Fractional banking refers to a banking system where banks keep only a fraction of their deposits in reserve and lend out the remainder. This practice allows banks to create credit and expand the money supply beyond the amount of base money (such as cash and reserves) held by the central bank. Fractional banking is the foundation of modern banking systems worldwide, facilitating lending and economic growth.
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Key Features of Fractional Banking
- Fractional Reserve Requirement: Banks are required to hold only a fraction of their deposits as reserves. The rest can be lent out to borrowers.
- Money Creation: By lending out more than they hold in reserves, banks effectively create money in the form of loans.
- Credit Expansion: Fractional banking enables the expansion of credit and supports economic activity by providing funds for investment and consumption.
How Fractional Banking Works
Reserve Requirement
Central banks set reserve requirements that dictate the minimum fraction of deposits that banks must hold as reserves. For example, if the reserve requirement is 10%, a bank must keep 10% of its deposits as reserves and can lend out the remaining 90%.
Money Creation Process
- Deposits: Customers deposit money into their bank accounts.
- Reserve: The bank keeps a portion of these deposits as reserves, as required by regulations.
- Lending: The bank lends out the remaining deposits to borrowers, such as individuals and businesses.
- Re-deposit and Repeat: The borrowed money is typically spent and eventually re-deposited into another bank, where the process can repeat, further multiplying the effect of initial deposits.
Example of Fractional Banking
Suppose Bank A has $1,000,000 in deposits and the reserve requirement set by the central bank is 10%. According to this requirement, Bank A must hold $100,000 (10% of $1,000,000) as reserves and can lend out $900,000.
If a borrower takes a $900,000 loan from Bank A, they might use it to purchase a house. The seller, upon receiving the $900,000, deposits it into their bank account at Bank B. Now, Bank B holds $900,000 in deposits. Following the same 10% reserve requirement, Bank B keeps $90,000 as reserves and lends out $810,000.
This process continues, with each bank lending out a portion of the deposits it receives, thereby multiplying the initial deposit and creating new money in the economy.
Importance of Fractional Banking
Credit Availability
Fractional banking ensures that banks can lend out funds beyond the amount of actual deposits they hold, thereby supporting borrowing for investment in businesses, mortgages for homes, and loans for personal consumption.
Economic Growth
By facilitating credit expansion, fractional banking supports economic growth. Businesses can access capital for expansion, individuals can finance large purchases, and overall economic activity increases.
Liquidity Management
Banks use fractional banking to manage liquidity, ensuring they have enough reserves to meet withdrawal demands while also maximizing lending to generate income.
Example of Economic Growth
During an economic downturn, central banks may reduce interest rates to encourage borrowing and spending. Fractional banking allows commercial banks to respond by increasing lending, thereby boosting economic activity through increased investment and consumption.
Criticisms and Risks of Fractional Banking
Risk of Bank Runs
If depositors lose confidence in a bank’s ability to meet withdrawal demands, they may withdraw funds en masse, potentially leading to a bank run.
Financial Instability
Fractional banking can contribute to financial instability during economic downturns if banks face significant loan defaults or if there is a sudden loss of confidence in the banking system.
Regulatory Oversight
To mitigate risks, regulatory authorities impose capital adequacy ratios and other measures to ensure banks maintain sufficient reserves and manage risks prudently.
Example of Financial Instability
In the 2008 financial crisis, excessive lending by banks, facilitated by fractional banking, led to a collapse in mortgage-backed securities markets and widespread bank failures, highlighting the risks inherent in the system.
Conclusion
Fractional banking is a fundamental concept in modern banking systems, allowing banks to lend out more money than they hold in reserves and thereby expanding the money supply. This practice supports credit availability, economic growth, and liquidity management. However, fractional banking also poses risks, including potential bank runs and financial instability, which necessitate careful regulation and oversight by central banks and regulatory authorities. Understanding how fractional banking works is essential for grasping the dynamics of banking and its role in the broader economy.