What is Fractional Reserve Banking?
Fractional reserve banking, or fractional banking, refers to a banking system mandating financial institutions to reserve only a fraction of its clients’ deposits. These reserves must either go into the financial institution’s account held by a central bank, such as the Federal Reserve in the U.S or in the commercial financial institution’s vault.
Fractional reserve banking gives commercial banks the ability to act as a middleman between borrowers and savers. As financial institutions only need to keep a fraction of their clients’ deposits, they can put the rest of the money back into the economy by loaning it out to borrowers. The ‘reserve requirement’ (i.e. a minimum amount that must be available or liquid) ensures the bank can service those who wish to withdraw their deposited funds.
EXAMPLE
Someone deposits $50 in their commercial bank of choice. Let’s say the bank has a reserve requirement of 10%. It keeps $5 and lends $45 to a business, which deposits the money into its bank account. The bank then keeps $4.50 and then lends the remaining $40.50 to a different business. Repeating this process over and over, the bank generates loans of a much higher collective value than the original deposit.
A Quick History of Fractional Banking
Fractional reserve banking emerged in the 16th century, during the gold trading era.
People deposited their silver and gold coins at their local goldsmith and received a promissory note in return. These promissory notes could be used in exchanges and commercial transactions. Goldsmiths eventually had an epiphany: depositors withdraw their money at different times. They started charging a storage fee and leveraging the deposits to issue loans and bills at high-interest rates.
Although this all seems obvious now, that epiphany revolutionized the role of the goldsmith from a protector of valuables to a full-fledged bank.
The potential dangers of fractional banking, however, were eventually realized. Just think: what would happen if many noteholders lost trust in their shared goldsmith and withdrew their coins en masse (aka a run on the bank)? The goldsmith would not have the liquidity, or available reserves, to pay back all of their depositors. In other words, they would be insolvent.
The threat of bank runs motivated governments around the world to establish their own central banks, national regulatory agencies that monitor and sometimes support commercial financial institutions. Bank runs remain a serious concern for countries using the fractional reserve banking system. That’s why the central bank often serves as a lender of last resort, saving (unnecessarily, to some) commercial financial institutions on the verge of collapse.
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Reserve Requirements
Reserve requirements, or the reserve ratio, refers to one of a central bank’s key monetary policies and plays a major part in fractional reserve banking.
It mandates a minimum amount of reserves commercial banks must hold. Financial institutions are free to hold more in their reserves in order to have a safety net if they ever need extra liquidity. Furthermore, some countries, including the U.S., even incentivize this behavior by paying interest on excess reserves.
A central bank can lower the reserve requirements in order to increase the money supply circulating in the economy. Banks, with lower reserve ratios, can loan larger percentages of deposits, at lower interest rates, thus attracting borrowers. On the flip side, a central bank can increase the reserve requirement in order to reduce the money supply in the economy and keep inflation down.
In the U.S., the Fed sets the reserve ratios, and it scales depending on each bank’s net transaction accounts. Just a year or so ago, the Fed set the requirements as follows: banks with more than $124.2 million in net transaction accounts were required to keep a reserve of 10% of net transaction accounts. Banks with more than $16.3 million to $124.2 million had to keep 3% of net transaction accounts. Banks with net transaction accounts of up to $16.3 million or less did not have a reserve requirement. The majority of banks in the United States fell into the first category.
However, due to the projected monetary damages of the Coronavirus pandemic, the Fed made a historic decision to set the reserve requirement to 0% for all net transaction accounts in March 2020. The Fed decided to continue on with the zero percent reserve requirement in 2021.
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The Money Multiplier
The ‘money multiplier’ refers to the amount of commercial bank funds that can be generated with a specific unit of central bank ‘money (e.g. precious metals, coins, banknotes, etc.).
Financial analysts utilize the following money multiplier equation to estimate the effects of reserve ratios on money supply in the economy.
The Money Multiplier Equation
m=1/R
m refers to the money multiplier
R refers to the reserve ratio
Take, for example, a reserve ratio of 10%.
That would be m=1/0.1
The money multiplier, in this case, equals 10. That means the commercial bank supply will be around ten times the amount of central bank money.
A Deeper Look into how Fractional Reserve Banking Works
While a quick example appears in the introduction, we will go through how calculations work in a fractional reserve banking system step-by-step.
Let’s say we have established a brand new economy and you want to deposit $1000 to your bank. This new economy has established a 20% reserve requirement.
- You deposit $1,000 into your bank account. The system now has $1,000.
- The bank has to keep $200 (20%) in its reserves and can lend up to $800 (80%) to other customers.
- The other customers decide to borrow the full $800. When you check your bank balance you still have $1,000. The available funds in the system are now $1,800.
- They end up spending every single cent of the $800 they borrowed. The recipients of that money, then, deposit the $800 into their bank.
- That bank must now save $160 (20%) and can lend up to $640 (80%) to other customers.
- Customers borrow the $640. You have $1,000 in your account, and the recipients of the $800 still have that money available in their accounts. So now we have $2,460 ($1,000 + $800 + $640) in the system.
- This cycle of depositing and lending (i.e. the money multiplier) continues, generating more and more wealth in the system from the initial deposit.
Any Alternatives to Fractional Reserve Banking?
Anything in between but not including a reserve ratio of 0% and 100% is fractional reserve banking.
For a 100% system or a full-reserve banking system, banks would potentially have to keep every cent of all deposits at all times. That would be a return back to the time before the goldsmiths made their epiphany.
But a 100% reserve ratio does not have to apply to all deposits; it could be exclusively established for checking and savings accounts (i.e. when immediate liquidity is required). Particularly a wholesale full-reserve banking system would dry up lending and the drastic money supply would drastically dip.
Furthermore, banks would have to create or increase service charges in order to compensate for revenue lost from lending.
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The other alternative to fractional reserve banking is actually what we have now (as of Jan. 2021) where the reserve ratio sits at 0%. When the lending keeps happening without any reserves, the chance of a catastrophic domino effect increases. How will commercial banks pay off depositors in the event of a bank run? Even at the old 10% reserved ratio, many have had concerns about the lack of liquidity in the U.S. financial system that has arguably led to some major economic crises (e.g. LTCM, the Savings and Loan crisis, etc.)
What do you think about Fractional Reserve Banking?
Fractional reserve banking and the Federal Reserve have received much criticism over the years. Particularly in the aftermath of the 2008 financial crisis, when the Fed used close to $500 billion in taxpayer money to bail out banks with the Emergency Economic Stabilization Act of 2008.
While ProPublica reports a $110 billion profit from the companies that managed to pay back the bailout funds, we should also wonder if those linked to the crisis were tried and potentially convicted. We must also consider if the Fed’s bailouts did not make certain people very rich.
The Zero Theft Movement seeks to eradicate crony capitalism from the U.S. economy. We need to work together to identify, debate, and decide exactly where the economic foul play is occurring through investigations and voting. Citizens author theft proposals and the community decides whether that investigation has convincingly proven (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.