Fractional Reserve Banking

Definition

Fractional reserve banking is a banking system where banks only hold a fraction of their total deposits as cash reserves, and use the remaining deposits to make loans. This allows banks to create money through the lending process, but also introduces the risk of bank runs and financial instability.

5 Must Know Facts For Your Next Test

1. Fractional reserve banking allows banks to lend out a portion of their deposits, creating new money and expanding the money supply.
2. The reserve requirement set by central banks determines the minimum fraction of deposits that banks must hold as reserves.
3. The money multiplier effect describes how banks can use their fractional reserves to create new loans and deposits, increasing the overall money supply.
4. Fractional reserve banking can lead to bank runs if depositors lose confidence in a bank's ability to meet withdrawal demands.
5. Central banks and regulators play a key role in monitoring and regulating the fractional reserve banking system to maintain financial stability.

Review Questions

• Explain how fractional reserve banking allows banks to create money and expand the money supply.
  • In a fractional reserve banking system, banks are only required to hold a fraction of their total deposits as cash reserves, typically set by the central bank. This allows banks to lend out the remaining deposits, creating new loans and deposits in the process. As these new deposits are lent out again, the money supply expands through the money multiplier effect. This money creation process is a key feature of fractional reserve banking, but it also introduces the risk of financial instability if banks do not maintain adequate reserves.
• Describe the role of the central bank in regulating the fractional reserve banking system.
  • Central banks play a crucial role in regulating the fractional reserve banking system to maintain financial stability. They set the reserve requirement, which determines the minimum fraction of deposits that banks must hold as reserves. Central banks can also use monetary policy tools, such as adjusting interest rates or conducting open market operations, to influence the availability of reserves and the lending activities of banks. By monitoring the banking system and intervening when necessary, central banks aim to ensure that the fractional reserve system operates in a way that supports economic growth and financial stability.
• Analyze the potential risks associated with fractional reserve banking and the measures taken to mitigate them.
  • The fractional reserve banking system introduces several risks, including the potential for bank runs and financial instability. If depositors lose confidence in a bank's ability to meet withdrawal demands, a bank run can occur, where large numbers of depositors simultaneously withdraw their funds. This can lead to a liquidity crisis and potentially a broader financial crisis. To mitigate these risks, central banks and regulators implement measures such as setting reserve requirements, providing deposit insurance, and establishing lender-of-last-resort facilities. These measures aim to maintain public confidence in the banking system, ensure banks have sufficient liquidity, and prevent the spread of financial contagion. However, the inherent leverage and money creation process of fractional reserve banking also means that the system remains vulnerable to shocks and imbalances, requiring ongoing monitoring and regulation to maintain financial stability.

Related terms

Reserve Requirement:

The minimum amount of cash reserves that banks are required to hold as a percentage of their total deposits.

Money Multiplier:

The process by which banks can create new money through the lending of their fractional reserves, leading to an expansion of the money supply.

Bank Run:

A situation where a large number of depositors simultaneously withdraw their funds from a bank, due to a loss of confidence in the bank's ability to repay its obligations.