Fractional reserve banking is a system that allows commercial banks to make a profit using part of the money their customers have deposited, while only a small fraction of those deposits are stored as real money and can be withdrawn. In practice, this system creates money out of thin air using a percentage of its customers' deposits.
In other words, banks are required to keep a minimum percentage (fraction) of the money deposited by customers, and can lend the remainder of this capital. When a loan is granted, both the bank and the person who received that loan classify the amount as an asset, doubling the original value in an economic definition. Then this money is reused, reinvested and re-lent several times. This entire process brings us to the main function of the Fractional Reserve system, “creating new money” out of thin air.
Debt and loans are an integral part of the fractional reserve system and often require a central bank to put new currencies into circulation to ensure that banks have the capacity to support their customers' withdrawals. Most central banks also act as regulatory agencies that determine, among other things, minimum reserve requirements. This is the system that most financial institutions around the world use. It is prevalent in the United States and several other countries that adopt free trade.
The Creation of Fractional Reserve Banking Systems
The fractional reserve banking system was created in 1668, when the Central Bank of Sweden (Sveriges Riksbank) became the first central bank in the world - it is worth remembering that other, simpler forms of fractional reserves were already being used previously. The idea that cash deposits could grow and expand, stimulating the economy through lending, quickly became popular. It made sense to use available resources to encourage spending, rather than hoarding it in a coffer.
After Sweden took several steps to make the practice more reliable, the fractional reserve structure took hold and spread very quickly. Two central banks were created in the US, the first in 1791 and the next in 1816, but neither succeeded. In 1913, the Federal Reserve Act created the Federal Reserve Bank of the United States, thus becoming the American central bank. The financial institution's objectives were to stabilize, maximize, and supervise the economy with regard 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 provides the customer with an account that can be used for withdrawals. This means that the bank's customer must have access to the full amount of the deposit whenever they wish, with previously established rules and procedures.
However, when the bank takes possession of the deposited money, it does not retain the full amount. Instead, a small percentage of the deposit is set aside (fractional reserve). This reserve amount typically ranges from 3% to 10% and the rest of the money is used to provide loans to other customers.
Understand how loans create new money with this simple example:
Customer A makes a deposit of R$50,000.00 at Bank 1. Bank 1 lends R$45,000.00 to Customer B.
Customer B makes a deposit of R$45,000.00 at Bank 2. Bank 2 lends R$40,500.00 to Customer C.
Customer C makes a deposit of R$40,500.00 at Bank 3. Bank 3 lends R$36,450.00 to Customer D.
Customer D makes a deposit of R$36,450.00 at Bank 4. Bank 4 lends R$32,805.00 to Customer E.
Client E makes a deposit of R$32,805.00 at Bank 5. White 5 lends R$29,525.00 to Client F.
With a 10% fractional reserve requirement, the original deposit of R$50,000.00 increased to a total of R$234,280.00 in cash in circulation, which is the sum of all customers' deposits. Although this is a very simple example of how a bank generates money through multiplication, it demonstrates the idea in general.
Note that the process is based on the principal amount of the debt. Deposit accounts represent the money banks owe their customers (liabilities) and interest-bearing loans generate more money for banks and are considered financial assets. Simply put, banks make money by generating more assets in the form of loans than the amount held by customers in their accounts.
What about the Bank Run?
What if all the customers of a particular bank decide to show up and withdraw all their balances? This effect is better known as a Bank Run, and since the bank only needs to hold a small fraction of its customers' deposits, this would likely cause the institution to fail due to the inability to meet its obligations.
For the fractional reserve system to function properly, it is imperative that customers do not rush to banks to withdraw or access all of their deposits simultaneously. Although several bank runs have occurred in the past, it is not usual behavior. Typically, consumers only attempt to withdraw all their money if they believe the bank has serious solvency problems.
In the United States, the Great Depression is a notorious example of the devastation that a massive withdrawal can cause. Today, reserves held by banks are one of the ways they work to minimize the chance of this happening again. Some banks hold more than the required minimum in reserve to better meet the demands of their customers and provide immediate access to deposited funds.
Advantages and Disadvantages of Fractional Reserve Banking
While banks enjoy most of the benefits of this very profitable system, customers also receive some of this profit in the form of interest on the money they have left in their accounts over time. National governments are also part of the scheme and often argue that fractional reserve systems stimulate spending and provide economic stability and growth.
On the other hand, many economists believe that the system is unsustainable and quite risky - especially if we consider that the current monetary model, implemented by most countries, is actually based on credit/debt and not real money. The economic system depends on the premise that people trust both banks and fiat currency, established as the official currency by governments.
Fractional Reserves and Cryptocurrencies
In contrast to the traditional fiat currency system, Bitcoin was created as a fully decentralized digital currency, giving rise to an alternative economic structure that works in an entirely different way.
Like most cryptocurrencies, Bitcoin is maintained by a distributed network of Nodes. All data is protected by cryptographic proofs and recorded in a public Ledger known as Blockchain. This means that there is no need for a central bank and there is no authority responsible for the functioning of the system.
Furthermore, Bitcoin issuance is finite, ensuring that no additional coins will be generated after the maximum ceiling of 21 million units. Therefore, the context is totally different and there is no fractional reserve in the world of Bitcoin and cryptocurrencies.