Fractional reserve banking is a banking system in which banks only keep a small percentage of deposits on hand. The rest of the money is lent out.
Under a fractional reserve banking system, banks expand the money supply with each new loan. This provides the economy with money. At the same time, fractional reserve banking comes with risks such as bank runs. When a large number of depositors attempt to withdraw their money at the same time, banks might not have enough money on hand to pay all depositors.
Fractional reserve banking has its roots in precious metal custody.[1] World Bank: “The History of Banks” Accessed May 2, 2022. Until the beginning of the 19th century, most countries were on a silver or gold standard.
Due to their special properties, silver and gold became the predominant forms of money. They acted as store of value, medium of exchange and unit of account.
In order to protect and safeguard their wealth, people deposited their coins and bullion at gold smiths. In return, they received paper receipts that were redeemable into gold at any time. These paper receipts were so convenient that people used them as money substitutes and conducted trade with them.
Money substitutes overcame an important limitation of precious metals. They were easier to transport and more convenient to use for daily transactions.
These paper receipts became so widely accepted that one could go to any gold smith and redeem them for actual money. A person could deposit gold at a goldsmith and receive a paper receipt. The same person could then travel across the country, go to another gold smith many miles away and exchange the paper receipt for an equal amount of gold.
This is how the modern banking system started.
As people began holding and trading primarily paper receipts, gold smiths realized that people rarely demanded all their gold at the same time.
This left gold smiths holding a large percentage of precious metals, with few people ever withdrawing a large part of their deposits at the same time. As a result, gold smiths discovered a new business opportunity.
Instead of keeping 100% of precious metal, gold smiths only kept a small percentage on hand and lent out the rest of the gold or silver to earn interest.
This is how fractional reserve banking was born. The fractional reserve is the amount of precious metal a gold smith or bank kept on hand in case depositors wanted to redeem their paper receipts and demanded gold or silver.
However, when too many people demanded their deposits at the same time, gold smiths didn’t have enough gold or silver on hand to pay out all depositors.
This led to frequent bank runs, where people panicked and attempted to withdraw their deposits at the same time. In case banks couldn’t cancel enough loans or borrow money from other places to repay depositors, they faced bankruptcy and depositors lost their money.
Bank panics and bank runs were frequent occurrences in the early fractional reserve banking system. The reason for this is because banks can easily overextend loans and keep too little reserves on hand.
For example, a bank might notice that few depositors ever demand their deposits. In order to increase revenue, the bank decides to further reduce its reserves and lend out more deposits.
This allows the bank to earn more interest. Under normal circumstances, this might work well. But during an economic crisis or other event that causes depositors to panic, many depositors might attempt to withdraw their money simultaneously in a short period of time.
If the bank only kept 1% as fractional reserve, the bank might quickly run out of money to pay depositors. The first few depositors might be able to get their money.
But as lines grow longer and crowds of people gather in front of banks, all demanding their money, the bank can quickly face insolvency unless it can cancel enough loans or borrow money from another place to pay depositors.
Due to frequent bank panics and bank runs, and the the risks and instability this can bring to the economy, many countries established central banks.
Central banks go back as early as the 16th century. The first central bank, the Swedish Riksbank, was created in 1668 to bring stability to the fractional reserve banking system.[2] Federal Reserve Bank of Cleveland: “A Brief History of Central Banks” Accessed May 2, 2022.
Central banks could set reserve requirements. They could make sure commercial banks held enough reserves on hand to satisfy depositor requests in case of a crisis.
While many countries in Europe already had central banks, the Untied States established the Federal Reserve in 1913 after several earlier attempts at creating a central bank.[3] Federal Reserve: “History of the Federal Reserve” Accessed May 2, 2022.
The Federal Reserve, similar to other central banks, was established to prevent bank panics and bank runs that were frequent in the 18th century.[4] Federal Reserve Bank of Cleveland: “A Brief History of Central Banks” Accessed May 2, 2022.
The Federal Reserve sets the reserve requirement for the fractional-reserve banking system in the United States. It also sets the target interest rate at which banks can provide overnight loans to each other.
Each commercial bank has to keep an account at the Federal Reserve. In this account, the bank holds its reserves. Banks that hold excess reserves at the Federal Reserve can provide overnight loans to other banks that have a shortage.[5] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.
This allows banks with a lot of reserves to lend their excess reserves to struggling banks that might see an increased demand in withdrawals or face other liquidity issues.
The target interest rate at which commercial banks provide overnight loans to each other is called the federal funds rate. However, in case a bank faces insolvency and loans provided by other commercial banks aren’t enough, the Federal Reserve can step in as lender of last resort.
In this case, the central bank itself lends money to the struggling bank. Since the 2008 Global Financial Crisis, the Federal Reserve also uses more exotic monetary policy instruments, such as quantitative easing, to provide struggling commercial banks with money.
Each country’s central bank defines the reserve requirements for commercial banks. In most cases, the reserve requirement for large banks and financial institutions is 10%.
Certain financial institutions that handle smaller sums of money are subject to lower reserve requirements.
In the United States, liabilities up to $16.9 were exempt from reserve requirements, liabilities up to $127.5 million required 3% as reserves until recently.[6] Federal Reserve: “Calculation of Reserve Balance Requirements” Accessed May 2, 2022. As of March 2020, since the beginning of the Covid-19 pandemic, the Federal Reserve removed all reserve requirements for commercial banks.[7] Federal Reserve: “Reserve Requirements” Accessed May 2, 2022.
