Fractional reserve is a banking system that allows commercial banks to make a profit by lending out a portion of customer deposits, with only a small portion of these deposits held as cash reserves. to serve customers' withdrawal needs. In fact, such a banking system has the ability to create money from customers' deposits at the bank.
In other words, these banks only have to reserve a minimum percentage (a fraction) of the total amount deposited in their financial accounts, which means they can use the remaining funds to loan. When a bank makes a loan, both the bank and the borrower consider this loan as a form of asset, from which the original volume has been multiplied by 2 in economic terms. This money will then be reused, reinvested and re-lent out many times creating a multiplier effect, and eventually forming the reserve banking system's "new money creation" method. ratio.
Borrowing and debt are part of the fractional reserve banking system, and in order for commercial banks to be able to provide cash for their customers' withdrawals, a central bank is usually required. The task of pushing new currency into circulation. Most central banks also have administrative duties, have the power to determine minimum reserve requirements, and many other functions. Currently, most countries' financial agencies apply this banking system, most commonly in the US and many free trade countries.
The Creation of the Fractional Reserve Banking System
This system was born around 1668, which is also the year the Swedish Riksbank (Sveriges) - the first central bank in the world was established. However, basic forms of fractional reserve banking systems have been used before. The idea that deposits can grow and grow on their own, using loans to stimulate the economy very quickly, has become extremely popular. Using available resources to encourage spending actually makes more sense than just hoarding it.
After Sweden completed a few steps to officially apply it, this proportional reserve structure was quickly accepted and developed. Two central banks were established in America, in 1791 and 1816 respectively, but both did not last long. In 1913, the Federal Reserve Act officially established the Federal Reserve Bank of the United States, now the Central Bank of the United States. The main goals of these financial institutions include stabilization, maximization and economic forecasting based on consumer price indexes, labor and interest rates.
How it works
Supposedly, when a customer deposits money into their bank account, that money is no longer their property, at least visually. The current owner is the bank, and in return, they give the customer a deposit account with an available balance. This means that the customer still has the right to access the balance in that account whenever they want as long as they comply with the regulations and procedures set by the bank.
However, when the bank takes over ownership of those deposits, they do not reserve them all. Instead, only a small portion of deposits are held in reserve (a reserve ratio). This rate usually ranges from 3% -10%, the remaining amount will be used for loans to other customers.
Considering the following example, we will easily see how these loans "generate" new money:
Customer A deposits $50,000 in Bank 1. Bank 1 lends $45,000 to Customer B.
Customer B deposits $45,000 in Bank 2. Bank 2 lends $40,500 to Customer C.
Customer C deposits $40,500 in Bank 3. Bank 3 lends $36,450 to Customer D.
Customer D deposits $36,450 in Bank 4. Bank 3 lends $32,805 to Customer E.
Customer E deposits $32,805 in Bank 5. Bank 3 lends $29,525 to Customer F.
With a reserve ratio requirement of 10%, the initial $50,000 deposit has increased to $234,280 in available funds, which is the total of all customer deposits. This is just a very simple example of how fractional reserve banks create money by the multiplier effect.
It is important to remember that this process is based on the principle of debt. Deposit accounts represent money that banks owe to their customers (liabilities), and interest-bearing loans bring in the majority of a bank's revenue, and are also assets. of the bank. Simply put, a bank makes money when it creates more loan assets than deposit account liabilities.
Bank runs
However, what happens when everyone with a deposit account at a certain bank simultaneously wants to withdraw all their deposits? This event is called a “deposit run,” and since the bank only has to reserve a portion of its total customer deposits, it appears that its financial obligations cannot be met. present.
A prerequisite for a fractional reserve banking system to work is that all customers cannot withdraw all of their deposits at the same time. Although this event has happened in the past, it is not typical customer behavior. Normally, only when customers see that the bank is having a really serious problem do they try to withdraw all their deposits.
In the United States, the Great Depression is a classic example of the terrible devastation caused by massive deposit withdrawals. Today, bank reserves are one of the methods used to minimize the likelihood of this event occurring. Some banks often set reserve levels higher than the minimum requirements to better serve customers' withdrawal needs.
Advantages and disadvantages of this system
In such a highly profitable system, the bank is the one who enjoys most of its advantages, however, the customers will also benefit a small amount by the interest they receive on their deposits. Governments, as part of this model, often argue that a fractional reserve banking system will encourage spending, helping to stabilize and grow the economy.
However, many economists believe that the fractional reserve model is unsustainable and quite risky - especially if we consider the current monetary system in place in most countries. All prices are based on credit/debt, not real money. The economic system we have depends on the premise that people must absolutely trust both banks and fiat money - a legal means of payment established by the government.
Fractional Reserve Banks and Cryptocurrencies
In contrast to the fiat currency system, Bitcoin is a decentralized digital currency, laying the foundation for a new economic form that operates in a completely different way.
Like most cryptocurrencies, Bitcoin is maintained by distributed network nodes. All data is secured by cryptographic proofs and recorded on a public distributed ledger called blockchain. Therefore, cryptocurrencies do not need a central bank, and there is also no government intervention.
In addition, the number of Bitcoins issued is limited with a maximum supply of 21 million units. Once this quantity is fully mined, no more new Bitcoin units will be born. Therefore, the circumstances here are completely different, there is no such thing as fractional reserves in the world of Bitcoin and cryptocurrencies.
