Fractional Reserve Banking is a banking system that allows commercial banks to make a profit by borrowing a portion of their customers' deposits, while only a small portion of those deposits are held as actual cash and available for withdrawal. In practice, this banking system creates money out of thin air using a percentage of its customers' bank deposits.
In other words, these banks are required to keep a minimum percentage (portion) of the money that is kept in their financial accounts, which means they can lend out the remaining money. When a bank makes a loan, the lender and the person borrowing the money consider the funds to be assets, doubling the original amount in an economic sense. This currency is then reused and reinvested, which in turn leads to a multiplier effect. This is how fractional reserve banking “creates new money.”
Lending and debt are an integral part of the fractional reserve banking system and require the central bank to issue new currency in order for commercial banks to be able to make withdrawals. Most central banks also serve as regulators, who also determine minimum reserve requirements. This banking system is used by financial institutions in most countries. It is common in the United States and many other free trade countries.
Creation of the Fractional Reserve Banking System
Fractional reserve banking was created around 1668, when the Swedish Riksbank opened as the world's first central bank, but other primitive forms of fractional reserve banking were in use at that time. The idea that cash deposits could grow and expand, stimulating the economy through credit, quickly became popular. It makes sense to use existing resources to reduce costs, rather than hoarding them in storage.
After Sweden took steps to implement the practice in a more formal form, the fractional reserve structure began to spread rapidly. Two Central Banks were created in the United States, first in 1791 and then in 1816, but they quickly closed. In 1913, the Federal Reserve Bank of the United States was created by the Federal Reserve Act, which is currently the Central Bank of the United States. The main objectives of this financial institution are to stabilize, maximize and control the economy in terms of pricing, employment and interest rates.
How it works?
When a customer deposits funds into their bank account, they are no longer the property of the depositor, at least not directly. Now they belong to the bank, and in return it provides its customers with a deposit account that they can use. This means that a bank customer can have access to the full deposit amount on demand, subject to established bank rules and procedures.
However, when the bank takes possession of the deposited money, a fractional reserve is established. This reserve amount is usually between 3% and 10%, and the rest of the money is used to make loans to other customers.
Let's look at how these loans create new money using a simplified example:
Customer A deposits $50,000 with Bank 1. Bank 1 extends a loan to Customer B in the amount of $45,000.
Customer B deposits $45,000 with Bank 2. Bank 2 extends a loan to Customer C in the amount of $40,500.
Customer C deposits $40,500 with Bank 3. Bank 3 loans Customer D $36,450
Customer D deposits $36,450 with Bank 4. Bank 4 loans Customer E $32,805.
Customer E deposits $32,805 with Bank 5. Bank 5 loans customer F $29,525.
With a 10% fractional reserve requirement, this initial $50,000 deposit grew to $234,280 in total available currency, which is the sum of all customer deposits. Although this is a very simplified example of how fractional reserve banking generates money through the multiplier effect, it demonstrates the basic idea.
Please note that the process is based on the underlying debt. Deposit accounts represent the money that banks owe their customers (liabilities), and interest-bearing loans generate most of the money for banks and are an asset of the bank. Simply put, banks make money by generating more loan account assets than deposit account liabilities.
What About Bank Operations?
What if everyone who has deposits at a particular bank decides to withdraw all their money at one time? This term is known as a “depositor run,” and since the bank is required to hold only a small portion of its customers' deposits, it can lead to the bank's failure due to its inability to meet its financial obligations.
For a fractional reserve banking system to operate, it is necessary that depositors are not able to withdraw or access all amounts of their deposits at once. Although investor runs have occurred in the past, clients generally do not behave this way now. Typically, consumers will only try to withdraw all their money if they believe the bank is in serious trouble.
In the US, the Great Depression is one of the notorious examples when there was a mass exodus of depositors. Today, reserves held in banks are one of the protection methods that can minimize the likelihood that a “run of depositors” may occur again. Some banks hold more of the required minimum funds in reserve to better meet the needs of their customers and ensure access to their funds in deposit accounts.
Advantages and Disadvantages of Fractional Reserve Banking
While banks enjoy most of the benefits of this high-yield system, a small portion of the funds earned will end up in the hands of bank customers in the form of interest earned on their deposit accounts. The government is also part of the scheme and supports fractional reserve banking systems that stimulate spending and provide economic stability and growth.
On the other hand, many economists believe that the fractional reserve scheme is unsustainable and quite risky, especially considering that the current monetary system implemented by most countries is actually based on credit/debt rather than real money. Our economic system relies on people trusting both banks and fiat currencies established by governments as legal tender.
Fractional Reserve Banking and Cryptocurrencies
Unlike the traditional fiat currency system, Bitcoin was created as a decentralized digital currency with an alternative economic structure that works completely differently.
Like most cryptocurrencies, Bitcoin is supported by a distributed network of nodes. All data is protected by cryptographic evidence and recorded in a public distributed ledger - Blockchain. This means that there is no need for a Central Bank and there is no responsible body.
In addition, Bitcoin has a limited supply, meaning that once the maximum supply of 21 million units is reached, generation will stop. Therefore, the context is completely different and there is no such thing as fractional reserve in the world of cryptocurrencies.