $5,000 was already money, so the new money the banking system created is $25,000 - $5,000 = $20,000, which also equals the first loan of $4,000 times the multiplier of 5. Raise the ratio to 25% and the multiplier falls to 4, so the same deposit supports $20,000 of deposits and only $15,000 of new money.
The mistake students make with fractional reserve banking
The tempting move is to let one bank lend the multiplied amount, writing that Bank A takes a $5,000 deposit at a 20% ratio and immediately lends $25,000. A single bank can lend only its own excess reserves, $4,000 here, because it settles checks with real reserves. The $25,000 belongs to the whole system after many rounds of relending. A second slip is reporting total deposits as money created. Subtract the original deposit first, since it existed before the lending chain started.
Fractional Reserve Banking questions
How does fractional reserve banking create money?
Banks create money by lending the deposits they are not required to hold. When a bank keeps 20% of a $5,000 deposit and lends $4,000, that loan becomes a deposit at another bank, which lends part of it again. Each round adds new checkable deposits without cancelling the old ones, so the money supply grows by a multiple of the original excess reserves. No physical currency is printed anywhere in the process.
Why do banks not keep all deposits in reserve?
Holding every dollar idle would earn a bank nothing, since interest income comes from loans and securities. Fractional reserve banking rests on the assumption that depositors withdraw at different times, so a fraction of deposits covers normal daily withdrawals. Keeping 100% of deposits, called full reserve banking, would set the money multiplier equal to 1 and end deposit expansion entirely.
What is a bank run in a fractional reserve system?
A bank run happens when many depositors demand cash at once while the bank holds only a fraction of deposits in reserve. Because most of the money sits in outstanding loans that cannot be called in quickly, even a solvent bank can fail to meet withdrawals. Deposit insurance and central bank lending exist to make runs unlikely by removing any reason to rush the teller window.
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