The fractional reserve system is a banking system that allows commercial banks to lend out part of their customers' deposits and make a profit. In this case, only a small part of the customer's deposits are stored in cash that can be withdrawn. In effect, this system is a way for banks to use a certain percentage of customers' bank deposits to create money.
That is to say, banks only need to deposit a small part of the funds in bank vaults or central bank accounts, while most of the remaining funds can be used for lending or investment. When a bank issues a loan, both the bank and the borrower regard this portion of the funds as an asset, and the original amount is doubled in economic terms. These funds are then reused, reinvested or lent again multiple times, creating a multiplier effect, and this is how fractional reserve banking is used for "new money creation."
Loans and debt are part of a system of fractional-reserve banking, and usually require the central bank to put new money into circulation so that commercial banks can provide withdrawals. Most central banks also act as regulators, who will determine minimum reserve ratios. This banking system is used by financial institutions in most countries. This type of banking system is common in the United States and many other free-trading countries.
The formation of fractional reserve banking
The creation of the fractional reserve banking system began around 1668, when Sweden established the world's first central bank, Riksbank (Swedish Central Bank), but the original form of fractional reserve had already been used before that. The idea that deposits could grow and expand, and that loans could penetrate the economy, quickly caught on. The government has also found it sensible to use existing resources to encourage consumption rather than hoarding them in coffers.
After Sweden took steps to make the practice more formal, the fractional reserve system took hold and spread rapidly. The United States established a central bank twice, first in 1791 and second in 1861, but unfortunately neither lasted long. Finally, in 1913, the United States created the Federal Reserve Bank, now the Central Bank of the United States, under the Federal Reserve Act. The financial institution's stated goal at the time was to stabilize, maximize, and monitor the economy in terms of pricing, employment, and interest rates.
How does the system work?
When a customer deposits funds into a bank account, the funds are no longer the depositor's property (at least not directly). The bank now owns the funds and, in turn, gives the customer a deposit account from which to withdraw funds. This means that bank customers will withdraw all their deposits in accordance with the bank's established rules and procedures. However, when a bank receives deposits, it does not retain all of those funds. Instead, only a small portion of deposits are held in banks (fractional reserves). This part of the reserve is generally between 3% and 10%, and the remaining funds will be used by banks to issue loans. [1]
Let’s use this simple example to see how these loans create 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 issued a loan of US$36,450 to Customer D
Customer D deposits $36,450 in Bank 4. Bank 4 issued a loan of $32,805 to Customer E
Customer E deposits $32,805 in Bank 5. Bank 5 issued a loan of $29,525 to Customer F
With a reserve requirement of 10%, the initial deposit of $50,000 has grown to $234,280 in available currency, which is the total of all customer deposits. This is a very simple example showing the multiplier effect under the partial reserve banking system, but it has clearly demonstrated the basic idea.
But please note that this is a process based on the principal of the debt. Deposit accounts represent the funds (liabilities) owed by the bank to customers, and interest-bearing loans are the bank's most profitable business and are also the bank's assets. Simply put, banks create money by generating more loan account assets rather than deposit account (liabilities).
What is a "bank run"?
What if everyone decided to withdraw all their money in the bank? This situation is also known as a bank run. Since banks are only required to retain a small part of their customers' deposits, they may have difficulty meeting their financial obligations in this situation, which directly leads to bank failure.
For a fractional reserve system to work properly, it has to be avoided that depositors don't all show up at the bank at the same time to withdraw their deposits. While bank runs have occurred before, they were not caused by customers' wishes. Typically, customers only try to withdraw all their deposits if they believe the bank is in serious trouble.
The Great Depression in the United States is an example of the devastation caused by large-scale withdrawals. Today's banks hold reserves to prevent such a situation from happening again. Many banks have a reserve requirement ratio that exceeds the legal minimum reserve ratio, and they use this method to better meet customers' needs in withdrawing account assets.
Advantages and Disadvantages of Fractional Reserve Banking
While banks enjoy most of the advantages of this high-profit model, a small part of the advantages gradually benefit customers by earning interest on deposit accounts. Government agencies are also part of the system, and usually governments praise the fractional reserve system for promoting consumption, maintaining economic stability, and providing economic growth.
On the other hand, many economists believe that fractional reserve banking is unsustainable and carries great risks - especially given that the current monetary policy adopted by most countries is based on credit/debt. of, rather than actual currency. The economic system we rely on is based on trust in banks and their fiat currencies.
Fractional Reserve Banking and Cryptocurrencies
Unlike the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving rise to an alternative economic framework that works completely differently.
Like most cryptocurrencies, Bitcoin is maintained by a distributed network of nodes. All data is protected by cryptographic evidence and stored in a distributed ledger called the blockchain. And this means that there is no need for a central bank or a major authority.
Furthermore, the issuance of Bitcoin is limited, meaning that no more new tokens will be created after reaching 21 million Bitcoins. Therefore, fractional reserves do not exist in the world of Bitcoin and cryptocurrencies due to different circumstances.