Fractional Reserve Banking

Definition

Fractional reserve banking is a banking system in which banks hold a fraction of their deposits as reserves and use the remainder to make loans and create credit. This practice allows banks to expand the money supply by lending more than they actually possess in physical cash, leading to increased economic activity. It plays a critical role in financial intermediation and credit creation, enabling the flow of funds from savers to borrowers and facilitating investment in the economy.

5 Must Know Facts For Your Next Test

1. In fractional reserve banking, if a bank has a reserve requirement of 10%, it can lend out 90% of its deposits while still meeting customer withdrawal demands.
2. This system enables banks to generate income through interest on loans, while also providing liquidity to the economy by making funds available for investment.
3. Central banks regulate fractional reserve banking by setting reserve requirements, influencing how much money banks can create through lending.
4. When many depositors withdraw their funds simultaneously, it can lead to a bank run, highlighting the inherent risks in fractional reserve banking.
5. Fractional reserve banking can lead to inflation if too much credit is created in the economy without a corresponding increase in goods and services.

Review Questions

• How does fractional reserve banking facilitate the process of financial intermediation?
  • Fractional reserve banking allows financial institutions to act as intermediaries between savers and borrowers. By keeping only a fraction of deposits as reserves, banks can lend out the majority of their deposits to those seeking loans. This process not only provides funds for individuals and businesses but also helps allocate resources efficiently within the economy, enhancing overall economic growth.
• Discuss the implications of high levels of credit creation in a fractional reserve banking system.
  • High levels of credit creation in a fractional reserve banking system can lead to increased economic activity, but it also carries risks such as inflation and financial instability. When banks lend excessively, it may result in more money chasing the same amount of goods and services, driving up prices. Furthermore, if borrowers default on loans during an economic downturn, it can lead to significant losses for banks, threatening their solvency and potentially resulting in a financial crisis.
• Evaluate the role of central banks in regulating fractional reserve banking and maintaining financial stability.
  • Central banks play a crucial role in regulating fractional reserve banking by setting reserve requirements and conducting monetary policy. By adjusting these requirements, central banks influence how much money banks can lend, directly impacting credit creation. Additionally, central banks act as lenders of last resort during times of financial distress, providing liquidity to banks facing insolvency risks. This regulatory oversight helps maintain confidence in the banking system and promotes overall financial stability.

Related terms

Money Multiplier: The money multiplier is a ratio that indicates the maximum amount of money that can be created in the banking system for each unit of reserves held by banks.

Reserve Requirement:

The reserve requirement is the minimum amount of reserves that a bank must hold against its deposits, as mandated by regulatory authorities.

Liquidity:

Liquidity refers to how easily an asset can be converted into cash without affecting its market price, which is crucial for banks to meet withdrawal demands.