Fractional-reserve banking
Banking system where only a fraction of deposits is held in reserve.
Fractional-reserve banking is the system of banking under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, and lend a percentage to borrowers, thus increasing the money supply by the loaned amount. It differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves. This system permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank, and is the prevailing banking system in almost all countries worldwide.
- field
- Banking and monetary economics
- known_for
- Allowing banks to lend a portion of deposits while keeping only a fraction in reserve, expanding the money supply
- key_feature
- Banks hold reserves as cash or central bank balances, often less than total deposit liabilities
- risk
- Bank runs can occur if depositors collectively withdraw more than reserves
Lore & Background
Fractional-reserve banking predates the existence of governmental monetary authorities and originated with bankers' realization that generally not all depositors demand payment at the same time. In the past, savers deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit. These notes gained acceptance as a medium of exchange, and goldsmiths observed that people would not usually redeem all their notes at the same time, leading them to invest coin reserves in interest-bearing loans. This generated income for the goldsmiths but left them with more notes on issue than reserves, thus fractional-reserve banking was born.
Reader's Guide
Fractional-reserve banking is significant because it allows banks to provide credit and liquidity to borrowers while acting as financial intermediaries. This 'borrowing short, lending long' or maturity transformation function is considered an important role of the commercial banking system. However, the system increases the risk that a bank cannot meet depositor withdrawals, as reserves only cover normal withdrawal patterns. Modern central banking reduces this risk through mechanisms such as lender-of-last-resort facilities, reserve requirements, and capital adequacy ratios. The central bank may also use the system to influence the money supply and interest rates as part of monetary policy. Historically, early financial crises from bank runs led to the creation of central banks, which were given legal power to set reserve requirements and regulate commercial banks. Today, fractional-reserve banking functions smoothly in most countries, though some nations do not impose explicit reserve requirements.
Did You Know?
- Fractional-reserve banking originated with goldsmiths who issued notes for deposited gold and then lent out the coin reserves.
- Bank deposits are usually short-term or available on demand, while loans tend to be longer-term, creating a risk of liquidity shortfalls.
- Central banks can act as lender of last resort during bank runs to provide funds for short-term shortfalls.
- Some countries, including the United States, United Kingdom, Canada, Australia, New Zealand, and three Scandinavian countries, do not impose explicit reserve requirements.
Frequently Asked Questions
What is fractional-reserve banking?
It is a banking model in which institutions holding public deposits retain only a portion of those funds as liquid reserves while lending out the remainder to borrowers. Rather than keeping every dollar on hand, banks hold reserves in the form of cash or central-bank balances that are typically less than their total deposit obligations.
How does fractional-reserve banking differ from full-reserve banking?
Under full-reserve banking, a bank would be required to keep 100% of depositor funds available and could not lend them out. Fractional-reserve banking relaxes that constraint, allowing banks to allocate a share of deposits to loans, which in turn creates additional purchasing power in the economy.
How does fractional-reserve banking expand the money supply?
When a bank lends out a portion of its deposits, that loan becomes a new deposit at another institution, and the cycle repeats as each subsequent bank lends out a fraction of the newly received funds. This multiplier effect means the total money supply can grow well beyond the initial base money issued by the central bank.
What is the primary risk associated with fractional-reserve banking?
Because reserves are deliberately held below the level of total deposit liabilities, a sudden wave of withdrawals—a bank run—can exceed the liquid assets available. If enough depositors lose confidence simultaneously, the bank may be unable to meet all claims, potentially triggering a broader financial crisis.
Why is fractional-reserve banking the prevailing system in most countries?
It strikes a practical balance between providing credit to borrowers and maintaining enough liquidity to honor withdrawals, making the financial system more efficient than a strict full-reserve alternative. Nearly every modern economy relies on this framework because it supports lending, investment, and economic growth while central banks set reserve requirements to manage systemic risk.
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