Fractional-reserve banking

In economics, particularly in financial economics, fractional-reserve banking is the near-universal practice of banks of retaining only a fraction of their deposits to satisfy demands for withdrawals, lending the remainder at interest to obtain income that can be used to pay interest to depositors and provide profits for the banks' owners. Fractional-reserve banking allows for the possibility of a bank run in which the depositors collectively attempt to withdraw more money than is in the possession of the bank, leading to bankruptcy. It also increases the money supply through a mechanism called the deposit creation multiplier, explained below, which can lead to inflation if reserves are too low. Most governments impose strictly-enforced reserve requirements on banks, with the exact fraction of deposits that must be kept in reserve generally set by a central bank.

Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking for the practice of only partially backing a nation's currency with gold or other accepted stores of value, as occurred in various countries before the adoption of unbacked fiat money in most developed countries in 1971 with the collapse of the Bretton Woods Agreement. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partially-backed currencies as a form of fractional-reserve banking may create more confusion than it alleviates. Mainstream economists do not generally make this analogy.

Historical background

At one time, people deposited their precious metal valuables at goldsmiths, receiving in turn a note for their deposit. As these notes began to be used directly in trading, participants no longer needed to redeem their gold to perform the trade. Thus an early form of paper money was born. Goldsmiths became known as money changers.

As the notes were used directly for trade, the money changers realized that people would never withdraw all their deposits at the same time. Thus money changers saw the opportunity to issue new bank notes and lend them at interest—a process that altered their role from passive guardians of bullion to interest-earning (and interest-paying) banks. Here fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the money changer to back up their note, they would try to redeem the note. This was called a run on the bank and many early money changers either went broke or refused to pay up.

The deposit creation multiplier

We have said that fractional-reserve banking implies that the amount of the asset in reserve, that the money is based on, amounts to only a fraction of the money in circulation. For example if a central bank has $100 worth of foreign currency or gold in a bank's reserves and $500 in circulation, then the bank would be practising 1/5 fractional-reserve banking.

Commercial banks operate in a similar way. The system starts with an initial deposit at a commercial bank. Because of this deposit (called a primary deposit), the bank is holding currency. To make a profit for it's investors, the bank loans this money out. The person that gets the loan spends the money which will eventually be deposited in a bank. This second deposit is refered to as a derivative deposit or secondary deposit. Any of these additional derivative deposits increase the amount of the money supply.

Governments (or their central banks) generally restrict the proportion of primary deposits that can be lent out. This is called the cash reserve ratio. For example, lets assume that a primary deposit of $1000 is made into bank A. If the cash reserve ratio is 12%, then $120 must be kept on hand by the bank and $880 is available to be lent to someone else (called the excess reserve). Now if bank A uses its $880 in excess reserve by lending it out, and that is deposited in bank B, it represents a primary deposit to the second bank. Bank B must keep 12% of $880 on hand but can lend out $774.40. If that $774.40 is eventually deposited in bank C, the third bank must keep $92.93 on hand but can lend out $681.47. The process continues until there is no excess reserve left (For simplicity we will ignor safety reserves.). By adding all the derivative deposits we can calculate the amount of money created. Alternatively we can use the deposit multiplier equation:

TD = ID / crr

Where:
TD=change in Total Deposits
ID=Initial change in Deposit
ccr=cash reserve ratio

The initial change in deposit of $1000 will increase total deposits by $7333.33 given a reserve ratio of 12% (1000/.12=7333.33).

In actual fact, the money creation multiplier is more complex than this simple description. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system),the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold - usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different reserve ratios.

The opposite of fractional reserve banking is full reserve banking, but this is not used in practice.

See also

• gold standard
• bimetallism
• Bretton Woods
• Credit money
• Fiat money
• The Money Masters

Related topics

• list of economics topics
• list of finance topics
• list of business ethics, political economy, and philosophy of business topics

References

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• John F. Kennedy vs The Federal Reserve