Fractional Reserve Banking is the banking system, where, banks lend more money than they really have. In fact, banks just have a small fraction of what they lend out. Fractional Reserve Banking is followed by every modern economy in the world, and even though it sounds scary to people who hear it for the first time; it works pretty well.
At the heart of – fractional reserve banking – is the fact (or idea?) that every bank depositor will not ask for his money back at the same time. Fractional Reserve Banking assumes that only a certain percentage of people will ever demand their money back at the same time, and the rest of the money is free to be utilized productively.
How does the Fractional Reserve Banking system work?
For example – let’s consider that this percentage is 10%, and there are two banks in an economy – The Jeeves Bank, and – Bertie Bank.
Now, suppose that I have $100 and go and make a deposit of $100 with the Bertie Bank. Since, The Bertie Bank, is required to keep just 10% as reserves, it loans out $90 to Ms. Agatha, who wants to start a business, but doesn’t trust the – Bertie Bank enough to bank with them.
So, she goes and opens an account with – Jeeves Bank and deposits her $90 there.
So, now the situation looks like this:
- Ms. Agatha – $90 with Jeeves Bank
- Me – $100 with Bertie Bank
Notice, that with the initial $100, now there are deposits worth $190 in the economy, and what is more – there is still plenty to go around.
Since, Jeeves Bank has got deposits worth $90, and they just need to have a reserve of $9, they can loan out the remaining $81 to Mr. Psmith, who wants to start a – Consultancy Business. Mr. Psmith – then promptly goes out and deposits his $81 with – Bertie Bank, as he doesn’t share the same suspicions as Ms. Agatha.
So, now the score stands at:
- Mr. Psmith – $81
- Ms. Agatha – $90
- MeÂ – $100
Notice, now that the initial $100 has grown to $271.Â But, this is not the end of it, as now – Bertie Bank has an additional $81, which it didn’t have before and can lend out 90% of that to Pongo Little, who needs a little something to start his Onion Soup business.
This cycle could go – on and on, till a 1000 dollars are created in the economy with the initial 100. If the Central Bank was to reduce the reserve required to – 5% – an additional 1000 dollars can be created in the economy.
Pros and Cons of Fractional Reserve Banking
All modern economies use the Fractional Reserve Banking system, and it works quite well as it gives a lot of control in the hands of the central bank to add or reduce the money supply in the economy, and keep a check on excessive liquidity or overheating of an economy.
The disadvantage of using such a system is that a financial crisis can spread elsewhere and panic and rumors can become true in a self-fulfilling prophecy causing bank runs. Bank Runs can occur and financial system be destroyed just by the loss of trust alone.
For example, if one day Ms. Agatha and Mr. Psmith decide that the – Bertie Bank is not to be trusted, and it is better for them to bank with – Jeeves Bank – that would be the end of the Bertie Bank. Since it has loaned out more than it actually has – just the crisis of confidence can cause a systemic crash.