Fractional Banking is a banking system that requires banks to hold only a portion of the money deposited with them as reserves. The banks use customer deposits to make new loans and award interest on the deposits made by their customers.
The reserves are held as balances in the bank’s account at the central bank or as currency in the bank. The reserve requirement allows commercial banks to act as intermediaries between borrowers and savers by giving loans to borrowers and providing immediate liquidity to depositors who want to make withdrawals.
The fractional banking system came into place as a solution to problems encountered during the Great Depression when depositors made many withdrawals, leading to bank runs. The government introduced the reserve requirements to help protect depositors’ funds from being invested in risky investments.
For example, if a person deposits $1,000 in a bank account, the bank cannot lend out all the money. It is not required to keep all the deposits in the bank’s cash vault. Instead, banks are required to keep 10% of the deposits, i.e., $100, as reserves, and may lend out the other $900. The Federal Reserve sets the reserve requirement as one of the tools for guiding monetary policy.
History of Fractional Banking
The concept of fractional banking emerged during the gold trading era, with the realization that not all people needed their deposits at the same time. When people deposited their silver and gold coins at goldsmiths, they were given a promissory note. The notes were later accepted as a means of exchange, and the holders used them in commercial transactions.
Since the notes were used directly in trade, the goldsmiths realized that not all savers would withdraw their deposits at the same time. They started using the deposits to issue loans and bills at high interest, in addition to the storage fee charged to the deposits. The goldsmiths then transitioned from being guardians of valuables to interest-paying and interest-earning banks.
If the noteholders lost faith in the goldsmiths, they would withdraw all their coins and other deposits simultaneously. In a situation where a bank did not have enough reserves to support the mass withdrawals, it would end up in insolvency. Due to the risk posed to consumer deposits by banks, various governments came up with laws to set up a central control agency to regulate the banking industry.
Sweden was the first country to establish a central bank in 1668, and other countries followed suit. The central banks were given the power to regulate commercial banks, set reserve requirements, and act as a lender of last resort to commercial banks that were affected by bank runs.
Reserve requirements, or the reserve ratio, are central bank regulations that dictate the minimum amount of reserves that a bank should hold. Some countries, such as Canada, the United Kingdom, Australia, Sweden, New Zealand, and Hong Kong do not impose reserve requirements. Instead, banks in these countries are constrained by capital requirements. When a commercial bank’s reserves deplete, the central banks in these countries step in to offer the needed reserves.
In the United States, the reserves are held in the bank’s vault or the nearest Federal Reserve Bank. The Board of Governors of the Fed set the reserve requirements and use it as one of the tools of guiding monetary policy. As of January 2016, commercial banks with deposits of less than $15.2 million were not required to maintain reserves.
Banks with deposits valued at $15.2 million to $110.2 million were required to maintain the reserve requirement at 3% while those with more than $100.2 million in deposits were required to keep a reserve requirement of 10%. The Garn-St. Germain Act of 1982 exempted the first $2 million of reserve liabilities from the reserve requirements.
Banks must hold no less than the set reserve requirement. They are allowed to hold reserves in excess of the required percentage. Any reserves beyond the level of reserve needed are termed excess reserves. The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay interest on excess reserves starting October 1, 2008. Some banks hold excess reserves as a safety measure in the event of mass cash withdrawals by customers, especially during periods of economic uncertainty.
How Banks Create Money
Commercial banks are required to hold only a fraction of customer deposits as reserves and may use the rest of the deposits to award loans to borrowers. When giving loans, commercial banks accept promissory notes in exchange for credit that is deposited in the borrower’s account in the bank. Deposits to the borrower’s account, as opposed to giving loans in the form of currency, are part of the process banks use to create money.
When a bank issues a loan, it creates new money, which in return increases the money supply. For example, when a person borrows a $100,000 mortgage loan, the bank credits the borrower’s account with money equal to the size of the mortgage loan instead of giving them currency amounting to the value of the loan.
The Money Multiplier
The money multiplier measures the amount of commercial bank money that can be created using a specific unit of central bank money. Commercial bank money refers to the demand deposits in the retail bank that you can use to write checks or use a debit or credit card.
Central bank money, on the other hand, refers to the money adopted by the central bank and includes precious metals, coins, banknotes, reserves held in accounts with the central banks, and anything else used by the central bank as a form of money. Analysts use the multiplier equation to estimate the impacts of the reserve requirements on the economy. The equation is expressed as follows:
m is the money multiplier
R is the reserve requirement
In this respect, the central bank can alter the money supply by changing the reserve requirement. For example, if it sets a reserve requirement of 10%, it creates a money supply equal to ten times the amount of reserves. A 20% reserve requirement creates a money supply equal to five times the amount of reserves in the economy.
The banking industry is the backbone of an economy. To learn more about the banking system, we suggest the following CFI readings.