Fractional Reserve Banking

 Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve as cash and other highly liquid assets. The rest of the deposits are available for the banks to generate more capital. This practice has been in place for over two centuries, when the full-reserve banking principle was used.[br]  

 Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve as cash and other highly liquid assets. The rest of the deposits are available for the banks to generate more capital. This practice has been in place for over two centuries, when the full-reserve banking principle was used.[br]  

How Is The Fractional Reserve Banking Principle Used?

Under the fractional reserve banking principle, banks have ample free cash in their hand. They generally use these ample funds to:

• Provide new loans to their customers

• Invest in various investment options, such as equity and foreign exchange.

 

In this concept, the bank takes loans from its depositors and offers those funds to people in need of them. This means that you are indirectly funding the loans and investments made by your bank. However, this could also mean that if you are taking a loan from your bank, you might be indirectly lending money to yourself.

Advantage of Fractional Reserve Banking

 

The advantages of fractional reserve banking are:

• Fractional reserve banking allows banks to capitalize on the funds lying unused to generate substantial returns.

• When banks lend your money to a customer, it charges interest on the loan. You get part of this interest.

Dangers of the Fractional Reserve Banking Principle

Dangers of this system include:

• The practice of fractional reserve banking expands the supply of money beyond what it actually is. As this principle is used by banks across the world, the broad money supply in most countries is larger than the base money created by the country’s central bank by a specific multiple, also called as money multiplier.

• Limits liquidity and creates the danger of a bank run. This is a situation in which the bank does not have enough funds to honor customer’s demand for the withdrawal of their deposits.[br]

The Role of Financial Regulators in Fractional Reserve Banking

 

Central banks usually act as financial regulators to avoid a bank run because of fractional reserve banking. Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This limits the amount of money creation that occurs in the commercial banking system and ensures that banks have enough cash in hand to meet normal withdrawals demand.