Banking systems are an institution people often trust without knowing much about how they work. What happens to an account holder’s money after they deposit it? Fractional reserve banking can help answer that. Fractional reserve banking is a system that can help stimulate the economy, but can also create financial chaos in a worst-case scenario.
What Is Fractional Reserve Banking?
Fractional reserve banking is a system where only a fraction of the cash banks have is liquid. In other words, banks only keep a fraction of the cash customers deposit in reserves and lend the rest out. They may also use remaining funds to invest to grow their available cash reserves.
The interest banks charge on loans to customers is typically used to pay for expenses and generate more cash. The goal of fractional reserve banking is to stimulate the economy by helping more cash circulate while also meeting customer withdrawal needs.
The Federal Reserve doesn’t always make it mandatory for banks to have a minimum reserve, but there was a time when it was necessary to have a percentage in reserves.
Benefits of Fractional Reserve Banking
If every customer’s money sat in banks untouched, it would lower the risk of banks going bust but it would also leave cash sitting idly. Fractional reserve banking makes it possible to put what would be idle money to use and stimulate the economy through lending and investing.
As an example, if you have $20,000 sitting in your savings account, the bank may leave $15,000 there and lend $5,000 to a customer who needs a loan. They could also take the interest they charge on that loan and invest it in real estate, bonds, or stocks.
The Money Multiplier
The money multiplier is the idea that customer deposits can increase the total money supply-the end goal of fractional reserve banking.
The money multiplier equation is:
Money multiplier = change in total money supply / change in monetary base
By example, if a bank had a deposit of $50,000 and they ended up with a money supply of $500,000, the multiplier would be 10.
Risks of Fractional Reserve Banking
One of the catalysts of the financial crisis during the Great Depression was banks running out of money when too many people withdrew funds at once. This led to many Americans losing their life savings which was catastrophic.
Based on these moments in history, some people believe it’s possible for banks to fail again and history repeat itself. While this is a risk, the reality is that most people don’t need all of their money at once. Even when a customer does decide to withdraw all of their money, the bank can usually provide their balance by tapping into reserves from another customer. Oftentimes, people only rush in droves to withdraw their money when they fear banks may fail like during the Great Depression. The Federal Deposit Insurance Corporation (FDIC) also established the Banking Act of 1933 to prevent said events from happening again. The FDIC protects deposits in participating banks, up to certain limits.
The central bank has the authority to set a mandate on how much cash banks have to keep in their reserves. In 2002, the requirement was 10% of a bank’s demand and checking deposits and the requirement has continued to change over the years.
Fractional reserve banking can be good for the economy but it also carries risk.
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