Reserve banking

Definition of fractional reserve banking

What is fractional reserve banking?

Fractional reserve banking is a system in which only a fraction of bank deposits are backed by cash on hand and available for withdrawal. This is done to theoretically develop the economy by freeing up capital for loans.

Key points to remember

  • Banks are required to keep on hand a certain amount of cash that depositors give them, but banks are not required to keep the full amount on hand.
  • Often, banks are required to keep part of the deposits on hand, which is called the bank’s reserves.
  • Some banks are exempt from holding reserves, but all banks receive an interest rate on reserves.

Fractional reserve bank

Understanding fractional reserve banking

Banks are required to keep on hand and available for withdrawal a certain amount of money that depositors give them. If someone deposits $ 100, the bank cannot lend the full amount.

Banks are also not required to keep the entire amount on hand. Many central banks have historically required banks under their jurisdiction to keep 10% of deposits, called reserves. This requirement is set in the United States by the Federal Reserve and is one of the central bank’s tools to implement monetary policy. The increase in reserve requirements takes money out of the economy while the decrease in reserve requirements injects money into the economy.

Historically, the reserve rate required on non-transaction accounts (such as CDs) is zero, while the requirement on transaction deposits (eg, checking accounts) is 10%. Following recent efforts to stimulate economic growth, however, the Fed has also reduced reserve requirements for transaction accounts to zero.

Fractional reserve requirements

Deposit-taking institutions must report their transaction accounts, term and savings deposits, safe cash, and other Fed-bookable obligations to the Fed on a weekly or quarterly basis. Some banks are exempt from holding reserves, but all banks charge an interest rate on reserves called “interest rate on reserves” (IOR) or “interest rate on excess reserves” (IOER) . This rate encourages banks to keep excess reserves.

Banks with assets of less than $ 16.3 million are not required to hold reserves. Banks with assets less than $ 124.2 million but greater than $ 16.3 million have a 3% reserve requirement, and banks with assets greater than $ 124.2 million have a reserve mandatory 10%.

Fractional banking aims to develop the economy by freeing up capital for loans.

Fractional reserve multiplier effect

“Fractional reserve” refers to the fraction of deposits held on reserves. For example, if a bank has $ 500 million in assets, it must hold $ 50 million, or 10%, in reserve.

Analysts refer to an equation called the multiplier equation to estimate the impact of reserve requirements on the economy as a whole. The equation provides an estimate of the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $ 500 million multiplied by one divided by 10%, or $ 5 billion.

This is not how money is actually created, but only a means of representing the possible impact of the fractional reserve system on the money supply. As such, while useful for economics professors, it is generally viewed as an oversimplification by policy makers.

The bottom line

Fractional reserve banking has advantages and disadvantages. It allows banks to use funds (the bulk of deposits) that would otherwise be unused to generate returns in the form of interest rates on loans and to make more money available to grow the economy. However, it could also take a bank overdrawn into the self-perpetuating panic of a bank run.

Many American banks were forced to close during the Great Depression because too many customers tried to withdraw assets at the same time. Nonetheless, fractional reserve banking is an accepted business practice that is used in banks around the world.

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