While there is no minimum reserve requirement for fractional reserve banking in the United States anymore, banks can earn interest by keeping reserves at an account at the Federal Reserve.
The Federal Reserve mentioned that its removal of minimum reserve requirements isn’t temporary but permanent. However, other countries still have reserve requirements in place.
Fractional reserve banking provides credit to the economy and expands the money supply. Every time a commercial bank provides a loan, new credit money is lent into existence.
If person A deposits $100 at bank A, the bank will keep $10 and lend out $90 to person B. However, both the $100 “owned” by person A and the $90 that person B receives, count as money.
This means, by lending out $90 the bank expanded the money supply by $90. The initial money supply was $100. After the bank loan, the money supply is $190.
But let’s assume person B deposits his money at a second bank B. This bank now keeps $9 on hand and lends out $81 to person C. This additional $81 loan is lent into existence. It counts as new money along with the original money “owned” by person B.
This continues as the money is further lend out. Person C deposits his $81 at bank D, which keeps $8.1 as reserve and lends out $72.9 and so forth.
As the money works itself through the financial system, the money supply expands. This is the multiplier effect. In a perfect fractional reserve banking system, where each bank keeps 10% as reserve, the money multiplier is the inverse of the reserve requirement.
If the reserve requirement is 10%, the money multiplier is 10. This means, an initial deposit could theoretically grow the money supply tenfold. However, this traditional theory about fractional reserve banking and the money multiplier has been challenged.[8] Federal Reserve: “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” Accessed May 2, 2022.
The federal funds rate, the target interest rate at which banks lend their excess reserves to each other on an overnight basis, also impacts the money supply. If the federal funds rate is low, other interest rates throughout the economy follow suit.
By lowering the fed funds rate, the Federal Reserve makes borrowing cheaper. This leads to more individuals and companies borrowing money from banks. As a result, more bank loans are created, leading to more new credit money in the economy.
On the flip side, when bank loans are paid back or the Federal Reserve increases the federal funds rate, this slows down the creation of new credit money or even contracts the money supply.
By expanding the money supply, the economy might grow faster. Due to fractional reserve banking, investments in new companies don’t need to be based on savings alone. Instead, investments are based on credit money which is loaned into existence by commercial banks.
In times of economic crisis, the Federal Reserve might lower the federal funds rate. This makes credit cheaper and incentivizes borrowing. It also leads to an expansion of the money supply, which can counteract an economic downturn.
Despite the establishment of the Federal Reserve in 1913, the United States experienced its worst economic crisis less than two decades later during the Great Depression.
There are different theories about the causes and consequences of the Great Depression. But the fractional reserve banking system might have contributed to the economic crisis.
During the Great Depression, many depositors attempted to get their money out of banks at the same time.[9] Roth, Benjamin: The Great Depression. A Diary (2010), pp. 11ff. Crowds of people waited in front of bank tellers, quietly lined up to withdraw their deposits.
As the bank runs intensified, many banks didn’t have enough money on hand to pay depositors and went bankrupt. Bank failures were an almost daily occurrence. This further shattered people’s trust in the banking system and led to subsequent bank runs and additional bank failures.
In order to restore faith in the banking system, president Roosevelt established the Federal Deposit Insurance Corporation (FDIC) which insures all bank deposits up to a certain amount.[10] Federal Deposit Insurance Corporation: “History of the FDIC” Accessed May 2, 2022.
Without introducing the FDIC, it is questionable how quickly people would have trusted the banking system after the Great Depression.
Many economists view the fractional reserve banking system as something positive and necessary. It provides commercial banks with a way to expand the money supply by issuing credit.
It also provides central banks with ways to influence the money supply through monetary policy instruments such as the federal funds rate.
However, there is some debate about the necessity, usefulness and risks of the fractional reserve banking system. Economist Irving Fisher suggested a full reserve banking system to lift the United States out of the Great Depression.[11] Allen, William R.: Irving Fisher and the 100 Percent Reserve Proposal, In: Journal of Law and Economics, Vol. 36, No. 2 (1993), pp. 703-717.
The Global Financial Crisis of 2008 sparked renewed interest in the discussion about the risks of fractional reserve banking.
Some heterodox economists argue that fractional reserve banking leads to boom and bust cycles and is fraudulent. This view is especially prominent among proponents of the Austrian school of economics.
Murray Rothbard believed that fractional reserve banking is a fraud because banks are unable to keep their contractual obligation to both depositors and borrowers.[12] Rothbard, Murray N.: The Mystery of Banking (2008).
If the borrower has a right to the loaned sum and the depositor has a right to the same money, one can argue that this is a form of accounting fraud.
Critics of fractional reserve banking argue that the practice should be illegal. They view it as fraudulent and something that destabilizes the economy and banking system. Instead, critics express that through the creation of central banks, the risky practice of fractional reserve banking was nationalized.
They attribute the expansion of the money supply through cheap credit to boom and bust cycles. This is prominently expressed in the Austrian Business Cycle theory. They also view the transfer of purchasing power from the general public to governments and banks through inflation as a form of theft.
According to them, fractional-reserve banking and central banks should be abandoned in favor of commodity money and full reserve banking.