Fractional reserve is a banking system that allows commercial banks to make profits by lending a portion of their customers' deposits, while only a small portion of those deposits is actually stored as real money and remains available for withdrawal. Concretely, this banking mechanism creates money out of nothing, using a percentage of customers' bank deposits.
In other words, banks are required to hold a minimum percentage (a fraction) of the money deposited in their financial accounts, which therefore means they can lend the rest of the money. When a bank grants a loan, both the institution and the person borrowing consider the funds as assets, thereby doubling the initial amount in the economic sense of the term. This money is then reused, reinvested and loaned out repeatedly, leading to a new multiplier effect. This is how fractional reserve banking “creates new money”.
Loans and debt are an integral part of fractional reserve banking and often require a central bank to put new funds into circulation so that commercial banks can service withdrawals. Most central banks also act as regulators that determine, among other things, minimum reserve requirements. This banking system is most used by national financial institutions. It is thus widely used in the United States and many other countries based on free trade.
The creation of fractional reserve banking systems
Fractional reserve banking emerged around 1668 when the Swedish Riksbank (Sveriges) became the world's first central bank – but other, more rudimentary forms of fractional reserve banking were already in use. The idea that silver deposits could increase and grow, stimulating the economy through lending, quickly became popular. It was indeed quite logical to use available resources to encourage spending, rather than storing them in a safe.
Once Sweden took steps to make the practice more official, the fractional reserve structure was established and spread quickly. Two central banks were thus created in the United States, the first in 1791 and the second in 1816, but neither of them lasted. In 1913, the Federal Reserve Act created the US Federal Reserve Bank (the FED), which is now the US central bank. The objectives of this financial institution are to stabilize, maximize and supervise the economy in relation to prices, employment and interest rates.
How it works?
When a customer deposits money into their bank account, that money is no longer the property of the depositor, at least not directly. The bank now owns it and, in return, it offers its customer a deposit account that it can draw on. However, this means that bank customers must be able to access their entire deposit, upon simple request, in compliance with current banking rules and procedures.
However, when the bank takes possession of the deposited money, in reality it does not keep the entire amount in the customer's account. Instead, a small percentage of the deposit is reserved (the fractional reserve). This reserve amount usually varies between 3% and 10% and the rest of the money is used to provide loans to other customers.
Below are simple examples of how loans have the ability to create money:
Customer A deposits $50,000 with Bank 1. Bank 1 lends Customer B $45,000
Customer B deposits $45,000 with 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 with 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 a required fractional reserve of 10%, the initial deposit of $50,000 increased to $234,280 in total available currency, which is the sum of all customers' deposits at their respective establishments. Although this is a very simplified example of how fractional reserve banks generate money via the multiplier effect, it illustrates the basic idea in concrete terms.
Note that the process is based on the principal of the debt (the amount on which the loan interest is based). Deposit accounts represent the money that banks owe to their customers (liability) while loans that earn interest are what make the most money for banks, because they constitute an asset for them. Simply put, banks make money by generating more assets in their loan accounts than in their current (deposit) account liabilities.
What about the bank panic?
What happens if all the fund holders at a certain bank decide to show up and withdraw all their money? This is called a bank run because as the bank is only required to hold a small fraction of their customers' deposits, it is likely that they will go bankrupt due to their inability to meet their financial obligations .
For the fractional reserve banking system to work, it is imperative that depositors do not all rush to banks at the same time to withdraw or access all of their funds. Although bank runs have occurred in the past, this is generally not the normal way for customers to act. Indeed, a priori, users only try to withdraw all their money if they believe that the bank has serious problems.
In the United States, the Great Depression is a notorious example of the catastrophe that can be wrought by mass withdrawal. Today, the reserves held by banks constitute one of the means they use to minimize the chances of such an event happening again. Some banks hold more than the minimum required in reserve for this purpose, to better respond to the demands of their customers and ensure access to funds in deposit accounts.
Advantages and Disadvantages of Fractional Reserve Banking
While banks enjoy most of the benefits of this highly lucrative system, a small part of the system also trickles down to bank customers who earn interest on their deposit accounts. Governments are also part of this mechanism and often argue that fractional reserve banking systems encourage spending and ensure economic stability and growth.
However, many economists believe that the fractional reserve system is unsustainable and even quite risky - especially considering that the current monetary system, implemented by most countries, is actually based on credit/debt and not on real money. Our economic system is based on the principle that people trust both banks and fiat money, established as legal tender by governments.
Fractional reserve banking and cryptocurrency
Unlike the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving rise to an alternative economic framework that operates in an entirely different way.
Like most cryptocurrencies, Bitcoin is managed by a distributed network of nodes. All data is protected by cryptographic proof and recorded on a public, distributed ledger called the blockchain. This means that there is no need for a central bank and there is no authority in charge.
Additionally, the issuance of Bitcoin is limited, so no more units will be generated once the maximum supply of 21 million units is reached. Therefore, the context is totally different and there is no fractional reserve in the world of Bitcoin and cryptocurrencies.