Fractional Reserve is a banking system that allows commercial banks to make a profit by lending out a portion of their customers' deposits, with only a portion of those deposits held in cash and available for withdrawal. In effect, the banking system creates money out of nothing using a percentage of the bank's customer deposits.
In other words, the bank is required to keep a minimum percentage (a portion) of the money deposited into their financial accounts, which means they can lend out the rest of the money. When the bank makes a loan, both the bank and the borrower consider the money an asset, and multiply the original amount in the economy. This currency is then reused, reinvested, and lent out again many times, leading to a multiplier effect, and this is how fractional reserve banking “creates money.”
Lending and borrowing are part of the fractional reserve banking system and often require a central bank to put currency into circulation so that commercial banks can provide withdrawals. Most central banks also act as regulatory agencies, setting minimum reserve requirements. This is a common practice in the United States and other free-trading nations.
Creation of the Fractional Reserve Banking System
Fractional reserve banking dates back to 1668 when the Swedish (Sveriges) Riksbank was established as the world’s first central bank – but primitive forms of fractional reserve banking were already in use. The idea was that deposited money could grow and expand, stimulating the economy through lending, and it quickly became very popular. It made sense to use existing resources to encourage use, rather than lock them away in a vault.
After Sweden made this move more formal, fractional reserve structures were established and spread rapidly. Two central banks were established in America in 1791 and another in 1816, but they did not survive. In 1913, the Federal Reserve Act created the Federal Reserve Bank, which is now the Federal Reserve Bank of the United States. The purpose of this financial institution is to stabilize, maximize, and monitor the economy in terms of prices, employment, and interest rates.
How does it work?
When a customer deposits money into their bank account, the money does not belong to the customer directly, not directly. The bank of the customer's choice owns the money, and in return, they create a deposit account from which they can withdraw their money. This means that the customer of that bank has the right to withdraw their money at any time, subject to the rules applicable to that bank. However, when the bank takes the money that is deposited, the bank does not take the entire deposit, and only a percentage is set aside (fractional reserves). The nominal reserve is only between 3% - 10% and the rest is used to provide loans to other customers.
Imagine how these loans create new money with a simple example like this:
Customer A deposits $50,000 in Bank 1. Bank 1 lends customer B $45,000.
Customer B deposits $45,000 in Bank 2. Bank 2 lends customer C $40,500.
Customer C deposits $40,500 in Bank 3. Bank 3 lends customer D $36,450.
Customer D deposits $36,450 in Bank 4. Bank 4 lends customer E $32,805.
Customer E deposits $32,805 in Bank 5. Bank 5 lends customer F $29,525.
With fractional reserve requiring only 10% of the initial nominal amount, the initial deposit of $50,000 has grown to $234,280 in total available, the sum of all customers' total deposits plus $29,525. While this is only a simple example of how fractional reserve banking creates money through the multiplication effect, it provides the basic idea.
Please note that this process is based on the principle of debt. Deposit accounts represent money that the Bank owes to customers (liabilities) and interest income from debt is the largest source of income for banks, and they are bank assets. In simple terms, banks make money by creating more debt account assets than deposit account liabilities.
What about Bank Runs?
What would happen if everyone who deposited their money in a bank decided to withdraw it all? This is known as a Bank Run and since banks are only required to hold a small portion of their customers' deposits, it would cause the bank to fail due to its failure to meet its financial obligations.
For fractional reserve banking to work, it is essential that everyone takes their money out at the same time. While bank runs have happened in the past, this is not generally how customers behave. Typically, customers only try to take out all their money if they believe the bank is in trouble.
The Great Depression in the United States is one of the worst examples of the effects of a runaway drawdown at one time. Today, the reserves held by banks are one way they can minimize a repeat of that. Some banks hold more than what is needed as reserves to meet the needs of their customers and provide access to funds in their deposit accounts.
Advantages and disadvantages of Fractional Reserve Banking
While banks benefit most from this lucrative system, there is still a small benefit that bank customers can enjoy, namely interest on deposits. Governments are also part of the scheme and often argue that the fractional reserve banking system encourages use and brings stability and growth to the economy.
On the other hand, many economists believe that fractional reserve schemes are unsafe and extremely risky - especially considering that the current financial system, implemented by many countries, is based on credit/debt and not real money. The economic system we have today relies on a situation where customers trust banks and fiat currencies, which are legal tender by governments.
Fractional Reserve Banking and Digital Currency
In contrast to the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving birth to an alternative workspace for an economy that works in a very different way.
Like other cryptocurrencies, Bitcoin is guarded by a network of cryptographic nodes. All data is protected by cryptographic evidence and recorded on a distributed ledger called the blockchain. This means there is no need for a central bank and no authority in charge.
Also, Bitcoin issuance is limited and there will be no more creation after 21 million bitcoins are issued. Therefore, the context we are using is very different and there is no fractional reserve in the world of Bitcoin and Digital Currencies.