Fractional reserve banking is a system used by commercial banks to create money and facilitate lending. It involves keeping only a fraction of deposits as reserves while lending out the remaining funds. This system allows banks to expand the money supply beyond the amount of actual reserves held.
Here's how it works:
Reserves: When individuals or businesses deposit money into a bank, the bank is required to hold a portion of those deposits as reserves. The reserve requirement is set by the central bank, such as the Federal Reserve in the United States.
Required Reserves: The central bank mandates that banks maintain a certain percentage of their deposits as reserves. For example, if the reserve requirement is 10%, a bank must keep $10 for every $100 deposited.
Excess Reserves: Banks can hold reserves in excess of the required amount, known as excess reserves. These reserves act as a buffer for unforeseen withdrawals or financial stability.
Money Creation: Banks use the majority of the deposited funds (above the required reserve) to make loans and investments. When a loan is made, the bank credits the borrower's account with the loaned amount, effectively creating new money. This newly created money enters circulation and can be spent, stimulating economic activity.
Deposit Multiplier: The fractional reserve banking system works based on the deposit multiplier effect. As banks lend out the funds they receive, those funds are redeposited into other banks, and the process repeats. Each time this cycle occurs, a new round of lending and deposit creation takes place, increasing the overall money supply.
Risks and Regulations: Fractional reserve banking carries risks. If depositors withdraw their funds en masse or if loans default, banks may face liquidity problems. To mitigate such risks, central banks enforce regulations, including reserve requirements, capital adequacy ratios, and stress tests.
It's important to note that fractional reserve banking is a key feature of modern banking systems. However, it also creates a potential for bank runs and financial instability if not properly managed or regulated. Central banks play a crucial role in overseeing and stabilizing the fractional reserve banking system to maintain confidence in the financial system.
